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Summary

  • Valeant is likely to talk about the industry's R&D productivity in general, and not about Allergan's excellent R&D productivity.
  • Valeant will likely not mention the EV/EBITDA valuation of Allergan and Valeant. Instead, Valeant is likely to talk about Allergan's "unaffected" share price to avoid drawing attention to Allergan's undervaluation.
  • Valeant is likely to talk mostly about Bausch & Lomb, and ignore non-Bausch & Lomb revenues. Most of Valeant's revenues are non-Bausch & Lomb, but it has negative organic growth.

Introduction

This article covers what investors need to watch out for during Valeant Pharmaceuticals International's (NYSE:VRX) May 28 event. The event is for Allergan Inc. (NYSE:AGN) and Valeant Pharmaceuticals International shareholders.

When the news of Valeant Pharmaceuticals' hostile takeover attempt of Allergan Inc. became public on April 22, Valeant's stock price jumped to $137. Then, Valeant's stock price drifted downward until it hit an intra-day low of $122 on May 16. Since Valeant's takeover offer consists of 0.83 Valeant shares for every Allergan share, this brought down the value of Valeant's offer.

On May 20, Valeant announced the agenda for its May 28 event. Among other things, Valeant will be improving its offer for Allergan on May 28. Valeant stock's latest close is at $133. Thus, Valeant's stock has been gyrating as investors try to make up their minds.

Allergan held a conference call on May 12 to discuss Valeant's takeover offer. Going through some of the discussion of that conference call are required for perspective on the May 28 agenda. Valeant has said it will refute Allergan's "allegations" with a "thoughtful" and "fact-based" presentation.

Allergan's May 12 conference call

Allergan's CEO, David Pyott, made some great points, but I will pick only a few of them. He talked about Valeant's low organic growth rate (1%+ in Q1 2014). He said that "Valeant's model of cutting and slashing really doesn't work for more than a very short period of time. That shows up in the same-store low growth that they produce."

(Note that if we exclude the Bausch & Lomb (B&L) acquisition that closed in August 2013, Valeant's organic growth is negative. This has to be deduced from Valeant's earnings releases, because its earnings releases are not frank. This is discussed in more detail in my previous articles, and I won't repeat it here. The organic growth rate excluding Bausch & Lomb was -6% in Q1 2014 and -3.3% in Q4 2013. The organic growth rate including Bausch & Lomb was 1%+ in Q1 2014 and 2%+ in Q4 2013.)

In the same conference call, David Pyott went on to say that Valeant doesn't talk much about Medicis, Valeant's largest acquisition until it acquired B&L. The Medicis acquisition closed in December 2012, and sufficient time has elapsed to evaluate Valeant's strategy. David Pyott said that Medicis' products have lost market share to Allergan's products during that time. As examples, he specifically mentioned the US neuromodulator market and the US filler market, where Medicis has lost market share. Referring to the filler market, Pyott said that he has rarely seen such a dramatic market share change in his career in such a short period of time.

Pyott said that based on IMS data for ophthalmic pharmaceuticals, in Q4 2013, B&L grew at 3%, whereas Allergan grew 13%. The May 28 agenda indicates that Valeant seems to have interpreted this statement about ophthalmic pharmaceuticals in particular as an allegation about all of B&L.

Allergan's "unaffected price"

Valeant will no doubt bring up $116 as Allergan's "unaffected" price. It has mentioned this at every opportunity. Whenever Michael Pearson, Valeant's CEO, brings up Allergan's unaffected price, valuation metrics are conspicuously absent. But as I showed in this article, "Buy Allergan, Not Valeant. It's A No-Brainer", even at current market prices, Allergan and Valeant are almost at the same EV/EBITDA multiple, even though Allergan's position and prospects are far superior. Therefore, I believe that Allergan's stock will not fall if the takeover doesn't happen.

Allergan was undervalued compared to Valeant until recently, because Valeant is a momentum stock with a junk debt rating and no P/E. In the current go-go market, not having P/E is an advantage.

Talking about Allergan's stock price in the absence of any valuation metric is a telltale sign. Is Valeant afraid to point out that Allergan's valuation was absurdly low compared to the company's growth prospects? Valeant acquiring Allergan is similar to the AOL-Time Warner merger, i.e. it is like buying a non-bubble asset using a bubble stock as currency.

I predict that there will be no mention of Allergan's and Valeant's EV/EBITDA multiples on May 28.

R&D productivity

Pyott said that in terms of R&D productivity, Allergan has been consistently moving up the rankings, and is expected to be the number one pharmaceutical company in 2015 in terms of productivity. He said that the rest of the industry's R&D productivity should not be confused with Allergan's R&D productivity. This Forbes article says that Ackman is "fundamentally wrong", and cutting Allergan's R&D would be "value-destroying".

The data in the Forbes article shows that Allergan's R&D productivity (rank 5) is at the top of the pharma industry, right behind hot favorites like Celgene (NASDAQ:CELG) and Gilead (NASDAQ:GILD). Just as Apple's R&D productivity is different from some others in its industry, so is Allergan's. But so far, Valeant has only referred to the industry's R&D productivity, and not Allergan's.

Pyott gave some specific return-on-R&D examples on May 12. He said that by investing $7 billion in R&D over a 10-year period, Allergan has generated more than $50 billion in cumulative sales so far, and is expected to generate $120 billion more in sales over the next 10 years. Pyott said that if Allergan were to stop DARPin development today, it would save $400 million in R&D but lose $20 billion in sales in the product's first 10 years alone.

I expect that on May 28, there will be no reference to Allergan's stellar R&D productivity ranking. Instead there would be some vague, general references to the industry's R&D productivity as a whole.

Valeant will avoid mentioning non-B&L products

Even though David Pyott spent more time talking about non-B&L products, i.e. Medicis, neuromodulators and fillers, Valeant will not talk much about its non-B&L products on May 28. This is because Valeant's non-B&L organic growth has been negative. Valeant has not mentioned its non-B&L organic growth in its recent earnings releases, even though most of its revenue is from non-B&L products. As I described in my previous articles, this negative organic growth rate needs to be deduced. Valeant has spent lot more money on non-B&L acquisitions than B&L (Valeant's debt load is $17 billion, it paid $8.7 billion for B&L, not all of the B&L payment was cash).

In its earnings releases, Valeant states only B&L's organic growth and overall organic growth, even though most of Valeant's revenue comes from non-B&L products. This is really aggressive accounting; other companies mention their revenue and profits from recent acquisitions separately so that investors get an idea of how well the pre-existing businesses are doing.

A term that Valeant has used a lot in earnings releases is "pro forma". Has anyone been able to find Valeant's definition of "pro forma" when it talks about pro forma organic growth? If companies are allowed to exclude and include products as they please when reporting revenue growth, every company in the world would report great growth.

Valeant will talk a lot about B&L

Even though David Pyott referred to the pharmaceuticals of B&L, Valeant seems to have interpreted this as an allegation that "the Bausch & Lomb portfolio is not growing". In its May 28 announcement, Valeant seems to have ignored what Pyott said about the non-B&L products.

In the Q1 earnings call, Valeant's CEO attributed B&L's growth to "largely products that they had when we bought them, because most of their new products are just starting to launch now".

Warburg Pincus, B&L's former private equity owner, had been planning an IPO for Bausch & Lomb. Naturally, it had developed but not launched new products. If not, an IPO would be hard. It is difficult for a company to show up for an IPO and say that it doesn't have any upcoming products. It would also have under-invested in sales and planned to ramp up sales after the IPO.

Soon after B&L was acquired, Michael Pearson said that Warburg Pincus did a good job of investing in R&D, and that Valeant would be the main beneficiary. Even though private equity investors are aggressive at cutting jobs and costs, Valeant managed to cut around $900 million more. This was killing the golden goose and having a big feast.

The B&L products that were developed but not yet launched, were launched recently and will be launched in the near future. Pearson said a year ago, when Valeant was buying B&L, that "Bausch has 9 near-term approvals and launches expected in the next few years." This is one of the sources of B&L's growth. The other source is Valeant's larger sales force. But these are one-time bumps. What happens after the anniversary of B&L's acquisition? We can have a fair assessment of Valeant's slash-and-burn strategy only after sufficient time has elapsed; but Valeant will be trumpeting B&L on May 28, even though it has been less than a year since it closed the B&L acquisition.

Conclusion

The table below is a summary. The next week is going to be interesting.

Cheat sheet for investors

When Valeant says thisAsk for this
"Unaffected price" of AGNEV/EBITDA multiples for VRX and AGN
B&L organic growth, "pro forma" non-B&L organic growthNon-B&L organic growth without any "pro forma" exclusions
Pharma industry R&D productivityAllergan's R&D productivity
Source: Investor's Guide To Valeant's May 28 Event For Allergan And Valeant Shareholders