By Jake King
Endo Health Solutions (ENDP) named its new CEO Monday morning, Rajiv De Silva, who was formerly President and COO of Valeant Pharmaceuticals (VRX). In a January article, we speculated that a Valeant executive could be among the lead candidates for the top spot at ENDP and noted the meteoric performance of Valeant under De Silva, a key member of the leadership team. While take-out speculation caused ENDP to trade up briefly and then down when the market became doubtful about a near-term acquisition by VRX or Warner Chilcott (WCRX), the news Monday goes back to the initial plans from Endo's Board when current CEO, David Holveck, announced he would leave his post early. While the take out speculation has fallen out of the stock, a new, capable CEO has come to town, and ENDP shares are trading higher.
But that doesn't mean the near-term upside is over. It's the knowledgeable investor that understands there are significant gains to be made through what Mr. De Silva can do with ENDP's business. In this article, we'll provide to investors the roadmap for ENDP's repositioning, noting that among the most powerful things that Rajiv can do is to restructure ENDP's tax jurisdiction, like Valeant did in 2010. Notably, there are also a number of other strategic initiatives that can create significant value prior to, or concurrent with, the company lowering its tax burden. We'll study the DNA of Valeant's success and learn how Endo's valuation could climb to new highs. Note that ENDP will host an analyst/investor call Monday at 4:30 PM to announce the new CEO's arrival. In our view, the call will likely focus on housekeeping items such as an introduction of the new CEO and any potential changes to ENDP's Board of Directors.
Like ENDP, VRX was on its back; but new management changed its destiny. In 2003, Valeant was renamed from the old ICN Pharmaceuticals, which was famous for commercializing the widely-used Hepatitis C treatment, Rebetol (ICN's brand of the antiviral ribavirin). When Rebetol lost patent exclusivity in 2005, Valeant was nothing more than a collection of global assets, including manufacturing facilities and unexciting drug products. Shares of VRX languished for the next several years due to questionable growth prospects. In January 2005, VRX started the year at $10.93 (split adjusted), and by February 2008, the stock was largely in the same place ($10.73 also split adjusted) due to a lackluster line-up of products and a failed growth strategy. That month, Valeant named Michael Pearson as its new CEO, and under Mr. Pearson's leadership, investors have seen their shares rise more than 600% in value. Importantly, a year after taking the reins at VRX, Pearson brought in long-time friend and associate at consultancy group McKinsey & Co., Rajiv De Silva, to run the Specialty Pharmaceutical division of the company. Together, these two leaders have created significant value. Looking at the value creation at Valeant, in our view, is likely the roadmap for what Mr. De Silva will do at Endo Health Solutions.
Divest assets, reduce costs, acquire new high-performing assets. The first move for the new VRX was to divest certain non-performing global divisions. In this case, management jettisoned the Asia-Pacific division (divested March 2008), operations in Argentina (divested in June 2008), and the much larger Western and Eastern European operations (divested in August 2008), all of which brought in cash of approximately $440M to VRX and, importantly, streamlined operations. From there, VRX acquired Coria Labs and Dow Pharma for a total of $380M, which now serve as the basis of Valeant's key dermatology franchise. Integrating these acquisitions carefully is important, and that's where Rajiv De Silva went to work. Reducing expenses, extracting synergies among the new Specialty Pharma divisions at VRX, and growing the revenue pie is what this executive does best. Importantly, VRX shares rose 53% in 2009, 102% in 2010, 62% in 2011, and 24% in 2012, indicating what the right "divest and acquire" strategy can bring to a languishing specialty pharmaceutical company like Endo Health. Key to this value creation strategy was the acquisition of Biovail Corp. in September 2010, which enabled VRX to take advantage of a significantly more favorable tax structure. We will discuss this move below, but it should be emphasized that prior to the Biovail tax benefits, Pearson and De Silva were able to deliver a 47% rise in VRX's value over an 18-month period on strategic repositioning alone. Of course, the Biovail tax benefit has been key to the current VRX story, and if Mr. De Silva can deliver this element of the strategy, ENDP investors could be in for a long and strong ride.
Potential tax strategy could make ENDP just like VRX. As noted above, the key ingredient to Valeant's success is the extremely favorable tax rate on the company's net income. Essentially, anything Valeant buys instantly turns to gold, as net cash flow goes up on this company's highly favorable tax structure. This is possible because Valeant takes advantage of tax rates in non-U.S. jurisdictions, which came from the "merger" with Biovail. We believe that Mr. De Silva has potential to implement a similar strategy with Endo, and below, we explain how it can be done.
In June of 2010, Valeant entered into what we'll call a "double reverse merger," in which Valeant initiated a unique M&A process: Actually, Biovail acquired Valeant in order to preserve its favorable tax structure. But once the merger was complete, the new entity changed its name to Valeant, and Valeant's existing management team took over operations. The only other time we've seen this kind of deal structure in pharma was when Schering Plough acquired Merck (MRK) in 2009; but, the new entity was renamed Merck, and Merck's existing senior management took over operations. In this case, the convoluted deal structure (for Merck and Schering) was done to protect ownership of certain assets, not for tax benefits. However, these two examples of "double reverse mergers" demonstrate what Endo and its new leadership can do to transform the company. Whether Rajiv chooses to reboot the tax structure, acquire and divest assets, or simply clean up the business and sell it to his colleagues at Valeant remains to be seen. Either way, there's a lot of optionality, and investors have a chance at significant returns.
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