Valeant Is An Unassuming Value

Aug.20.13 | About: Valeant Pharmaceuticals (VRX)


Valeant Pharmaceutical (NYSE:VRX) is a specialty pharmaceutical company. The main areas of focus are dermatology, ophthalmology, neurology and branded generics, in where they develop, manufacture and market over 400 products. Further, this large portfolio of products is quite diversified. Indeed, there is no individual product that makes up more than 10% of sales and 50% of sales will come from outside the US, including about 20% from emerging markets. The company was created through the merger of Biovail and Valeant Pharmaceuticals in 2010. Since Michael Pearson took over in 2008, Valeant has grown sales by about 33% CAGR through the end of 2012 through a combination of acquisitions and [to a much lesser extent] organic growth.


Management has made an overwhelming insistence on only participating in markets where they feel they will end up having a competitive advantage. When Michael Pearson came aboard in 2008, Valeant (Biovail at the time) was a distant 11th in size within the Dermatology market, with a mere $100 million in sales versus the number one spot generating $800 million. Due to a high cash-pay business model (i.e. low government reimbursement related transactions) and a market that was generating strong returns on capital yet was too small for the largest companies to bother with, Valeant made it a point to become "the big fish in a small pond." Through a number of highly accretive acquisitions, they are now the number one company in regards to Dermatology sales, with second place generating less than half the sales that Valeant is. To that same account, they have also pursued products with low generic risk, pay more attention to duration of growth than magnitude, have avoided markets/regions where they would be a small company with no advantages, look for companies with near-term product development as opposed to speculative pipelines, and have focused on running a low cost operating structure.

Earlier in 2013, they entered the ophthalmology market with their $8.7 billion purchase of Bausch & Lomb. Valeant will most likely be unable to create the same level of dominant growth in ophthalmology as they had in dermatology due to the fact they are going against much larger companies (e.g. Novartis and Johnson & Johnson). However, Bausch & Lomb is still a top-4 competitor in all of the major eye-care markets, and the business provides the same attractive characteristics that Valeant gravitated to within dermatology, including low government reimbursement pressures, a visibly growing market globally, high cash returns on invested capital, and durable products. Further, Bausch & Lomb will allow Valeant to further their footprint in the emerging markets for stronger organic growth going forward. Valeant will end up realizing more than $800 million in synergies from the deal.

Looking forward, Valeant should be able to generate middle single digit growth rates in revenues off of a base of nearly $8 billion in 2014. Gross margins will most likely decrease slightly, as Bausch & Lomb was able to generate about a 62% rate, but the combined company should still be able to maintain levels between 65% and 70%. Earnings should increase at a much faster pace as restructuring charges, other one-time events, and the amortization of intangibles roll off. Further, Valeant should be able to generate significant free cash flow margins, leading to very attractive free cash returns on invested capital.


Michael Pearson took over as CEO and Chairman in 2008 after spending 23 years at McKinsey & Company where he rose to the head of global pharmaceuticals, dealing extensively in acquisitions, turnarounds and corporate strategy. Since taking over, Valeant has made a large number of acquisitions, and will most likely continue to do so as it is Pearson's strength from his experience at McKinsey. Pearson has shown to be exceptionally disciplined in his strategy, and the deals they've made since he came on have been highly accretive. Pearson and Howard Schiller, CFO, seem to consistently be very conservative in their estimates when estimating a target's NPV, will avoid getting involved in bidding wars, and have shown they will walk away from any deal that exceeds their price at which they feel will be an accretive acquisition. Pearson has also shown a willingness to sell assets that are worth more to another company than Valeant. They run a low cost structure, have bought back shares, and seem to be highly focused on generating long term shareholder value. Thus far, Pearson has done a good job of growing the intrinsic value of the firm at a much faster pace than the cost of equity. Finally, management has been incredibly forthright with information and has kept shareholders very well informed with all aspects of the business.


Using both Discounted Cash Flow to the Firm and Discounted Cash Flow to Equity, I estimate Valeant shares to be worth between $120 and $130, per share. This assumes a 10% cost of equity, which in turn equates to a 7.87% cost of capital. This is assumed by forecasting cash flows 10 years out, and then finding the terminal value by using the H-Model, with a reversion time of 10 years and a long term growth rate at 3%. If we assume an immediate drop off to 3% at year 10, the value of the shares would decrease by about 10%. If we assume a 12% cost of equity, shares look fairly valued at about $100 per share. Earnings will continue to lag free cash flows as the company has a high level of intangibles they are amortizing off the balance sheet. Finally, I assume less than a 6% rate of growth in sales in 2015 and beyond.


There are two main risks with Valeant, which are a leveraged balance sheet and the acquisition strategy. After the acquisition of Bausch & Lomb, Valeant will now have a debt-to-equity ratio of about 3.5 times. This is somewhat mitigated by their diversified products and steady industry, but this could put pressures on Valeant as I estimate their Free Cash Flow to barely cover interest in 2013, and to be not-quite 2 times interest payments in 2014. Further, the high level of activity in acquisitions leaves the company exposed to mistakes in their assumptions and what they end up paying for assets. A large acquisition that ends up destroying shareholder value could be highly toxic for shareholders. Further, if a number of small acquisitions that are "under the radar" destroy shareholder value, this could come to light in a surprise write down in the future.

Disclosure: I am long VRX. 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.