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Summary

  • Valeant didn't explain its lower return on capital, lower per-employee cash-flow compared to Allergan, negative organic growth, high EV/EBITDA multiple, and excellent Allergan R&D productivity. Can Valeant forecast 2015 organic growth?.
  • What Valeant omits in its "fact-based" presentations is very dangerous to investors. Considering that Valeant has already presented hundreds of slides, Valeant doesn't intend to ever address these dangerous questions.
  • Valeant is in a huge hurry to complete a deal before the B&L anniversary. If Valeant doesn't complete a deal soon, it will be in an existential crisis.
  • There are eerie parallels to Enron and Worldcom. Cheerleading analysts, McKinsey partner who invents a new business model, breathtaking revenue and cash-flow growth by capitalizing expenses, opaque accounting, and financial engineering.
  • What Valeant doesn't say is very dangerous compared to what it says. Just concentrate on what Valeant chooses not to address. That is where the scary truth lies.

Dangerous Questions Unanswered

Has anyone noticed that Valeant (NYSE:VRX) hasn't addressed any of my questions in its numerous "fact-based" presentations, including the one today? Let me summarize the questions again:

1. Valeant claims to have a superior business model. Why then is Valeant's return on capital of 12.8% much lower than Allergan's (NYSE:AGN) 36%? If we look at pre-tax return on capital, the comparison is even worse. The ROC is calculated in this article.

2. Why is Allergan's per-employee cash-flow ($181,000 per year) higher than Valeant's per-employee cash-flow ($153,000 per year)? These numbers used Valeant's favored "adjusted" cash-flow and Allergan's non-adjusted cash-flow. Despite this, Allergan generates more cash per employee. Where is Valeant's efficiency that it keeps touting? Doesn't this prove Allergan's business model is far superior?

3. Valeant said it would see 10% growth in B&L through 2014. Sure, we know that they launched products that B&L developed pre-acquisition, and Valeant has a larger sales force. What happens after this one-time effect passes?

Reminder: Non-B&L growth is hugely negative (-6% in Q1 2014). B&L has to grow at 10% just to keep overall organic growth for the company at around 1%.

Can Valeant forecast its 2015 organic growth? Is it 0% or 1%?

4. Valeant keeps evading its huge debt load of $50 per share. Why doesn't it mention that it trades at almost the same EV/EBITDA multiple as Allergan? Valeant is hugely overvalued. But Valeant pretends its debt position is on par with debt-free Allergan by using Price/Cash earnings. Cash earnings is misleading and overstates Valeant's true earnings as I pointed out in my previous article.

5. How does Valeant explain its 1% organic growth compared to Allergan's 20% organic EPS growth? How can a 1% grower have such a high multiple?

6. Allergan's R&D productivity is at the top of the industry. But as SA commenter afinemess pointed out, Valeant took data from an article praising Allergan's R&D productivity and omitted Allergan's name in the ranking list. Why does Valeant hide Allergan's excellent R&D productivity? It shows the extent to which Valeant will go to misrepresent Allergan. This is described in more detail later in the article.

Enron parallels

I am not saying Valeant is another Enron or Worldcom. I am just pointing out similarities.

Enron's CEO, Jeff Skilling had a great career at McKinsey (like Valeant's CEO, Michael Pearson). He propounded a new business model at Enron that captured the imagination of Wall Street. Enron was named the most innovative company in America for six consecutive years by Fortune magazine. This is what McKinsey had to say about Enron (quoting from this Guardian article):

"McKinsey called the process 'atomising'. In one of its influential quarterly reviews it gushed: 'Enron has built a reputation as one of the world's most innovative companies by attacking and atomising traditional industry structures. Enron no longer produces oil and gas in the US, no longer owns an electric utility, and has never held a large investment in telecom networks. Yet it is a leading value creator in each of these industries.'

Indeed, why try anything hard, when financial engineering can give better results. We know how that promising story ended - in bankruptcy and infamy.

Jim Chanos shorted Enron. Now, Chanos is short Valeant.

Worldcom parallel

This must be why Joel Greenblatt is short Valeant.

Worldcom reported eye-popping increases in revenue and cash-flow until its equally eye-popping bankruptcy. Worldcom was also an acquisition-driven company with GAAP losses, that later turned into the largest ever bankruptcy at the time. Like Worldcom, Valeant capitalizes what others expense. Others expense R&D, Valeant capitalizes R&D through acquisitions. Four days after I wrote my article on this issue, Barron's agreed with me on Valeant's capitalizing versus expensing issues in this article. Look at the section titled "The Problem with Valeant."

Worldcom's 10-Ks are fascinating. You can see the difference between GAAP profits and prodigious cash flows in the 1998 10-K and 1999 10-K for example.

While pointing out the difference between capitalizing and expensing, Barron's even invoked the book "Financial Shenanigans" - that was a book written in the wake of the accounting shenanigans at Enron/Worldcom/Tyco. The Barron's article contains too many choice quotes on Valeant to excerpt; readers are referred to the article for lack of space here.

In the last two weeks, there have been insightful articles from prominent publications such as Barron's, New York Times, Wall Street Journal and Forbes. It is encouraging to see the media shed light on Valeant.

But Valeant's CFO, Howard Schiller, told Barron's, NYT and WSJ, that every other pharma company makes the same adjustments to GAAP. That is like an alcoholic using the excuse "everybody has a drink" (Supreme Court Justice Potter Stewart commented: "I know it when I see it"). Valeant's acquisition-driven financials consist mainly of adjustments; they are obviously different from R&D-based pharmas.

This is worthy of a Hollywood comedy

1.5 hours before the market closed on Friday May 30, Ackman and Valeant announced their increased offer for Allergan. They did this while knowing that Ackman would file for a proxy fight on Monday June 2. Naturally, the unprepared stock market was surprised on both Friday and Monday, and VRX closed up on both days. Ackman declared that the market had spoken.

But starting the next day, Valeant's stock fell for 10 days consecutively until today, from $134 to $117. This must have rattled Valeant's management, because they produced yet another "fact-based presentation" today (which was devoid of the facts I listed at the beginning of this article).

The reason I think this can be a Hollywood comedy is that Ackman wanted to buy Valeant, but bought Allergan instead upon Pearson's suggestion. If Ackman had gone ahead and bought Valeant, he would have lost money.

Another joke is that the arbitrageurs have made more shorting Valeant, though they would have originally intended to bridge the price gap between the offer price and current market price. Given the relative price action of VRX and AGN, I doubt there are any arbitrageurs left in Allergan stock.

Ackman proclaimed that he would take 1.22659 shares of Valeant for every share of Allergan. Has the recent price drop changed his mind? If not, will Ackman accept anyone's Valeant stock in exchange for Allergan right now? Ackman's offer to take 1.22659 Valeant shares will net him $20 less now than when he made the offer.

WSJ on filler market share: how good are Valeant's revenue claims?

A deeply concerning excerpt from this WSJ article shows a big gap between what Pearson says and what independent researchers say:

Valeant's share of the $490 million antiwrinkle filler market in the U.S. had fallen to 30.3% by April from 43% during the quarter the company bought Medicis, according to market research by Guidepoint Global reviewed by The Wall Street Journal. Perlane's share of the market dropped to 9%, down from 14.4%.

Meanwhile, Allergan's market share rose to 46.2% from 33.8%, according to the Guidepoint data. Voluma notched a 13.8% share in April, in just its third quarter on sale.

Mr. Pearson disputed the scope of the Guidepoint data, and said Valeant's own figures show sales of injectables including the fillers grew 20% over the prior year. Valeant doesn't break out sales for particular products.

If it was growing at 20%, why did Pearson sell it to Nestle? It doesn't mesh with what Allergan said either: Allergan's CEO David Pyott said he had never in his career seen such a dramatic market share change in such a short time as he saw in the filler market where Allergan gained at Valeant's expense.

Forbes article (thanks to reader afinemess for pointing this out)

A Forbes article called Valeant's statements on R&D "misleading and wrong." Look at slide 9 in this Valeant SEC filing, at the bottom it reads, "Source: Forbes Who's the best in drug research." That Forbes article is linked here. The author of that Forbes study even said this about Allergan's R&D productivity:

"It's absolutely counter to Valeant's argument, no doubt, " says Evans.

Now go back to slide 9 of Valeant's filing. See that even though Allergan is ranked number 5 in the Forbes table, Valeant has omitted Allergan on slide 9! This confirms my suspicion that Valeant doesn't really have any good data on R&D productivity - it had to go the extent of taking a table from a study that praised Allergan and stripping out the mention of Allergan at rank #5.

Valeant fighting for survival

Valeant's business model is in an existential crisis. A rejection by Allergan shareholders would mean the end of Valeant - leading institutional investors would deliver a verdict from which Valeant cannot recover. If Allergan shareholders reject Valeant, every other pharma company can use the same argument and reject Valeant's acquisition attempts.

Valeant's overvalued stock price depends on perception. Valeant's stock price is unsupported by its financials.

Though it's a risky gamble to go for a vote by Allergan shareholders, Valeant has no option. The Bausch and Lomb anniversary is fast approaching and Valeant desperately needs something quickly to maintain the illusion of growth.

The battle for Allergan can be Valeant's Waterloo.

Conclusion

Investors should not get lost in the weeds - by weeds I mean all the stuff Valeant put out in today's "fact-based presentation." They should instead focus on the items I listed at the beginning of this article. Valeant would like nothing better than investors getting lost in the weeds. Investors should instead focus on the few key variables that I have listed and demand answers from Valeant.

It is encouraging that the financial media has started taking a critical look at Valeant over the last two weeks. However, we can't expect the same from analysts. Analysts acted as cheerleaders all the way to the end in past debacles and we can expect the same from them this time.

Source: Valeant Left Important Questions Unanswered; Allergan Shareholders Beware