When I predicted in my first article on Valeant (NYSE:VRX) last week that it was "highly likely that well-known investors like Glenn Greenberg are selling Valeant in the wake of its hostile attempt to acquire Allergan", I hadn't imagined that it would be ValueAct Capital that would do the selling. Today, Valeant announced that ValueAct's Mason Morfit would resign from Valeant's board. The stated reason was that ValueAct would have more freedom in selling its large Valeant stake - ValueAct owns 5.7% of Valeant.
ValueAct has been at Valeant for a long time, even before Valeant's U-turn. No other major investor was so closely associated with Valeant. ValueAct plans to hold about $1 billion of Valeant stock; that means at current prices, it plans to sell most of its stake. Investors would be well served to pay heed; successful investors skate to where the puck is going to be, not to where it is currently. To paraphrase Warren Buffett, if extrapolating the past record was all it took, all the richest people would be librarians. Investors need to drive by looking at the windshield, and not the rearview mirror.
Q1 organic growth gets worse
In my second article on Valeant, we noted that the non-Bausch & Lomb products had negative organic growth (-3.3%) in Q4 2013. Let us update that calculation for Q1. In the latest 8-K, Valeant has disclosed the exact Bausch & Lomb revenue amounts for Q1 in footnotes g, h and i on the second-last page. Those numbers add up to $810 million out of the total revenue of $1855 million. That is 43.7% of total revenue.
Total organic growth in Q1 was 1%. Of this, Bausch & Lomb was reported as double-digit organic growth, without the exact number. Let us assume that it was the same 10% that was reported in Q4 2013. Using the equation
1.01 = 0.437 * 1.1 + 0.563 * x
yields x as 0.94. That is negative organic growth of -6% in non-Bausch & Lomb products. Recall that Bausch & Lomb was acquired in August 2013. That looks really unhealthy.
What is also unclear is how much of the Bausch & Lomb organic growth is going to be sustainable. If some of the growth is a one-time effect due to, say a larger salesforce, it would be hard to grow at the same rate starting in Q3 2014, when year-over-year comparisons get harder (since the Bausch & Lomb acquisition closed in August 2013).
Valeant's credit rating and the junk-bond market
"Junk-bond investors are accepting yields that are 0.74 percentage point lower than the earnings yield on the Standard & Poor's 500 index....Historically, debt rated below investment grade has yielded an average 4.2 percentage points more than stocks since March 1995. That relationship has been turned on its head."
When this relationship normalizes, Valeant will find it much harder to fund its business model. Junk bond market booms and busts are frequent. During recessions, lenders are suddenly reminded that firms they lent money to are not as strong as they thought they were. Defaults and bankruptcies cause higher interest rates for all junk-rated firms.
The value of an investment-grade rating was best explained by the CFO of Perrigo (NYSE:PRGO) in its latest quarterly earnings call. Perrigo is a pharma that also grows by acquisitions, in addition to very healthy organic growth. There was an analyst question on increasing leverage. Perrigo's CFO explains it far better than I can hope to, so I am quoting her from the Seeking Alpha transcript:
"we're committed to investment grade because there's no better and deeper pool of resource to be able to fund long-term growth initiatives than the investment-grade market. And so while there are those in our universe who don't have an issue being more heavily levered today because of the relative expensive levels of debt today, if there are shocks to the system, the change between investment grade and high yield become fairly dramatic. So in order to be able to have a real long view on long-term growth initiatives, we are committed to that investment grade...".
I was not intending to discuss this, but since quite a few people have brought up this book in the context of Valeant, I will put down my thoughts. First of all, I read this book when the Kindle edition was around $4, after it became popular, its price went up.
This book is authored by a private equity investor. It is often brought up to support leverage. Paradoxically, the book also covers Warren Buffett, who is the most famous preacher against leverage (just Google for "liquor and leverage"). Some of the CEOs featured in the book used leverage; none of them were from tech, or pharma, or any other R&D-based industry.
There are two things that should strike an investor immediately. The book excludes companies like Wal-Mart, Home Depot, McDonald's, Microsoft, Intel, Google, Gilead, Biogen Idec, Johnson & Johnson, etc. These companies did not need leverage. The book also excludes leveraged companies that failed. If leverage was so universally good, everyone would use it. Leverage is not a new discovery, it's been around for centuries. The universe of companies that failed or succeeded is large. The entire universe needs to be considered before drawing any conclusions; but the book profiles just a handful of CEOs.
Allergan (NYSE:AGN) shareholders
Given the state of the junk-bond market, it is now or never for Valeant's hostile attempt to acquire Allergan. Allergan shareholders have been offered roughly 70% Valeant stock. The remaining 30% in cash is to come by leveraging Allergan's unleveraged balance sheet to the tune of $15 billion.
It turns out that Allergan is surprisingly vulnerable to hostile takeovers. The vulnerabilities were introduced by an investor owning "no less than 90 shares" of Allergan". It's quite an interesting story, I was surprised to learn how easy it is for small shareholders to destroy takeover defenses. On the other hand, Allergan has some intriguing defense moves available.
What this means is that this is going to get exciting very fast. If Allergan had a staggered board, Valeant would have just not been able to think of acquiring Allergan. I have covered the options that Allergan has to fend off Valeant in this article; the simplest way is for Allergan to announce a large dividend.
Disclosure: I am long PRGO. 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.