Valeant's Low Returns On Capital And Other Problems

Apr.30.14 | About: Valeant Pharmaceuticals (VRX)

Summary

Valeant doesn't have a high return on capital.

Valeant's focus on short-term profits, causes long-term harm.

Insufficient earnings details hide negative growth rate of non-Bausch and Lomb products in Q4.

Valeant has little economic goodwill, should translate to lower private market valuation.

This article addresses some of the issues that were not addressed in the previous article on Valeant (NYSE:VRX) due to lack of space. It would help fully address some of the issues raised in the comments to the previous article. To avoid repetition, I am assuming that the reader has read my previous article.

Low return on capital

Despite all the cost-cutting in acquired companies by Valeant, Valeant's return on capital is quite low. Let us calculate it using Valeant's 2013 10-K. Valeant has net debt of $50.3 per share ($17.36 billion in current and long-term debt, minus $600 million in cash, divided by 333 million shares). Valeant has book value of $15.7 per share.

Using the midpoint of Valeant's "cash EPS" forecast, we get a return on capital of 8.5/(50.3 + 15.7) = 12.8%. Note that using this "cash EPS" metric overstates the true shareholder profits as I discussed in my previous article.

This is only marginally higher than generics companies such as Perrigo (NYSE:PRGO) and Mylan (NASDAQ:MYL). This is despite Valeant's much lower tax rate. One should ask why Valeant's much professed cost-cutting has produced returns on capital that are the same as generics companies. For example, Perrigo's latest 10-K shows a return on capital of 12.7% (442 net income / 3472 total capital after backing out cash held) with a tax rate of 27%. Normalized for tax rates, Valeant's return on capital would be even lower; Valeant is just any other generics company.

Also, note that this return on capital is despite the big-bath accounting that I discussed in my previous article in the "cash EPS" section. Big-bath accounting refers to the practice of taking large charges in one year or quarter with the goal of reducing book value. This increases the reported return on capital in subsequent years.

Therefore, we see that Valeant doesn't really have any operational secret sauce as one might be led to believe with their talk of synergies. Where they leave everyone else in the dust is in the amount of leverage they use. It is simply far more than any other pharma. As covered in the previous article, their forecast for 2014 adjusted operating cash flow is just $2.6 billion compared to debt of over $17 billion. This is the source of their extra return on equity. Leverage is a double-edged sword. Any mishap for Valeant such as a consumer lawsuit, a debt downgrade, or an increase in interest rates will have a magnified effect.

Sensing that Valeant is a financial engineered entity, long-term Allergan (NYSE:AGN) investors are wary of Valeant's mostly stock offer as seen in this Wall Street Journal article.

Insufficient reporting details

Q4 2013 showed for the first time negative organic growth - it was actually negative in "ex-Bausch and Lomb" Valeant. Note that the Bausch and Lomb acquisition closed in August 2013. This is what their Q4 2013 earnings release said

  • 2% organic growth (same store sales) including impact from genericized products; 6% organic growth (pro forma) for total Company
    • 10% organic growth for Bausch + Lomb in Q4 and since close

Just how negative is difficult to figure out because I couldn't find how much revenue came from Bausch and Lomb in Q4. I couldn't find that information in the earnings release or the 10-K. As Warren Buffett likes to say, if they make it hard for you to find the information, it is because they don't want you to find it.

We can use an approximation. Valeant's Q4 revenue was $2063 million. The 10-K says Bausch and Lomb's revenue from the date of acquisition up to December 31, 2013 was $1345 million. Since the acquisition closed on August 6, that is an average revenue of $9.27 million per day ($1345 million / 145 days). When multiplied by 90 days in Q4, that is $834 million in revenue.

Thus, Bausch and Lomb contributed $834 million in Q4 revenue, which is 40% of the total revenue of $2063 million. Let x be the growth rate of non-Bausch and Lomb products.

Because of the overall 2% growth including Bausch and Lomb's 10% growth, we use the equation

1.02 = 0.4 * 1.1 + 0.6 * x

x turns out to be 0.967. Thus, pre-Bausch and Lomb products had negative 3.33% growth. Despite Bausch and Lomb closing as late as August 2013, Valeant did not mention this negative organic growth rate in the earnings release at all.

One more crucial data point missing is how much of Bausch and Lomb's organic growth came from price increases.

While we are on the subject of inaccuracies, in a new disturbing development, an analyst criticized Valeant's CEO for making false claims of overspending at Allergan.

Valeant's short-term focus causes long-term harm

After Valeant closed the Bausch and Lomb acquisition, Michael Pearson, Valeant's CEO said that he would retain the R&D team working on Bausch and Lomb's new contact lens until they finish the product. Pharma and medical device companies are not concentrated in one geographic region unlike Silicon Valley or Wall Street. Axing an R&D team would mean that it would be extremely hard to build such a team again.

Why would Pearson do this? Doesn't he want the team working on the next innovation in contact lens material? Unlike Silicon Valley or Wall Street, a replacement team cannot be easily built because pharma and medical device companies are scattered all over America. The reason Pearson axes teams is that he is interested only in short-term profits; he is not building a long-term company. Valeant wants to maximize short-term profits even if it causes long-term harm.

Similarly, in his hostile bid for Allergan, Pearson says that he would spend $300 million on R&D at Allergan until "high-probability and late-stage projects" are completed (Allergan's current annual R&D spend is $1 billion). Doesn't he want Allergan's brilliant R&D team to continue finding new innovations? Not if you want to maximize short-term profits.

Intel works on the next processor after releasing a new one. Apple works on the next iPhone and Microsoft on the next operating system. Similarly pharma companies work on discovering their next drugs. Those companies are building long-term value. But not Valeant; it would rather kill the golden goose than feed it.

Pearson claims that drug R&D is too expensive for the returns. But he has never provided any data to backup this claim. He did admit in this Financial Times video that there are "great opportunities for great science," but that Valeant wasn't good at it.

Economic goodwill

Drug companies such as Gilead (NASDAQ:GILD), Glaxo-SmithKline (NYSE:GSK), Biogen Idec (NASDAQ:BIIB), Johnson & Johnson (NYSE:JNJ), AbbVie (NYSE:ABBV), Alexion (NASDAQ:ALXN), Novo Nordisk (NYSE:NVO), etc., report very high returns on capital that are 2-3x more than Valeant despite higher tax rates. The reason is that they have what one would call "economic goodwill." Unlike Valeant, they have healthy R&D budgets and cash positions. They are built to last for generations and survive recessions and financial crises.

What is "economic goodwill"? This is a term described in Warren Buffett's 1983 Letter to Shareholders. Quoting from that letter, "businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill. ....What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation's economic Goodwill."

Note the term "unleveraged." The pharmas mentioned at the start of this section have high economic goodwill because of their R&D teams. Their R&D is the origin of their excess returns and economic goodwill. This is an intangible asset, building teams and hiring brilliant scientists is a difficult process that takes many years or decades. At Valeant, this doesn't exist - its effect would be apparent only over the long-term.

This means that the private market value - what an owner would pay to buy the whole of Valeant would be less. The lack of a capable R&D organization means that what you see is all you are going to get. There is nothing additional to be expected in the future.

Economic goodwill is an intangible asset that is hard to value, but in my opinion it is the most important thing in a drug or tech company. When Microsoft or Intel or Google or Johnson & Johnson or Gilead or Biogen Idec started out, they had huge economic goodwill that was hard to value. But that didn't make it any less important.

Conclusion

Valeant doesn't have any operational secret sauce as shown by its average returns on capital even with a lower tax rate. Its extra return has come from extremely high leverage compared to its peers.

Valeant's revenue reporting omits crucial details. The negative organic revenue growth in Q4 2013 in non-Bausch and Lomb's products wasn't listed, even though the Bausch and Lomb acquisition closed as late as August 2013.

Valeant's focus on short-term profits comes at the expense of long-term returns. This lack of long-term prospects reduces its intrinsic private market value.

This article and my previous article point out the problems with Valeant as a long-term investment.

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.