- Valeant's new offer generates terrific value for Allergan shareholders.
- The bear view of Valeant focuses too heavily on revenue and not on cash flow.
- Valeant is a valuable platform for creating value, due to CEO J. Michael Pearson and his capital allocation talent.
In just a few short weeks, Valeant's (NYSE:VRX) battle with Allergan (NYSE:AGN) has led to higher offers and more controversy. Valeant's latest offer is certainly the most intriguing for Allergan shareholders. Pershing Square's Bill Ackman has given up any claim on cash compensation for his shares, and thus, he will be receiving shares 1.22659 shares of VRX for every AGN share he owns. With Allergan's largest shareholder giving up his cash compensation, Valeant was able to boost the offer to a cash component of $72, with a share exchange ratio of 0.83. Additionally, Allergan shareholders will receive a contingent value right (CVR) for DARPin potentially worth $25 per share.
Assuming current market prices persist, Allergan shareholders could receive upwards of $181 per share in value from cash and Valeant shares alone. The CVR would just be an additional kicker, and would allow investors to express an opinion on the outcome of a given drug. It may take years for DARPin to get to market, but the macular degeneration drug could be blockbuster.
I think it's safe to say at this point that Allergan shareholders are receiving an incredible deal. Based upon the "unaffected share price," as defined by Valeant and Ackman, of $116.63, Allergan shareholders stand to make a return in excess of 55%. Plus, once the market becomes more confident in the deal's ability to get done, I believe Valeant will see robust share price appreciation.
What Obstacles Remain?
Potentially the largest obstacle preventing a deal from culminating is the reputation of Valeant and CEO J. Michael Pearson. In one camp are market participants such as myself that see Pearson as the quintessential "outsider" CEO. I do not see Pearson as a slash-and-burn private equity manager, but rather as a fantastic investor who realizes the value of decentralized corporate functions and bold capital allocation strategies. He focuses on free cash flow and cash EPS, rather than GAAP numbers that can often obscure reality.
Oddly enough, this is consistent with how the likes of Warren Buffett and Charlie Munger think about earnings. The Berkshire leaders do not like metrics like EBITDA (earnings before all the costs), and focus on cash.
Valeant bears take issue with cash EPS. They do not like how the company issues GAAP accounting, and point to the firm's high debt load and poor organic growth as other issues with the company.
Debt is an interesting topic. Valeant has been aggressive in terms of taking on debt. The company current has around $17 billion in debt, which undoubtedly makes the firm a riskier enterprise than an unlevered Allergan. However, I think a highly leveraged capital structure makes sense given Valeant's strategy. The company has been picking off deals with high returns on invested capital (20%+) that easily generate enough cash flow to cover interest expenses. Plus, it would seem foolish for Valeant not to borrow while its interest costs are ranging between 5.5%-7.25%. Even after adding tons of leverage, Valeant was able to generate $484.3m in operating cash flow in 1Q14. That's up 90% y/y.
To me, the debt argument is the weakest pillar of the Valeant bear case. Whether skeptics want to say the organic revenue growth rate at Valeant is inflated by 0.5% in 2013 is pretty irrelevant to the ability of Valeant to turn a positive return on invested capital. Even the GAAP cash flow makes it clear that Valeant is generating solid returns.
Many bears refuse to acknowledge that part of the Valeant business model may involve weak organic growth in some of its drugs. As Pearson acknowledged during the Annual Meeting held on May 28th, the company will occasionally scoop up shorter-lived assets and harvest them for cash flow.
Operating expense cuts are the other fear. Allergan is known for having a high-performing R&D model. However, CEO David Pyott clearly knows Allergan is spending too much on R&D. That's the only reason he's been able to guarantee 20%+ EPS growth going forward. He knows he can slowly decrease R&D spending and show tremendous earnings growth, without hurting any part of the business. In reality, Pyott agrees with Pearson - he would just never admit as much.
Valeant also doesn't cut all R&D spending. In fact, management is pretty indifferent as to where growth comes from. If the highest ROIC can come from internal R&D, management will spend on internal R&D. If it comes from an acquisition, then management will opt for an acquisition. Pearson ultimately views cost of capital in the same way Buffett does - as the next-best investment opportunity. Going forward, R&D spending may become undervalued, and investors will then see Valeant spend more on R&D than its competitors. Such is the beauty of the business model.
Instead of slowly extracting savings, Valeant will likely cut quickly to maximize cash flow generation. Additionally, like with Bausch & Lomb, Valeant will cut duplicative roles, but not necessarily slash and burn the entire sales force. And Valeant has identified quite a few synergies - enough to extract $2.7 billion in savings.
Will the Deal Get Done?
The largest obstacle for the deal getting done has always been the stock component. Some investors simply do not believe in the Valeant story. However, the current excess return generated by the offer, coupled with the fact that Valeant will probably be your best steward of capital in the healthcare industry going forward leave me confident that the board will make the correct decision and accept the offer. This could be the first of many transformational deals that makes Valeant the largest healthcare company in the world.
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.
Additional disclosure: I have owned VRX for close to 2 years, and truly believe in the talents of Mr. Pearson.