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Summary

  • VRX's business model has run into a wall.
  • The latest quarter had just 2% "same-store sales" organic growth.
  • VRX needs to make large, hostile acquisitions at high premiums to grow.
  • VRX has $17 billion in debt and forecasts $2.6 billion in adjusted operating cash flow for 2014 (debt/adjusted OCF ratio of 6.5).
  • Lack of R&D leaves it vulnerable to the obsolescence of its products.

Valeant Pharmaceuticals (NYSE:VRX) is a large-cap pharma company held by some famous investors with concentrated portfolios, such as Lou Simpson, Glenn Greenberg and Sequoia Fund (Ruane Cunniff Goldfarb). This article explains why Valeant is a very risky investment going forward. The predicament of Valeant is illustrated by its hostile offer to acquire the best-in-class pharma company, Allergan (NYSE:AGN), for $47 billion. Since 70% of the purchase price is in the form of Valeant stock, this is a bad deal for Allergan shareholders because Valeant's business model is unsustainable.

Background

Some years ago, the activist investment firm Valueact Capital took a stake in Valeant Pharmaceuticals. Soon after, Valeant hired Michael Pearson, then a management consultant at McKinsey, as CEO. Pearson got the job by stating that R&D was a waste of time and money. Instead, he proposed to acquire companies, cut away almost all the R&D in the acquired companies and report drastically higher profits. In addition, Valeant relocated from California to Canada using a tax inversion and obtained a mid-single-digit tax rate. Pearson also hired more sales people to increase sales of the acquired products. The modus operandi was to make acquisitions using debt, cut costs by laying off a lot of the employees in the acquired companies, pay very little tax, and increase the sales force.

These moves, along with the extremely high use of debt, led to greatly increased profits. Pearson quickly became a billionaire. Famous investors bought into Valeant's thesis that R&D can be acquired cheaply and that most of the employees are expendable. Valeant declared that it does not bet on science, but instead bets on management. The stock price multiplied 10 times over the last several years from a small base.

Investors who wouldn't invest in pharma companies before, heavily bought into this promise of pharma-like returns without the unpredictability of R&D. The largest holders of VRX are generalist investors. VRX was the largest holding at Ruane Cunniff Goldfarb (22% of portfolio), Weitz Investments (5%) and Glenn Greenberg's Brave Warrior Advisors (29% of portfolio) in Q4 2013.

Unsustainable Business Model

So far, Valeant was able to grow from a small base by acquiring private companies. Valeant's CEO preferred these private acquisitions because private companies were available at a lower multiple of price to sales compared to public companies. As it has gotten larger, Valeant needs larger acquisitions to replace its older products. Naturally, the larger acquisitions are public companies. Valeant has so far gotten away with paying just 2-3x sales for its private acquisitions. But public companies trade at much higher valuations.

The bigger problem is that Valeant's history of dismantling acquired companies by laying off large numbers of people has made it a detested acquirer. Valeant's hostile bid for Cephalon was rejected. Valeant's bid to acquire Actavis (NYSE:ACT) was also rejected last year. Now Valeant is making a hostile attempt at Allergan and is promising huge layoffs at the same time. Valeant hasn't been able to acquire a good-quality public company so far. Such hostile acquisitions require even greater premiums to be paid. Due to its slash and burn strategy, Valeant has become the least desired acquirer in the industry (contrast this with Warren Buffett who is the most desired acquirer and therefore gets good pricing).

Also, in response to an analyst's question, Valeant revealed in one of its conference calls that most of Valeant's organic growth is made up of price increases. This is another unsustainable aspect of Valeant's business model.

Organic Growth Non-Existent

Despite price increases, Valeant finds itself with just 2% organic growth in its latest quarter, as its second-class drug portfolio gets less relevant with age. Valeant claims that its 1,000-odd products are durable since they are not subject to patent risk. Note that other large-cap pharmas also have thousands of products; Valeant is not special. Its not just patent risk that obsoletes drugs; they get obsoleted by the discovery of better drugs as well.

Valeant has started reporting metrics such as "pro forma organic growth" and "ex-generics organic growth" in addition to the standard organic growth measure. Since the investor presentations have been removed from Valeant's investor relations website, the closest reference I could find was this Seeking Alpha transcript where they say: "As we stated during our Investor Day presentation in June, we are now breaking out both same-store sales and pro forma organic growth." Valeant has started doing this as its organic growth has slowed sharply. Check out the organic growth reported in the last 4 quarters of earnings releases Q4 2013, Q3 2013, Q2 2013, Q1 2013. Sometimes they excluded generics, sometimes include them, and the list of excluded generics grows longer every quarter.

In contrast, other pharma companies that invest in R&D do not resort to such creative accounting metrics and caveats. This point was also raised by the famous investment writer Jim Grant in an article on Valeant. (Jim Grant's article is priced at about $100 on his website.) Allergan reports a much higher organic growth rate without any asterisks. Drugs going out of patent are an inherent part of the pharma business -- if they didn't, R&D wouldn't be so important.

To illustrate Valeant's second-class portfolio with an example, Valeant's Dysport has just 14% market share compared to the 76% marketshare of its competitor -- Allergan's Botox. Even with a larger sales force, Valeant's Dysport hasn't been able to make any headway against Allergan's Botox. Instead, Valeant's Dysport has been losing market share. This proves that good R&D beats more salesmen. A better drug requires a lot fewer people to sell than a second-rate drug. In addition, Botox is being approved for more and more indications leading to accelerating organic growth for Allergan.

Unsustainable Debt Load

Valeant's acquisition spree has racked up $17 billion in debt. Valeant forecasts $2.6 billion in "adjusted" operating cash flow in 2014. Valeant's leverage is several multiples more than that of other pharma companies.

What happens to Valeant's ability to service debt if its drug portfolio is not as durable as it claims? Drug discovery by other pharma companies can result in quick obsolescence in pharma. Drug companies that invest in R&D have rich pipelines that replace existing drugs as they become obsolete. But Valeant's R&D and pipeline is negligible. Even without a drug pipeline, Valeant is far more debt laden than any other big pharma. Allergan has a rich pipeline and is debt-free.

Lack of R&D at Valeant

Valeant has an almost non-existent drug pipeline due to its negligible R&D investment of less than 3% of revenue. Valeant's CEO likes to say that his drug pipeline is other companies. But Valeant is forced to buy larger and larger companies at higher and higher premiums to grow. Valeant has been unable to buy any good public company so far, its hostile bids have fallen short.

The reputed investor Glenn Greenberg is a Valeant shareholder. Valeant was a staggering 29% of Greenberg's portfolio in Q4 2013; Greenberg commented on Valeant's attempt to acquire Allergan: "It's almost impossible to turn it into a high return investment if you pay that kind of price." Pearson's policy of buying companies and immediately axing off the R&D is breaking down, even for his biggest fans.

Valeant's Poor Earnings Quality and "Cash EPS"

A unique non-GAAP metric reported by Valeant is "cash EPS." Here Valeant adds back amortization of acquired drugs and other acquisition charges. This is incorrect because Valeant's business model requires regular acquisitions instead of R&D expense. Can other pharma companies add back their R&D expense and report a "cash EPS" too? To have an apples-to-apples comparison, Valeant should not be adding back its amortization of acquired drugs and acquisition charges. Unlike other pharma companies, these charges happen all the time at Valeant and are large.

Valeant's GAAP EPS is deeply negative. Instead of GAAP losses, Valeant keeps investors focused on this misleading "cash EPS" metric by highlighting it in every earnings report. Thus, they tell investors that they do not have any R&D expense because they grow by acquisition, at the same time they ask investors to ignore acquisition costs by adding it back to "cash EPS."

Acquisition costs are reported by Valeant under multiple headings:

  • In 2013, Valeant reported $1.902 billion for amortization of acquired intangibles, and in 2012 it reported $928 million, and in 2011 it reported $557 million.
  • Under IP R&D writeoffs, Valeant reported $153 million, $189 million, $109 million in 2013, 2012, and 2011, respectively.
  • Under restructuring and other charges, Valeant reported $514 million, $344 million, $97 million in 2013, 2012, and 2011, respectively.
  • Under acquisition-related costs, Valeant reported $36 million, $78 million, $33 million in 2013, 2012, and 2011, respectively.

These add up to $2.605 billion, $1.539 billion, $796 million in 2013, 2012, and 2011, respectively. With this big-bath accounting, Valeant effectively says, "ignore these expenses because we used debt to pay for acquisitions, focus on our 'cash EPS' instead where we add it all back." Thus, the increase in debt isn't factored into the "cash EPS."

Allergan's Accelerating Organic Growth

Allergan invests 17% of its revenue in R&D and has created a best-in-class drug portfolio. Allergan reported 15.6% organic growth in its latest quarter. Allergan's last four quarters have shown the following accelerating organic growth rates in 2013 - Q4 15.6%, Q3 12.9%, Q2 10.9%, Q1 9%. There are no caveats such as "pro-forma", or "ex-generics". Valeant badly wants Allergan's top-notch portfolio. Allergan has one of the best organic growth profiles in pharma. Allergan has obtained 11 approvals from the FDA in less than four years and is guaranteed to get some more approvals in the near future. Last year, the FDA said that Levadex had an easily fixable problem with the delivery device. It is certain to be approved by the FDA later this year.

These FDA approvals have led to accelerating organic growth for Allergan. As these drug approvals permeate through the market and sales ramp up, Allergan's organic growth is expected to accelerate even more in coming years. Botox continues to be approved for more and more indications all over the world.

Approval of Ozurdex for diabetic macular edema is guaranteed, which would result in huge sales due to the prevalence of diabetes. (Sometimes its easy to forget that Allergan is the leader in ophthalomlogy drugs due to Botox's fame.)

Allergan Out of Reach for Valeant

This hostile acquisition attempt by Valeant has suddenly highlighted the fact that Valeant's growth strategy is unsustainable. It is highly unlikely that Allergan will be acquired by Valeant.

Allergan has $1.6 billion in cash net of debt, compared to Valeant's enormous $17 billion debt load. This is despite both companies being of similar size. Allergan's organic growth rate is accelerating whereas Valeant's organic growth rate is decelerating. Allergan's organic growth is also much higher than Valeant's organic growth.

The stock market believes the acquisition won't go through -- if it had believed the deal would happen, VRX would have been trading far higher. Bill Ackman, Valeant's activist partner in the hostile attempt, claimed that VRX would hit $200 if the acquisition happens, but VRX is trading at $133.

From their 2013 10-Ks, Allergan had operating cash flow of $1.7 billion compared to just $1.04 billion for Valeant. Note that this is unadjusted operating cash flow. Allergan's debt-free position and excellent organic growth trajectory means that Allergan has the option of acquiring a foreign company and undergoing a tax inversion to lower its tax rate. Allergan can also acquire other pharma companies and get larger so that Valeant would not be able to afford Allergan.

Conclusion

  • Valeant's theory that R&D can be bought cheaply is no longer valid. Lack of R&D at Valeant and the policy of decimating the R&D teams at acquired companies has resulted in the lack of organic growth and an almost empty pipeline.
  • Valeant's current valuation (market cap plus debt adds up to $62 billion) assumes a much higher growth rate than Valeant can deliver going forward. This is because Valeant needs larger acquisitions, and public companies require large hostile premiums due to Valeant's status as the least desired acquirer. So far, Valeant has not been able to buy a good-quality public company. It keeps getting rejected as we saw with Cephalon and Actavis and now Allergan. Valeant is on the opposite side of the spectrum compared to Berkshire Hathaway; companies like being acquired by Berkshire. Warren Buffett doesn't touch the business after acquisition; whereas Valeant uses a scorched earth strategy.
  • This slowdown of growth would cause investors to take a closer look at Valeant's enormous debt load and the durability of its products. Any obsolescence or loss of market share is troublesome because there is little room for error. A debt downgrade would increase interest rates for Valeant. An increase in interest rates would also hurt Valeant's valuation; its tiny tax rate would cause higher interest expense to hit the bottomline without tax deductibility.
  • It is highly likely that well-known investors like Glenn Greenberg are selling Valeant in the wake of its hostile attempt to acquire Allergan. This unsustainable business model is not what they had signed up for. Valeant's stock offer is a bad deal for Allergan shareholders. Allergan shareholders are being asked to exchange their debt-free company that has a rich, best-in-class drug portfolio and pipeline with accelerating organic growth for a heavily indebted company with a low-quality drug portfolio, non-existent pipeline and decelerating organic growth.
Source: Valeant Skating On Thin Ice - Allergan Is Much Stronger And Deserves Better