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Valeant Pharmaceuticals International Inc. (NYSE:VRX) has made some decent and profitable acquisitions in the last two years and more. The good deals have resulted in a sales growth of approximately 40%. It is the company's stated policy that it will keep looking for more acquisitions.

The problem with that policy is that shareholders prefer cash deals and Valeant doesn't seem to have a lot of cash.

It appears that the company has not derived any lesson from its failed bid for what would have been its biggest ever merger/acquisition deal, a $13-billion offer for Actavis (NYSE:ACT). Talks with Actavis fell through as Actavis shareholders were not satisfied with the all-stock deal despite premium on market price. Things might have been different had it been an all-cash offer.

Mergers

Valeant has adopted a policy of aggressive acquisitions and normally targets markets such as dermatology and ophthalmology so as to restrict its exposure to cost sensitive insurers. The company makes nearly 20/25 deals in a year, most of which are too small to deserve financial reporting.

In May 2010, it acquired Aton Pharmaceuticals for $318 million. Four months later the company itself was taken over by Biovail Corp, which retained the Valeant name. Its latest acquisition in May 2013 was of Bausch & Lomb Holdings Inc., - an all-cash deal valued at $8.7 billion.

In its recent earnings report, the company CEO said that Valeant will pursue its policy of smaller acquisitions in 2013 and is discussing the possibility of "merger of equals." Although not clarified, it could be a reference to Actavis.

Earnings

Boosted by its recent acquisitions, the company's total revenue at $1.1 billion was up 34% from the same quarter prior year; product sales however were up 43%. However, excluding onetime milestone payment received from GlaxoSmithKline on launch of Potiga, an anticonvulsant, total revenue was up 41%.

Additionally, the company raised its 2013 forecast for adjusted profit - or cash earnings as it calls it - the second time running. It now expects it to be in the range of $6.00 - $6.20 per share against the earlier forecast of $5.55-$5.85 per share. This is above what the analysts are forecasting after factoring in the acquisition of Bausch & Lomb.

Competition

Acquisition of Bausch & Lomb, which is likely to become the company's ophthalmic division after the transaction is over, places Valeant in a position to compete with Lucentis of Novartis (NYSE:NVS). Lucentis is a standard treatment for age-related macular degeneration ('AMD) and vision loss in diabetic patients. A blockbuster drug, Lucentis contributed $2.4 billion to Novaris' $57.56 billion revenue in 2012.

Valeant's Branded Generic division competes with Teva (NYSE:TEVA), which is the world's largest producer of generic drugs. Teva has a market cap almost the same as Valeant at $33.24 billion. However, Teva's trailing twelve month revenues is $20.05 billion against Valeant's $3.76 billion.

What about organic growth

Valeant posted a negative growth in net sales in established markets. However, the company was quick to mention that this was primarily due to appearance of generic versions of Zovirax, the antiviral ointment, without which sales would have grown 4%. The emerging market segment however grew 14%.

The accountancy viewpoint

The company had less than a billion dollars in cash and cash equivalents as on December 31, 2012, which came down to $413.74 million by March 31, 2013. The company's long term debt increased more than three times in three years and stands at $10.54 billion. To pay for the Bausch & Lomb acquisition, transactions for which were completed on August 5, 2013, Valeant issued 27.1 million common shares to raise $9.6 billion and raised $7.3 billion through senior unsecured notes and senior secured credit facilities.

The company's total assets stand at $17.49 billion out of which a sum of more than $14 billion represents goodwill and other intangible assets.

Investor's takeaway

The general consensus is that Valeant's growth is driven by acquisitions and the company has stated that it will continue with the policy of aggressive acquisitions. But investors need to ask, where does the cash come from?

While debt is increasing (three times total shareholder equity), the company has diluted shareholder value by issuing fresh equity to pay for the Bausch & Lomb acquisition. That means you are now getting less than you paid for when you bought in. It also means that future acquisitions will further dilute your position. Now, that would have been fine if the acquisitions quickly made up that money for you. But they won't, even if some of the acquisitions have real synergies, it will take years to recover costs. Meanwhile, further acquisitions will keep diluting your share.

The Actavis deal fell through because it could not make an all-cash offer. A point to note is that the Bausch & Lomb acquisition was an all-cash deal. However, few analysts questioned the financial viability of even the Bausch & Lomb deal although it involved increasing long-term debt to $18 billion. It is another matter that the market gave a big thumbs-up to the deal and the stock price jumped more than 23% between talks and formal announcement. The stock is still on a role, having gained 13% in the last one month.

One fails to understand how the company can continue with aggressive acquisitions in absence of internal accruals - the company's trailing twelve months loss is almost $131 million - and without any significant cash in hand.

Additionally, the company highlights "cost synergies" every time it makes a new acquisition. When it took over Medicis in September 2012, "cost synergies" were supposedly to be to the tune of $225 million and in the case of Bausch & Lomb the company hopes to derive a cost benefit of $800 million in synergies.

Considering past record, I do not see that happening. Whereas annual revenue in 2012 increased by 30.5% over 2011, selling, general and administrative (SG&A) expenses increased by 33.72% (from $561.48 million to $750.81 million). Since companies prefer to compare quarter-on-quarter figures, the QoQ increase in SG&A this quarter is 28%. That is not a lot of "cost synergy" in my opinion. Valeant is bleeding cash, and that is not long term sustainable.

Conclusion

For all these reasons I just discussed here, I believe that the pharmaceutical and biotech trend is driving the stock up. In my opinion the market has not paid adequate attention to the fact that Valeant can grow only through acquisitions and must borrow more or dilute equity to accomplish that goal. For any company and its investors, that is not a good business model.

Source: Valeant Has No Cash In Hand But A Policy Of Aggressive Acquisition