Valeant Case Study in Progress

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There is an ongoing battle over Valeant’s (VRX) valuation and business model between short-sellers and investors.   This opportunity allows us to improve our analysis skills and understanding of business models.  Also, how will Sequoia, an owner of over 20% of Valeant’s equity, handle their portfolio?

My first question is whether Valeant is a franchise with durable competitive advantages or a roll-up of commodity products dressed-up in a fancy industry (Pharma)?   We should use this case to learn how experienced analysts present their opposing views.

First: What’s not to like?  Valeant has rapid growth with huge profit margins? Of course, the PERFECT investment is a company that has high returns on capital and can constantly redeploy its capital at the same high returns.  The classic case would be the early (pre-2000) history of Wal-Mart (WMT) as the high returns generated from its stores could be redeployed into new stores on the borders of their regions which had economies of scale in administration, advertising, and management costs per unit of sales.  WMT did not have, for example, advantages in gross margins, but net profit margins. See WMT_50 Year SRC Chart.

What would be the source of Valeant’s high returns and competitive advantages?

Sequoia (a well-known value fund with an excellent long-term record) saw strong competitive advantages.  See their recent investor transcript:

Sequoia-Fund-Transcript-2015-August  Note the date of the transcript and the questions regarding Valeant concerning Philador and Sequoia’s 20% concentration.

Other investors (Charlie Munger, Citron) disagreed:

April 2, 2015 from www.fool.com

…..Recently, during a shareholders meeting for the Daily Journal Corporation, a newspaper where he serves as Chairman, Munger had this to say about Valeant Pharmaceuticals Intl Inc. (TSX:VRX)(NYSE:VRX): “Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.”

What exactly does Munger mean by this?

A little history lesson

Who exactly was Harold Geneen? And what did he do at ITT that’s so infamous?

Geneen took over ITT Corp in 1959 when it was still mostly a telegraph and telephone company. After being blocked by the FCC in an attempt to buy the ABC television network in 1963, Geneen decided to diversify away from the company’s traditional business and completed more than 300 acquisitions during the decade in areas such as hotels, insurance, for-profit education, and the company that made Wonder Bread.

Geneen used cheap debt to finance these acquisitions, which later proved to be the company’s downfall. After Geneen’s retirement as CEO in 1977, subsequent CEOs spent much of the next two decades paying off the debt by selling most of Geneen’s acquisitions.

Is Valeant really comparable?

On the surface, Valeant looks like it could be pretty comparable to ITT. Since merging with Biovail in 2010, Valeant has made more than 30 different acquisitions, most of which were paid for with debt or by issuing shares.

Since the end of 2010, Valeant’s debt has skyrocketed from US$3.6 billion to US$15.3 billion. Shares outstanding have also gone up considerably from 196 million to 335 million. It’s obvious that Munger is onto something.

But on the other hand, I’m not sure Valeant is anywhere close to being as bad as ITT was. For one thing, all of the company’s acquisitions are at least in the same sector. ITT was buying up hotels and car dealerships, while Valeant is buying up pharmaceutical companies. Valeant’s efforts scale up a whole lot better than ITT’s ever did.

There’s also a bit of hypocrisy coming from Munger on this issue. Munger is actively involved in a company that does pretty much the same thing as ITT did back in the 1960s. Sure, Berkshire doesn’t use much debt or engage in hostile takeovers, but Berkshire and ITT have more in common than Munger is willing to admit. Both attempted to dominate the business world using a roll-up acquisition strategy; Buffett and Munger were just a little more patient with their plan.

But just because Munger exaggerates how bad Valeant’s acquisition spree has been doesn’t mean the stock is necessarily a buy at these levels. The company had earnings of just $2.67 per share in 2014, putting the stock at a P/E ratio of nearly 100 times. Yes, earnings are expected to grow substantially in 2015, but the outlook is simple. For the stock to continue performing, the company must continue to make acquisitions.

After making more than 30 acquisitions in just a few years, it’s hard to keep finding deals that will not only be big enough to make a difference, but will also prove to be good long-term buys. There’s so much pressure on management to keep buying that a serious misstep could be coming. If that happens, this hyped stock could head down in a hurry.

Although I don’t buy Munger’s alarmist concerns about Valeant, I agree with him on one thing. The stock just isn’t attractive at current levels.

A potential acquisition target, Allergan, Inc., points out its worries over Valeant’s business model. investor-presentation-may-27-2014-1 on VRX

Citron, a short-seller, attacks with a report: Valeant-Part-II-final-b. Valeant is another “Enron.”  Use the search box on this blog and type in Enron and follow links to review that case.  Enron never showed the profit margins that Valeant is currently showing.   NEVER take another person’s statement on faith.  Check it out for yourself. 

Valeant today (October 26th, 2015) counters Citron and answers investors’ concerns with 10-26-15-Investor-presentation-Final4 Valeant and video presentation:  http://ir.valeant.com/investor-relations/Presentations/default.aspxeep.

Ok, so what is Valeant worth?   Can you make such an assessment?  How do you think Mr. Market will weigh-in?   If you owned a 20% stake in Valeant, how would you manage the position?   What are the main issues to focus on?

This may be too difficult to analyze for many of us but we have  or will have many documents and reports to provide insights.  Remember that there are two sides to every narrative. Can we move closer to reality or the “truth”?

Note www.whalewisdom.com and type in VRX.   What type of investor owns Valeant?   Will momentum investors stick and stay?

Your comments welcome.

Sign up for Whitney Tilson’s emails on investing.  Worth a look: leilajt2+investing@gmail.com

10 responses to “Valeant Case Study in Progress

  1. I will admit I have been following the Valeant saga for sometime and have read both sides of the argument. I have not done much in-depth analysis just thought about the business model and some basic calculations on valuation below.

    What seems to me be the most interesting thing is the company is completed wiping out the R&D of all acquired companies essentially the company is only buying R&D and not producing it internally. This slash and burn mentality does not seem to be able to lead to a sustainable excess returns in an industry where the key activity is research and development.

    Acquiring products is never going to generate significant returns as you are doing something any other company can do and often you are competing with many other companies during the acquisition process driving up prices and driving down returns. The use of debt may be strategic but if the strategy very profitable the company would be overloaded with cash driving down the amount of debt on the balance sheet. At the end of H1 2015, net debt stood at roughly USD30 bn compared to equity of 6.5 bn (the company’s tangible equity is negative 34 bn), ttm operating income of roughly 2 bn and ttm operating cash flow of USD2.3 bn

    The company also has negative retained earnings and negative tangible equity of USD34 bn. The negative retained earnings and equity are typically reserved for companies which in the development stage. Valeant is supposedly buying profitable products not developing products therefore the company should be generating profit, which would flow through to the retained earnings.

    This is all before looking at valuations. All bull arguments are predicated on a cheap PE multiple. With the company’s debt load, PE metric does not seem to be the right metric (PE is never the right metric in my eyes). To buy the business you will also be purchasing the debt therefore when valuing the company debt needs to be taken into account. 30 bn in net debt + a mkt cap of roughly USD39 bn (10/23/2015 Price = USD116.16 * sh out = 334 mn) = Enterprise Value of roughly 70 bn compared to ttm operating profits of roughly 2 bn = EV/Operating Profit of 35 times.

    This is before the questions raised about accounting practices at Valeant raised by Citron, Bronte Capital and others. As a value investor the business model and the valuations do not make much sense. I would love to be proven wrong. Great blog. Thanks for all the work on it.

    • Thanks for your thoughtful comment. I have yet to dig in, but feel this is an important case study to learn from Also, when the case is ongoing it is easier to avoid hindsight analysis because the situation is fluid. The point is not to gloat over success or misfortune of other companies or investors but what are the lessons here that WE can apply?
      I hope you keep contributing and others pipe in as well.

  2. Apologies if it came off as gloating, not the idea used the “love to be wrong” as a call for debate. Also, the story has not played out so the end results will not be known for some time.

    Takeaways

    1) Superior returns can not be achieved unless you can do something different (Porter, Greenwald, and many others)
    2) If you are thinking like a business owner, debt should be taken into account during the valuation process.
    3) Acquisitions need strategic logic such as economies of scale or cheap valuation (Berkshire)
    4) The use of debt increases financial risk but if used excessively it could be a sign of weakness in the business model (inability to fund internal operations), overpaying for acquisitions or over acquiring.

    • No I was not meaning you but myself and others. The trick is to go beyond the famous investors–Ackman and Sequoia–the news coverage and focus on the essentials. Often, you may have to revisit this company several years later to see what the value will become. My initial fear after seeing Valeant four years ago in my perusal of pharma companies in Value-Line was how much could the market bear? The law of supply and demand is inevitable. I might have underestimated the pockets of third-party payers–but ultimately a cost/benefit analysis must set in. The healthcare market is not a true free market (similar to the for profit schools. I will not go near Devry and Apollo even though they look cheap in the rear-view mirror because would they charge those prices if the government wasn’t footing the bill. An what about free/low-cost Moocs combined with community colleges? Too tough.

      But am I correct in my thinking and Sequoia wrong. I want to learn more through this case study.

  3. Not only Ackman and Sequoia, but – and more importantly, in my view – also Glenn Greenberg. Greenberg’s got 36% of the fund tied up in Valeant. I really respect him as an investor and he’s got an impeccable multi decade track record. Another investor that I follow and respect, Jason Donville of Donville Kent, has a large position in Valeant. Additionally, in a recent Google Talk, William Thorndike – author of the excellent book “Outsiders” – mentioned Mike Pearson as one of the “new” outsiders, to him.
    I would not touch it. And not only for the numbers (that speak for themselves). I believe the business model is flawed, especially considering that it won’t be easy to keep purchasing big companies going forward, as, to me, there’s a little bit of a reputational issue in this whole thing, as well (which Allergan already pointed out a while ago by refusing to sell itself to them).

    • Yes, the shareholders are a whose who of the value mavens, but you still have to do your own thinking. See my comment below. I will be fascinated to see how this all plays out.

      Though I am critical of Valeant’s valuation vs. its business model, I don’t buy the chorus line that it is another Enron. Enron’s return on assets of $60 billion generated–even with phony financials–a less than 1% return. Who would buy that. Valeant shows strong cash flows, but how sustainable? don’t overpay for growth.

  4. I try to boil an investment into essentials. My two-minute view after looking at the Value-Line: OK, Valeant has huge profit margins because they can sell the branded drugs that they acquire while firing all the R&D folks. Maybe not platable to all of us, but certainly a legitimate strategy. However, with no R&D then where will the future branded drugs come from–more acquisition? How long can that game be played and why don’t the sellers offer a price that discounts the future profit growth of their drugs? The sellers are not stupid and in fact know the value of their company better than the buyer.

    So, Valeant eventually just sells generics. Nothing wrong with that but then this company will be a seller of “commodity products”. Where is the value-added in that? Won’t profit margins then revert to their cost of capital? We have to be looking out ten to twenty years since equities are perpetual.

    Valeant quickly raises the price of their acquired drugs. Fine, but how sustainable is that in the face of insurers? Won’t competitors quickly underprice them?

    At the end of the day, I could see the huge profits continuing perhaps for a year or a few, but then? And when the market wakes up, you then have a permanent loss of capital–which I believe has occurred for buyers of VRX over $200 per share.

  5. Just found this article (Materiality: Valeant and Beyond) from Audit Analytics: http://www.auditanalytics.com/blog/materiality-valeant-and-beyond/

  6. Thank you. I will put together another post since so much info is pouring out on the Valeant saga.

  7. John,

    Thank you for sharing this with us, I agree that VRX business model is not sustainable, for reason you mentioned, I also would like to add that their biggest contributor to revenue Jublia, is only 15% effective, in one of the case study I read ( not controlled trial), Vicks Vaporub showed 22% cure rate, it was a very small study, only 18 patients. Other drug Glumetza, is long acting Metformin, priced at super premium rate, didn’t have much traction. I am a practising physician, so I can analyze this thing soemwhat better. To me surprise Bill Ackman didn’t mention talking to a doctor about all the drugs Valeant is selling. People in our community are quite aware of price gouging and since I am a value investor myself, I can see it clearly. So I agree that quite possible this is a broken business model, I always remember Munger’s advice: avoid stupidity, or always Invert! In Valeant’s case their debt will be their biggest enemy, I can see it clearly. Now there are lot of smart people involved in this but I will take Munger’s advice any day ! It has served me so well, in investing and medicine ! JMHO!

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