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Summary

  • Valeant's May 28 presentation was what I had expected. There was no mention of Allergan's R&D productivity, EV/EBITDA, or Valeant's negative non-B&L growth rate.
  • Valeant is in a hurry to do a deal before the B&L acquisition anniversary. Otherwise, momentum investors will exit Valeant stock when they see Valeant's anemic organic growth rate.
  • Valeant is highly overvalued, with $50 debt per share. EV/EBITDA multiple of 10 puts Valeant's stock price at $58. Valeant's cash earnings are overstated because it capitalizes what others expense.
  • Valeant's offer for Allergan is 40% cash, 60% stock. It's a bad deal for Allergan shareholders. Allergan is growing through 2019 at 20%, Valeant revenue grew at 1% in Q1.
  • Valeant trashes the business model of other pharmas all the time. But Valeant has a poor return on capital (12.8%) compared to Allergan (36%) and other pharmas.

"If you mix raisins and turds, they're still turds."

- Charlie Munger (Vice Chairman, Berkshire Hathaway)

Prologue

This excerpt is from Valeant Pharmaceutical International's (NYSE:VRX) Q2 2013 earnings call transcript, a few days after the Bausch & Lomb acquisition closed.

Gregory D. Fraser - BofA Merrill Lynch, Research Division

Okay. Then just with your new revenue mix and larger size, what do you think is a reasonable organic revenue growth target going forward?

J. Michael Pearson - Chairman of the Board and Chief Executive Officer

We appreciate the question, but we're not going to answer it.

Introduction

Last week, Valeant increased its hostile offer for Allergan (NYSE:AGN) by $24 in cash. The offer is now 40% cash, 60% stock. Valeant gave a presentation to Allergan and Valeant shareholders on May 28 - the idea was to try and convince investors that Valeant's roll-up strategy is sustainable.

What I had expected

In my May 27 Seeking Alpha article, I said this in the 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.

I scored 2.8/3 - I dock myself a little bit for the third point, the first two were 2/2. In its May 28 presentation, Valeant made vague references to the industry's R&D productivity instead of saying anything about Allergan's R&D productivity (as an aside, every Big Pharma company out there has a higher return on capital than Valeant). Valeant also did not mention anything about EV/EBITDA. Instead, it used P/E. This way, it could pretend it doesn't have its industry-record debt. E was its "cash EPS". It is standard in mergers to use EV/EBITDA; so that a company that is leveraged to the maximum (Valeant) is not put on the same footing as a debt-free company (Allergan).

Regarding the third point, Valeant did mostly talk about B&L, but Valeant also cherry-picked its non-B&L growth. I missed the cherry-picking, otherwise my score would be 3/3. Of course, cherry-picked "revenue growth" depends on the metric. I don't know whether it used "excluding generics", "including generics", "pro forma excluding generics", or "pro forma including generics" for their graphs which went from lower left to upper right.

In its 176-slide presentation, it managed to evade showing its non-B&L growth. Its -6% non-B&L growth in Q1 is deeply negative, and non-B&L is 56% of its revenue.

Negative organic growth rate in non-B&L products

Valeant never showed its non-B&L growth rate in 176 slides! Regular readers would be familiar with what I am saying in this section, and can skip to the next section if they want. Instead of non-B&L, it showed its overall organic growth rate, i.e. B&L + non-B&L organic growth rate. In its latest quarter, B&L revenues were 44% of the total. Non-B&L revenues that were the remaining 56% grew at -6% in Q1 2014 and -3.3% in Q4 2013. As one might have expected, it didn't show this in its slide 162 titled "dissecting organic growth rates". Instead, it said Allergan's analysis had "several errors".

My calculation is very simple, and I first described it in my article titled "Valeant's Low Returns On Capital And Other Problems". Essentially, it gives you "B&L + non-B&L growth rate" and B&L growth rate. So you have to solve for the missing variable - non-B&L growth rate. This was -6% and -3.3% in the last 2 quarters.

Even though it says it is "very transparent about our adjustments", it has never shown its non-B&L organic growth rate in any earnings release or presentation so far. Nor could I find its definition of "pro forma" in any earnings release or presentation until May 28.

What Valeant means by "pro forma"

One thing it did de-mystify on May 28 was what it meant by "pro forma". I had looked in its earnings releases and 10-Qs and 10-Ks, but hadn't been able to find its definition of "pro forma". When it says "pro forma", it means growth that excludes divestitures and discontinuations. So, for example, when it sees that its market share in neuromodulators and fillers is falling (because Allergan is gaining), it can divest those to Nestle, as it did last week. Lo and behold, Valeant's "pro forma" growth rate increases sharply after the divestiture!

EV/EBITDA versus P/E

Valeant's stock is highly overvalued. But in a bubbly market, valuation concerns fall on deaf ears, as they did in the dot-com bubble. In what kind of world would a 1% growth stock with Debt/EBITDA of 4.6 be put on the same footing as a 20% growth stock with no debt? Valeant has 1% growth, Allergan has 20% growth.

Instead of using EV/EBITDA, which is the standard measure for mergers, Valeant uses P/E. Valeant completely avoids any mention of EV/EBITDA. This is because Allergan and Valeant trade at almost the same EV/EBITDA multiple.

EV includes debt, while P doesn't. Valeant has $50 debt per share, whereas Allergan has $5 cash per share. If you factor in the debt, the Valeant offer is really bad for Allergan shareholders. Nowhere in Valeant's 176-slide May 28 presentation did it talk of its debt load.

Valeant fans like to say that Allergan has a higher tax rate, and tax rate is Valeant's advantage. If so, let us factor out the taxes from the denominator in EV/EBITDA and call it EV/EBIDA. Are Valeant fans willing to use normal interest rates instead of the current record-low junk-bond rates? I guess not. Anyway, let us ignore the interest rate for now and remove just taxes from the denominator. Since this article is already long, please refer to the numbers in my article "Buy Allergan, Not Valeant. It's A No-Brainer" for the remainder of this section.

Let us calculate this EV/EBIDA ratio for Allergan. If I remove $500 million in taxes from Allergan's denominator, I get an EV/EBIDA multiple of 21.3 for Allergan, which is not that far off from Valeant's EV/EBITDA of 16.7. Allergan's EV/EBITDA is 17.4.

Now what happens to Valeant if junk bond interest rates normalize? It blows a big hole in Valeant. A 4% increase in junk bond rates would increase after-tax interest expense for Valeant by nearly $2 per share ($16.7B x 0.04 x 0.95 = $635M, assuming a 5% tax rate). Another big hole would appear if lawmakers remove Valeant's tax rate advantage. Valeant's stock price would be hit very hard if either of these events happen, let alone both.

Allergan's EV/EBITDA and P/E ratios will fall sharply due to its organic EPS growth for 2015-2019 (1.25 x 1.2 x 1.2 x 1.2 x 1.2 = 2.6). Trading Allergan for Valeant stock is a really bad idea.

Fair value of Valeant stock

What multiple should one pay for a 1% growth stock like Valeant? I wouldn't pay more than a multiple of 10 times EV/EBITDA.

Valeant Fair Value
EV/EBITDA MultipleEVVRX Price
1036B$58
1139.6B$69
1243.2B$79
1346.8B$90

At 10 times $3.6B 2014 EBITDA, EV would be $36B. Valeant's stock price would be $58.

At 12 times $3.6B 2014 EBITDA, EV would be $46.8B. Valeant's stock price would be $78.

At 13 times $3.6B 2014 EBITDA, EV would be $46.8B. Valeant's stock price would be $90.

The 60% stock offer for Allergan at the current Valeant stock price of $130 really stiffs Allergan shareholders.

Allergan-Valeant relative valuation

Valeant is like a car without gas in the tank. Allergan is like a car with a full tank of gas. Allergan has just started pressing the gas pedal, and will outdistance Valeant by a big margin in coming years. Recall its 25% growth forecast for 2015 and 20% growth forecast for 2016-2019. Which car would you rather drive?

Valeant's Cash EPS boosted by hiding R&D expense as impairment/amortization

Whereas companies like Allergan report R&D expenses, Valeant acquires companies and regularly reports amortization/impairments of the acquired assets. These impairments and amortization charges are ignored for "cash EPS". Voila! You get R&D output without R&D input! Capitalizing what should be expenses is one of the oldest accounting tricks. Quoting from Warren Buffett's 2000 letter:

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons

For example, Valeant reported an impairment charge of $551 million in 2013 for ezogabine. If this compound had failed during R&D, it would be considered R&D expense and deducted from earnings per share. But Valeant calls it an impairment and adds it back to Valeant's "cash earnings per share". This is why Valeant's debt keeps going up along with its "cash EPS". We should probably rename Valeant's "cash EPS" as "debt EPS".

Valeant's slide 169 is titled "Allergan and Valeant make the same adjustments to report non-GAAP earnings". Maybe. But what matters is how frequent and how big those adjustments are. If Allergan does it 1% of the time and Valeant does it 99% of the time, it is not the same; it is very different. As Supreme Court Justice Potter Stewart said, "I know it when I see it."

Saying "Allergan and Valeant make the same adjustments" is like saying Allergan and Valeant both do R&D and acquisitions. Sure, but it is obvious to everyone that Valeant's business model (and accounting) is very different from that of Allergan and other pharmas.

Valeant's true earnings - haven't seen any attempt to estimate

Valeant has taken billions of dollars in amortization charges and acquisition-related charges, such as integration and restructuring (see my article titled "Valeant Skating On Thin Ice..." for the numbers). But they have all been duly added back to "cash EPS".

I don't know whether analysts have calculated what Valeant's true earnings are, because I haven't read anything anywhere about Valeant's true earnings. Valeant's whirlwind pace of acquisitions/divestitures and aggressive accounting make it really hard to evaluate what true earnings are. But for the sake of Allergan shareholders, someone needs to at least make an attempt.

To illustrate the lack of detail in financial releases, Valeant's recent announcement of a divestiture to Nestle had no financial information except for the sale price of $1.4B. There was no mention of gain or loss or revenue or profit.

Revenue segments

In its slide 171 titled "Both Allergan and Valeant have changed segment reporting under current CEOs", Valeant sanctimoniously showed that both Allergan and Valeant have 2 reporting segments. A minor issue is that Allergan's 2013 revenue is $6.3B, not the $3.1B shown on that slide.

The major issue is that Allergan gives the revenue breakdown per-drug. Look at Allergan's latest 10-K. On page 42, Allergan breaks down the Specialty Pharmaceuticals segment into Eye Care, Botox, and Skin Care and Other. Under Medical Devices, Allergan gives data for Breast Aesthetics and Facial Aesthetics. Allergan also reports sales information for major drugs like Alphagan, Combigan, Lumigan, Restassis, and Latisse.

All that Valeant reports is two numbers - one for Developed Markets and one for Emerging Markets. This way, people cannot find out which product areas are growing and which aren't.

Just contrast the transparency in the financial reports of Allergan and Perrigo Company (NYSE:PRGO) with the opacity in Valeant's financial reports.

Number of products not an excuse, just look at Perrigo

Valeant bulls are enamored by Valeant's claim of over a thousand SKUs. They may say that unlike Allergan, Valeant cannot give the revenue breakdown by product because Valeant's revenue is diversified. But Perrigo has many times more products than Valeant and also makes a lot of acquisitions, yet its reporting is transparent. Here are some excerpts from Perrigo's latest 10-K to illustrate Perrigo's number of products.

The Consumer Healthcare segment currently markets over 2,700 store brand products, with over 10,000 stock-keeping units ("SKUs"), to over 1,000 customers.

The Nutritionals segment currently markets over 900 store brand products, with nearly 3,300 SKUs, to nearly 150 customers.

The Rx Pharmaceuticals segment currently markets approximately 700 generic prescription and ORx® products, with almost 1,400 SKUs, to approximately 300 customers.

Perrigo makes a lot of small acquisitions, but it generates consistent organic growth from these acquisitions. As a result, it is not afraid to report its revenue transparently. When you read Perrigo's earnings release, you aren't left with questions.

Perrigo reports five business segments in its earnings releases - Consumer Healthcare, Nutritionals, Rx Pharmaceuticals, API, and Specialty Sciences. For example, take a look at its latest earnings release. The revenue, operating income, and other financial information is reported for each segment. Under each segment, it identifies the sales increase attributable to the recent acquisitions, increase in sales of existing products, and new product sales. It reports the revenue attributable to acquisitions long after the acquisition closed.

This excerpt is an example of the revenue breakdown under each segment. Using this data, it is easy to gauge organic and inorganic growth.

Consumer Healthcare segment net sales were $537 million, reflecting an increase in sales of existing products of $17 million (smoking cessation and dermatologic categories), new product sales of approximately $12 million and $6 million attributable to the recent acquisitions of Velcera and OTC products acquired from Aspen Global Inc.

Why Ackman is accepting Valeant stock

Remember that Ackman bought mainly call options, in addition to a tiny amount of Allergan stock. His sensational profits are due to his relationship with Pearson, and not due to stock-picking skill. In a flat stock market, you can't get a better deal. Valeant tips him off about a deal, and Ackman buys call options with all the money he can gather.

According to the SEC filing, Ackman bought a lot of Allergan call options. It's a huge windfall. He would need to impress Valeant enough such that Valeant doesn't choose some other hedge fund to repeat this trick next time (perhaps, by now, other hedge funds have already approached Valeant offering their help in future endeavors?). Ackman bought just a tiny amount of stock. It's almost all calls. Of the roughly 29 million shares controlled by Ackman, just 600,000 are not in the form of call options.

Why Valeant is in a hurry

Valeant is in a hurry to get a deal done before the anniversary of B&L in August 2014. It is like the movie where someone turns into a werewolf at full moon. Valeant's bubbly valuation is based on its status as a momentum stock. After the B&L anniversary, the year-over-year growth rate will be its organic growth rate, which is currently 1%. A 1% revenue growth rate is a real turn-off for momentum investors.

Therefore, Valeant wants to use its overvalued stock to make some deal before it reports Q3 results in October. I am not the only one saying this about the B&L anniversary, Jim Chanos is saying it too. Valeant is so desperate for an acquisition that it enlisted the help of Ackman. Valeant had no cash to buy Allergan stock, so it tipped off Ackman, who bought Allergan call options.

ValueAct selling

ValueAct is the one major investor that knows the most about Valeant. But Mason Morfit resigned from Valeant's board to be able to sell most of ValueAct's Valeant holding. Mason Morfit was at Valeant even before Pearson, and he was the one who set the terms of Pearson's compensation.

Allergan shareholders should remember that they are being asked to take Valeant stock at the same time as its most knowledgeable investor is selling.

Return on Capital and snake oil

All the talk of Valeant being a better manager wilts in the face of three words "Return on Capital". How would Valeant explain its low return on capital? Valeant trashes the business model of other pharma companies all the time, but those other pharma companies have higher returns on capital. Despite all this talk of outsiders and synergies and lousy pharma R&D productivity and other Valeant epiphanies, Valeant's return on capital is much lower than Big Pharma and biotech companies.

Return on capital doesn't lie. Companies may tell all sorts of great stories, but if you want to cut to the chase, ask them for their return on capital. Valeant's return on capital is much lower than Allergan's, even with Valeant's low tax rate and "cash EPS" and Allergan's supposedly unnecessary R&D expenses.

Using the midpoint of Valeant's "cash EPS" forecast, we get a return on capital of $8.5/($50.3 + $15.7) = 12.8%. (The $50.3 is debt per share minus cash and $15.7 is equity per share).

For Allergan, with $1.6B in net cash and book value of $6.4B, and 300 million shares outstanding, the denominator is $16. Allergan's 2014 EPS forecast mid-point is $5.69 per share. That yields a return on capital of $5.69/16 = 36%. Far higher than Valeant.

The reason Valeant's return on capital is low is that return on capital does not exclude debt. This proves that all these new management theories and buzzwords from Valeant are just snake oil. Its high returns on equity are due to sky-high leverage - nothing else (Debt/EBITDA = 4.6). Valeant's debt-to-equity ratio is $50.3/$15.7 = 3.2. These are eye-popping numbers for a pharma. Warren Buffett has said whenever smart people go broke, it is because of leverage.

This return on capital gap is scheduled to increase vastly over the next few years, as Allergan's expected profit growth is vastly higher than Valeant's.

Conclusion

Allergan shareholders should heed Charlie Munger's maxim about raisins at the start of this article. Valeant's stock is highly overvalued when you factor in its debt and growth rates and compare with Allergan. Valeant is in a hurry to do a deal before the anniversary of the B&L acquisition. Without an acquisition, Valeant's organic growth rate, unsustainable business model, and valuation will become apparent to everyone, leading to the exit of momentum investors from its stock.

Valeant wants to use its overvalued stock as currency for acquisition before (as Warren Buffett would say) the tide goes out and it is found to be swimming naked.

This Bloomberg article indicates that bankers who advise healthcare companies are worried about Valeant's stock price.

Bankers and lawyers advising other health-care companies have told their clients to take cash instead of stock if any are approached by Valeant, according to people familiar with the matter.

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.

Source: Why Allergan Should Reject Valeant