Events: Quick Thoughts
March 5, 2016
- NYSE: VRX
- Recent PPS: $61.34
- Shares Out: 351 million
- Market Cap: $21,530
- 3Q15 Net Debt: $28,431
- Enterprise: $49,962
- Normalized PE: 13.9 times (EV/NOPAT)
Since puking up VRX in early November, I have had the ability to monitor the situation from the sideline with a relatively clear mind. Many lessons wrapped up in a single stock; but before getting into them, a brief timeline of events:
- April 2014 – Allergan deal confusion drives stock from over $145 to below $120 in April 2014.
- August 2014 – On-going Allergan saga + high profile short seller coverage drives stock to below $110 in August 2014.
- Late 2014 to Early 2015 – Allergan deal confusion + short seller created ‘entry catalyst’; Allergan-related increased financial transparency + late 2014 Allergan deal failure + early 2015 Salix acquisition created ‘upside catalyst’, driving VRX to over $200.
- Early 2015 thru July – Above-mentioned upside catalysts + narrow broad market advance led to a ‘dog pile’ into VRX thru July 2015, driving the stock to over $250.
- August to mid-November – Broad market weakness + healthcare ‘hedge fund trade’ unwind + Philidor scandal leads to a collapse in VRX to $70 in mid-November.
- Mid-November thru mid-December – Seller exhaustion + Pershing Square ‘doubling down’ + Walgreens agreement drives VRX from $70 to almost $120 (actually may have breached $120 intra-day) in mid-December.
- Mid-December 2015 thru early March 2016 – CEO Mike Pearson goes on sick leave + confusion around guidance + ultimate removal of guidance + 10K delay + short seller(s) ‘red zone’ dance + broad market weakness leads to new 52-week low below $60.
17 Mile VRX involvement
- Initiate long-term position in April 2014 on Allergan deal-related ‘entry catalyst’
- Add in August 2014 on short seller-related forced selling
- Super-size in late 2014 on deal conclusion ‘special situation’
- Reduce to core long-term position in December 2014 upon conclusion of special situation catalyst
- Hold position thru July 2015
- Exit position entirely in mid-August
- Re-enter position in late September on Hillary tweet-related weakness
- Exit position in mid-October on concerns Hillary-related weakness indicative of larger concerns
- Re-initiate in late October once Philidor scandal hit
- Puke once and for all in early November
As I will outline in detail in the upcoming investment letter, the VRX situation encapsulates my investment philosophy, portfolio management style, and the critical/painful lessons learned over the last several months.
- Philosophy. I will get the exact statistic wrong, but the average stock fluctuates something like 50% from low to high over any given 12-month period. While VRX – and the market environment from June 2014 thru now – perhaps is a bit of an extreme example due to the ‘inhuman volatility’ exhibited recently, the point is well-demonstrated that stock prices and investment theses fluctuate WILDLY over a very short amount of time. The relatively high turnover 17M strategy is predicated on this dynamic…in other words: think long-term in evaluating the value of a business, but manage the position according to the fact that the market’s assessment of said ‘value’ fluctuates wildly over a 1-2 year period.
- PM style. Not only was the VRX situation my quintessential investment situation – quality underlying business + entry catalyst + upside catalyst + expert backing – but it fully embodied my portfolio management style. I established a core long-term position into an attractive entry catalyst, then doubled down upon further forced-selling weakness. Once the final bottom was established, I added on the way up once a special situation upside catalyst was identified. And while VRX happened to work out quite quickly on the upside, once a position is ‘working’ in my favor, I leave it alone, as I did with VRX thru July 2015.
- Lesson Learned. My involvement with VRX from late September 2015 thru early November 2015 crystallizes – PERFECTLY – how I need to adapt my portfolio management style to volatile/distressed market environments. I run a highly concentrated, aggressive portfolio; and when the market backdrop is relatively stable, this is fine. [And when I say ‘market’ I mean broad market, sector and company…or some combination thereof.] But in the environment that has been in place since July 2015 – for the broad market, healthcare, and VRX – this style has failed miserably. Being heavily concentrated thru extreme downside volatility is incompatible with sound decision making. In a nutshell, thru a great amount of performance pain I have learned to ‘let the market come to me’. Even with a stable market backdrop, it pays to be patient – all the more in a volatile environment.
Prior to my early November ‘puke’, I had established a plan to average down on the core position I had initiated around the time of Pershing Square’s marathon VRX defense conference call; but once the stock declined more than 15% on 11/5/15 on no news, I went against my plan and sold. The stock went on to decline to just over $70 on 11/17/15, thus ‘justifying’ my sale. But like clockwork, the stock went on to rally to almost $120 in mid-December. I had moved on, but it was painful nonetheless.
Key lesson: STICK TO YOUR PLAN (it rarely pays otherwise)
In the November 2015 ‘Quick Thoughts‘ post I outlined why I believed the market was ‘telling’ us something with regard to VRX’s earnings power. Recent events would suggest that was the correct conclusion.
Obviously hindsight is 20-20, but this situation highlights how critical it is to let the market ‘come to you’. Had I stuck to my plan in early November and added to the position, I would have been sitting pretty in mid-December. But I likely would have rode the position down to current lower lows!!
Overriding lesson: Rationally assess the market environment (broad market, industry, and stock); and if volatile/distressed, let the market ‘come to you’ and be cold blooded about exiting even the highest conviction long-term position.
VRX SITUATIONAL UPDATE
I taunted a short seller on ‘FinTwit’ in July/August 2015, saying that I would gladly purchase $180 strike puts from them, as I would be more than happy to ride VRX to $0 alongside some of the smartest long-term money in the world. Be careful what you wish for…or taunt about…
It is ASTONISHING the confusion around the financials/business model of such a large, widely-covered company. In a nutshell it is ValueAct Capital – on the board since 2008; recruiter of Mike Pearson; affirmer of the accounting; intimately involved with the acquisition program – versus short seller John Hempton – Australian blogger; Bill Ackman despiser; outside observer. (This who v. who could be expanded to Pershing Square v. blogger AZ Value, and Mike Pearson v. Andrew Left…and so on and so forth.)
I repeat – ValueAct Capital has been on the board since 2008, and intimately involved with the acquisition program. The ‘shorts’ will laugh at this statement…but VAC is an extremely upstanding organization, and would not even think about touching a fraudulent accounting operation. (Ironically, one of the ‘shorts’ is a big believer in VAC…)
Emphatically, VRX is NOT a donut.
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After a smoking hot 1H15, the healthcare sector has remained volatile into 2016 as ‘hot money’ takes profits and deleverages more broadly. And that is on top of a very poor broad market environment – one that remains at record high valuations, in a well-defined downtrend, no longer has monetary conditions at its back (Fed tightening; uptrend in HY spreads), and faces a poor global economy.
So with an already unfavorable market backdrop, VRX has not done its stock price any favors by ‘stepping on its crank’: Mike Pearson goes on leave; SEC investigation announced; 10-K delayed; Pearson returns; guidance pulled; analyst meeting scheduling confusion; Pershing Square shenanigans. Not a great recipe for stock price stability.
But for those on the sidelines, the current set-up can be viewed as one enormous ‘entry catalyst’…as long as a ‘donut’ can be ruled out, and normalized earnings power determined.
Price is an amazing thing – at $61.34, I have VRX’s enterprise value trading at 13.9 times extremely conservative normalized earnings power. And while I am waiting for 12.5 times to begin averaging into the stock, the risk/reward is a completely different ball game at this level than it was just a few months ago over $100 (obviously).
For all of the bearishness around the Company and its business model, the analyst community continues to project robust financial performance. Consider – Jefferies has a $106 price target, yet projects the following:
- 2016: $12.5 billion
- 2017: $13.7
- 2018: $14.9
- 2019: $15.9
- 2020: $17
- 2016: $7 billion
- 2017: $7.9
- 2018: $8.6
- 2019: $9.2
- 2020: $9.9
- 2016: $13.38
- 2017: $16.13
- 2018: $18.22
- 2019: $20.2
- 2020: $22.30
I believe the answer lies somewhere in the middle: not as robust as the Jefferies projections, but not as dire as the short sellers would lead you to believe.
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It is clear VRX needs to change its business model in the medium-term. The trillion $$$ acquisition runway must be set aside while the Company deleverages and reinvests in organic growth. And because Mike Pearson ‘flew too close to the sun’, pricing power is gone…so margins need to come down, both due to lower pricing and the fact that R&D needs to rise in order to make up for the loss of highly accretive price-driven acquisitions (i.e. Marathon and Dendreon).
I normalize earnings power via the following: establish a ‘base’ level of revenue by averaging 2015- and 2016-estimated revenue, and set normalized EBITDAM to 45%, down from an estimated 55% in 2016. And due to the fact that VRX carries an above-average level of debt, I value the Company on an EV/NOPAT basis.
On a normalized basis I calculate that VRX is worth approximately $98.70, or 17.5 times normalized NOPAT. Assuming five years of deleveraging, and a 17.5 times EV/NOPAT terminal multiple, VRX is worth approximately $113.12.
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My target price to begin averaging into the stock is $47.36 – 12.5 times normalized NOPAT. I have no clue if it will get down to that level, but given how poorly the stock has been behaving I do not believe it is a stretch…especially if the broad market takes another leg down. Further – given the recent lessons learned, and how extremely ‘broken’ the VRX stock price remains, it is imperative that I average into the position over a period of weeks – not days – on big down days.