Thursday, March 23, 2017

A Valeant Update: Damaged Goods or Deeply Discounted Drug Company?


Rats get a bad rap for fleeing sinking ships. After all, given that survival is the strongest evolutionary impulse and that rats are not high up in the food chain, why would they not? That idiom, unfortunately, is what came to mind as I took another look at Valeant, the vessel in my investment portfolio that most closely resembles a sinking ship. This is a stock that I had little interest in, during its glory days as the ultimate value investing play, but that I took first a look at, after its precipitous fall from grace in November 2015. While I stayed away from it then, I bought it in May 2016 after it had dropped another 60% and I found it cheap enough to add to my portfolio. I then compounded my losses when I doubled my holding in October 2016, arguing that while it was, at best, an indifferently managed company in a poor business, it was under priced at $14 . With the stock trading at less than $12 (and down to $10.50, as I write this post) and its biggest investor/promoter abandoning it, there is no way that I can avert my eyes any longer from this train wreck. So, here I go!

Valeant: A Short (and Personal) History
I won't bore you by repeating (for a third time) the story of Valeant's fall from investment grace, which happened with stunning speed in 2015, as it went from value investing favorite to untouchable, in the matter of months. My first post, from November 2015, examined the company in the aftermath of the fall, as it was touted as a contrarian bet, trading at close to $90, down more than 50% in a few months. My belief then was that the company's business model, built on acquisitions, debt and drug repricing was broken and that the company, if it became a more conventional drug business company, with low growth driven by R&D, was worth $73 per share. I revisited Valeant in April 2016, after the company had gone through a series of additional setbacks, with many of its wounds self inflicted and reflecting either accounting or management misplays. At the time, with the updated information I had and staying with my story of Valeant transitioning to a boring drug company, with less attractive margins, I estimated a value per share of $44, above the stock price of $33 at the time. I bought my first batch of shares. In the months that followed, Valeant's woes continued, both in terms of operations and stock price. After it announced a revenue drop and a decline in income in an earnings report in November 2016, the stock hit $14 and I had no choice but to revisit it, with a fresh valuation. Adjusting the valuation for the new numbers (and a more pessimistic take on how long it would take for the company to make its way back to being a conventional, R&D-driven pharmaceutical company, I valued the shares at $32.50. That may have been hopeful thinking but I added to my holdings at around $14/share.

Valeant: Updating the Numbers
Since that valuation, not much has gone well for the company and its most recent earnings report suggests that its transition back to health is still hitting roadblocks. While talk of imminent default seems to have subsided, there seems to be overwhelming pessimism on the company's operating  prospects, at least in the near term. In its most recent earnings report, Valeant reported further deterioration in key numbers:
2016 10K2015 10K% Change
Revenues$9,674.00 $10,442.00 -7.35%
Operating income or EBIT$3,105.46 $4,550.38 -31.75%
Interest expense$1,836.00 $1,563.00 17.47%
Book value of equity$3,258.00 $6,029.00 -45.96%
Book value of debt$29,852.00 $31,104.00 -4.03%
Much as I would like to believe that this decline is short term and that the stock will come back, there is now a real chance that my story for Valeant, not an optimistic and uplifting story to begin with, is now broken. The company's growth strategy of acquiring other companies, using huge amounts of debt, raising prices on "under priced" drugs and paying as little in taxes as possible were perhaps legally defensible but they were ethically questionable and may have damaged its reputation and credibility so thoroughly that it is now unable to get back to normalcy. This can explain why the company has had so much trouble not only in getting its operations back on track but also why it has been unable to pivot to being a more traditional drug company. If researchers are leery about working in your R&D department, if every price increase you try to make faces scrutiny and push back and your credibility with markets is rock bottom, making the transition will be tough to do. It can also indirectly explain why Valeant may be having trouble selling some of its most lucrative assets, as potential buyers seem wary of the corporate taint and perhaps have lingering doubts about whether they can trust Valeant's numbers.

In fact, the one silver lining that may emerge from this experience is that I now have the perfect example to illustrate why being a business entity that violates the norms of good corporate behavior (even if their actions legal) can destroy value. At least in sectors like health care, where the government is a leading customer and predatory pricing can lead to more than just public shaming, the Valeant story should be a cautionary note for others in the sector who may be embarking on similar paths.

The Ackman Effect
You may find it strange that I would spend this much time talking about Valeant without mentioning what may seem to be the big story about the stock, which is that Bill Ackman, long the company's biggest investor and cheerleader and for much of the last two years, a powerful board member, has admitted defeat, selling the shares that Pershing Square (his investment vehicle) has held in Valeant for about $11 per share, representing a staggering loss of almost 90% on his investment. The reasons for my lack of response are similar to the ones that I voiced in this post, when I remained an Apple stockholders as Carl Icahn sold Apple and Warren Buffett bought the stock in April 2016. As an investor, I have to make my own judgments on whether a stock fits in my portfolio and following others (no matter how much regard I have for them) is me-too-ism, destined for failure.  

Don't get me wrong! I think Bill Ackman, notwithstanding his Valeant setbacks, is an accomplished investor whose wins outnumber his losses and when he takes a position (long or short) in a stock, I will check it out. That said, I did not buy Valeant because Ackman owned the stock and I am not selling, just because he sold. In fact, and this may seem like a stretch, it is possible that Ackman's presence in the company and the potential veto power that he might have been exercising over big decisions may have become more of an impediment than a help as the company tries to untangle itself from its past. I am not sure how well-sourced these stories are, but there are some that suggest that it was Ackman who was the obstacle to a Salix sale last year.

Valeant: Three Outcomes
As I see it, there are three paths that Valeant can take, going forward.
1. Going Concern: To value Valeant as a going concern, I revisited my valuation from November 2016 and made its pathway to stable drug company more rocky by assuming that revenues would continue to drop 2% a year and margins will stay depressed at 2016 levels for the next 5 years and that revenue growth will stay anemic (3% a year) after that, with a moderate improvement in margins. With those changes put in and leaving the likelihood that the company will not make it at 10% (since the company has made some headway in reducing debt), the value per share that I get is $13.68. 
To illustrate the uncertainty associated with this value estimate, I ran a simulation with my estimated distributions for revenue growth, margins and cost of capital and arrived at the following distribution of values.

The simulation confirms the base case intrinsic valuation, insofar as the median value of $13.31 is close to the price at the time of the valuation ($12) but it provides more information that may or may not tilt the investment decision. There is a clear chance that the equity could go to zero (about 12%), if the value dips below the outstanding debt ($29 billion). At the same time, there is significant upside, if the company can find a way to alter its trajectory and become a boring, low growth drug company.
2. Acquisition Target: It is a sign of desperation when as an investor, your best hope is that someone else will acquire your company and pay a premium for it. I am afraid that the Valeant taint so strong and its structure so opaque and complex that very few acquirers will want to buy the entire company. I see little chance of this bailing me out.
3. Sum of its parts, liquidated: It is true that Valeant has some valuable pieces in it, with Bausch & Lomb and Salix being the biggest prices. While neither business has attracted as much attention as Valeant had hoped, there are two reasons why. The first is that Ackman, with significant losses on the stock and a seat on the board, may have exercised some veto power over any potential sales. The second is that potential buyers may be scared away by Valeant's history. One solution, now that Ackman is no longer at the company, is for Valeant to open its books to potential acquirers and sell its assets individually to the best possible buyers. Note that this liquidation value will have to exceed $29 billion, the outstanding debt, for equity investors to generate any remaining cash.

There is one other macro concern that may make Valeant's future more thorny. As a company that pays a low effective tax rate and borrows lots of money, the proposed changes to the tax law (where the marginal tax rate is likely to be reduced and the tax savings from interest expenses curbed), Valeant will probably have to pay a much higher effective tax rate going forward, one reason why I have shifted to a 30% tax rate for the future.

The Bottom Line
Let's start with the easy judgment. This was not an investment that I should have made and much as I would like to blame macro forces, the company's management and Bill Ackman for my losses, this was my mistake. I was right in my initial post in concluding that the company's old business model (of acquiring growth with borrowed money and repricing drugs) was broken but I clearly underestimated how much damage that model has done to the company's reputation and how much work it will take for it to become a boring, drug company. In fact, it is possible that the damage is so severe, the company will not be able to make the adjustments necessary to survive as a going concern. 

So, now what? I cannot reverse the consequences of my original sin (of buying Valeant at $32) in April 2017 and the secondary sin (of doubling down, when Valeant was trading at $14) by selling now. The question then becomes a simple one. Would I buy Valeant at today's price? If the answer is yes, I should hold and if the answer is no, I should fold. My intrinsic value per share has dropped to just above where the stock is trading at now, and at this stage, my judgment is that, valued as a going concern, it would be trading slightly under value. In a strange way, Bill Ackman's exit is what tipped the scales for me, since it will give Valeant's management, if they are so inclined, the capacity to make the decisions that they may have been constrained from making before. In particular, if they recognize that this may be a clear case where the company is worth more as the sum of its liquidated parts than as a going concern, there is still a chance that I could reduce my losses on this investment. Note, though, that based on my numbers, I don't expect to make my original investment (which averages out to $21/share) back. I am not happy about that but sunk costs are sunk!

As I continue to hold Valeant, I am also aware that I might be committing one of investing's biggest sins, which is an aversion to admitting mistakes by selling losers. My discounted cash flow valuations may be an after-the-fact rationalizing of something that I don't want to do, i.e., sell a big loser. To counter this, I briefly considering selling the shares and rebuying them back immediately; that makes me admit my mistake and take my losses while restarting the investment process with a new buy, but the "wash sales" rule is an impediment to this cleansing exercise. The bottom line is that if I am holding on to Valeant, not for intrinsic value reasons (as I am trying to convince myself) but because I have an investing blind spot, I will be last one to know!

YouTube Video


Previous Posts on Valeant
  1. Checkmate or Stalemate: Valeant's Fall from Investing Grace (November 2015)
  2. Valeant: Information Vacuums, Management Credibility and Investment Value (April 2016)
  3. Faith, Feedback and Fear: The Valeant Test (November 2016)
Spreadsheets
  1. Valeant Valuation: March 2017


13 comments:

XFL said...

Dear Prof - Seems like you have some unrealized short term tax loss that could be used to offset capital gains now or in future. Even if this story get's a new life, the chances of it happening in the next 30 days are slim. So why not sell at least some of your VRX holding, capture ST loss for tax purpose and then decide to buy the shares back or not after 30 days?

Apprentice of Agamas said...

Thank you for the brutal honesty in your posts, Prof.
A clarification request too: In your Nov 22nd, post your
breakdown of the drop in operating income table has numbers I could not replicate.

Here are the major offenders in my view:
1) You have:
Declining Revenues : $(317)
Change in Gross Margin : $(192)
Change in Operating Income, , First 3Q 2016 vs First 3Q 2015 : $(2,077)

2) From the actual 10K, I get figures as seen below:
Declining Revenues : $7,271 (Q1 through Q3 of 2016) - $7,689 (Q1 through Q3 of 2015)
= $(418)

Change in Gross Margin : (($7,271-$1,946)/$7,271 ) - (($7,689-$1,855)/$7,689 ))
= 75.87% - 73.24%
= 2.63%

Change in Operating Income, , First 3Q 2016 vs First 3Q 2015 : $(2,077)
= -$716 (Q1 through Q3 of 2016) - $1366 (Q1 through Q3 of 2015)
= $(2,082)

Any clues for wretches as I attempting to piece together the real numbers ? (In this case, the conclusions drawn by this table are still intact I think even if your numbers are wrong.

Thank you,

Anonymous said...

Professor,

Thanks for doing this. I have a couple of questions in regards to your valuation:

1) CEO Joe Papa, has said they want to pay now $5bn worth of debt by end of 2017. $1bn-ish has been paid so far, there are pending asset sales for 1.78bn, and so roughly 2-2.5bn is the debt goal target. I assume this is paid by FCF and further asset sales. So why don't you account for this in the valuation, and see the value per share?

2) I see from your valuation, you are discounting the Future cash flow and for a firm value, netting out the debt, to give the equity value per share....But Valeant is like a public LBO, so why not model for this: For instance, Take a house worth $100,000. And we buy it with 10% equity, $10,000 and mortgage for $90,000. If we assume that the value of $100,000 is the intrinsic value and is constant, and the net rent yield is 5%, i.e. $5,000. Every year I use the cashflow to pay my mortgage, then by year 3, my house is still worth $100,000, but my equity value is $25,000 and the mortgage is $75,000.
So my point is, why in your valuation, do you not just say all FCF be used to pay the outstanding debt, Because if the 2016 EBIT = $3105.86 and interest expense is $1836. Then we still have FCF of $1269.86 which can pay down debt in 2017 If this figure is roughly the same...

Ian said...

We should come back to what Buffet says: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Zoltan Takacs said...

Dear Prof,
I like your work. Your analysis are usually high value and detailed build up. Great example of professional finance work.

On your last Valeant calculation I think you made a logical error. In your revenue you have already used the guidance which includes the impact of divestments. But on the debt you were looking at the pre divestment value.
I think it would better reflect reality if with your current top line numbers you would use a lower debt of around 28-29Bn as a starting point.

Rex said...

Professor,

A few things I think are a bit off in the DCF:

-Debt is too high. It should be adjusted pro forma to account for recent asset sales in 1Q16. Alternatively the asset sales should be included in FCFF for 2017.

-Given VRX's clear runway for debt paydown given recent refinancing, I think that holding a 9% discount rate into year 5 may be a bit punitive. 3 years seems fair, but after that it should be de-risked.

-Your revenue projections after 2017 run pretty strongly against management guidance. You may be right, but need to articulate why their growth guidance is incorrect.

-VRX will still have a tax shield for some time due to amortization of recent acquisitions. This is not included in the DCF.

-Why is reinvestment so high in the terminal year? This crushes the terminal value, but I don't understand the rationale for that big of a jump in reinvestment without different growth assumptions in year 11+ versus years 5-10.

-It might make more sense to give a probability-weighted tax code adjustment rather than just jumping to 30%. Tax codes are pretty difficult to change...

aphong said...

Dear Professor,

Thank you for your updated view on Valeant. It is my pleasure to follow your posts.
In your latest valuation, Sheet Cleaned Up Operating Income, Cell D10 Reinvestment needed for 2.25% growth you keyed in a D9*1.5%*9%
I would think you mentioned 2.4% for current Risk free rate or 2% for long term growth of Valeant. Is it a typo?
Thank you

Anonymous said...

Many thanks Professor!
A couple of questions/comments:
- can you share the xcl backup of your statistical analysis, for eveybody's learning?
- debt position after the recent divestment is about 28bn not 30bn;
- tax shield, understood that, at enterprise level, your pie to ALL stakeholders (equity, debt and government) shrinks if tax rate is reduced but, if our attempt is to estimate the share price (value to equity), should we not see a tax cut as a positive since more cash is left to shareholders?
- you apply a prob if default of 10%, although 1.8 bn looks more like a 5% haircut. Is it fair to say that, given the recent refinancing, bankruptcy is very unlikely to happen in the next 12-18 months? If so, is it correct to ignore this adjustment with a view to buy (very low) now and sell say in one year. I am pointing this out because 1.8bn is about 35-40% of yoour equity value. This plus the 2 bn of repaid debt gives room for an upside to your estimated price of 13.68 of almost 80%. Which in turn would make the current price extremely convenient in the short run (before bankruptcy risk is priced in by the market).

Thanks and best regards from Bangkok!

Unknown said...

Prof D:

Love your valuation class. Read book back in the day for my CFA.

One thing you emphasize again and again is AFTER-TAX costs. Not sure your marginal tax rate, but at 28%, your $16 loss on your initial shares has a value of $4.48, not counting state taxes which are pretty progressive in NJ, so I'm guessing at least $5, which is a lot more than your FV estimate. Even the newer shares have at least $1.25 benefit.

It's a no-brainer to sell the initial shares (the stock would have to go ~$16 in 30 days to breakeven), and possibly the newer shares (10%+ 30 day return). If you're worried about an event (takeover, spinoffs) in the next 30 days, you could buy some short-term (OTM?) calls or create a spread or synthetic to protect the upside and buyback the shares in a month.

Best,

Scott

Anonymous said...

Can you please let me understand why the re-investment is negative for the first 5 years?

Kedar Lele said...

Hi Sir,

Could you please recommend a list of books that I could read in order to start analyzing businesses and invest myself as I do not have any formal background in finance and am new to the field of investing.

Thanks

Anonymous said...

Hi Professor, could I ask what software did you use to run the simulation?

Best,

Anonymous said...

i think professor is using Oracle Crystal Ball for the simulation.