Valeant: High Leverage And Aggressive Synergy Estimates Make Me Skeptical

| About: Valeant Pharmaceuticals (VRX)

Shares of Valeant Pharmaceuticals (NYSE:VRX) continue to set fresh all time highs. The pharmaceutical company announced on Monday that it has reached an agreement to acquire global eye company Bausch + Lomb.

Investors are very enthusiastic about the deal. Ever since rumors about a possible deal hit the news wires on Friday afternoon, investors have been enthusiastic.

However, I remain skeptical about the built up in leverage and the aggressive synergy estimates.

The Deal

Valeant Pharmaceuticals confirmed that it has entered into a definitive agreement to acquire privately-held Bausch + Lomb Holdings.

Valeant will pay a total consideration of $8.7 billion for the company. It will pay $4.5 billion to a group of private investors, led by Warburg Pincus. Valeant will furthermore assume another $4.2 billion in debt held by Bausch.

Bausch + Lomb is a global eye healthcare company operating with a Pharmaceutical, a Vision Care and a Surgical division. Some well known brands of the company include Besivance, Lotemax, Ocuvite, Bioture, ONEday, PureVision, enVista and VICTUS, among others.

The brand name of the company will be retained and Bausch will become a separate division within the new company. Valeant's existing ophthalmology business will be integrated within Bausch + Lomb.

Bausch + Lomb expects to generate revenues of $3.3 billion for 2013, on which the company expects to achieve adjusted EBITDA of $720 million. More importantly, Valeant expects to achieve annual cost synergies of an unprecedented $800 million.

Consequently, Valeant expects the deal to be immediately accretive to cash earnings per share. Assuming a full realization of synergies, and assuming a transaction date on January the 1st of 2013, annual cash earnings per share could increase by 40%.

Valeant expects that it can cut the ratio of selling, general and administrative expenses from 40 percent of revenues towards 20 percent. Valeant expects to achieve significant non-personnel savings by achieving distribution, purchasing and real estate synergies.

The deal is expected to close in the third quarter of this year and is subject to customary conditions including regulatory approval.


Valeant ended its first quarter of 2013 with $423.8 million in cash and marketable securities. The company operates with $10.3 billion in short and long-term debt, for a sizable $9.9 billion net debt position. Following the completion of the deal, Valeant will increase its net debt position towards $16.6-$17.1 billion.

For the full year of 2012, Valeant generated revenues of $3.55 billion, up 44.0% on the year before. The company reported a net loss of $116.0 million, compared to a profit of $159.6 million a year earlier, due to large acquisition related charges.

At the first quarter, the company guided for annual revenues of $4.4 to $4.8 billion for 2013. Including the impact of the acquisition of Bausch, the company is on track to generate annual revenues of around $8 billion. Cash earnings per share were guided to come in between $5.55 and $5.85. Including the expected synergies, Valeant could achieve annual cash earnings of $8.00 per share for 2013, if the deal was executed at the first day of January.

Factoring in an 8% jump in Monday's trading session, and following the trading action on the Toronto Stock Exchange, the market values Valeant around $27.5 billion. As the company will issue $1.5-$2.0 billion in new equity related to the deal, the market capitalization will increase toward $29 billion.

As such the equity of the firm is valued around 3.6 times 2013's expected annual revenues and 12 times cash earnings per share.

Valeant does not pay a dividend at the moment.

Some Historical Perspective

Long-term holders in Valeant have seen incredible returns. Trading as low as $8 in 2008 shares have steadily advanced to highs of $50 in 2011, to consolidate around those levels in the years following. Shares have risen some 50% year to date, to levels around $95 at the moment, setting fresh all time highs as investors are applauding the deal.

Investment Thesis

Valeant Pharmaceutical has grown its operations in recent years, mainly by acquisitions. As recent as March of this year, the company announced its intentions to acquire Obagi in a $344 million deal. In September of last year, the company already acquired Medicis Pharmaceuticals for $2.4 billion. In May there were rumors that Valeant was in talks to merge with Actavis (ACT). This deal eventually did not go through, as Actavis acquired Warner Chilcott (NASDAQ:WCRX) instead.

Following the sizable deal with Bausch + Lomb, which will double annual revenues of the company and boost the workforce to 18,000, Valeant will increase its debt position significantly. The deal will boost the debt position to 4.6 times annual EBITDA, a ratio expected to fall under 4 at the end of 2014. Valeant will use the period to integrate recently acquired businesses and reduce leverage.

Ever since rumors about a possible deal surfaced halfway through Friday's session, shares of Valeant have risen by more than 25%, thereby boosting the valuation of the company by some $6 billion. It is easy to understand why investors are enthusiastic as Valeant expects to generate $800 million in annual synergies. This results in incremental EBITDA of $1.5 billion, valuing the deal at just 5.7 times incremental EBITDA.

While I applaud management for an excellent deal, if Valeant manages to achieve its annual synergy target in this short time frame, I am a bit skeptical. If Valeant can control its debt position, report modest acquisition related charges, while it can achieve its synergy targets, shares remain undervalued despite incredible returns in recent time periods.

Still I remain on the sidelines. I think the increase in leverage might become a problem if the company faces headwinds. At the same time I continue to expect integration charges in the periods ahead while I think current synergy estimates at 25% of revenues are too aggressive. Investors should continue to expect large differences between GAAP and cash earnings, driven by renewed impairment and restructuring charges.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.