The Company. On August 20, Warner Chilcott (WCRX) declared a special cash dividend to its shareholders of $8.50 a share. Investors who bought that day at $28.12 would see the obligatory $8 drop on the ex-date, but then the price rose to $24.96 on Oct 12, giving a wonderful 19% total return over those 50 or so days. This may have be something WCRX's investors are well used to by now - in 2009, along with the rest of the market, WCRX began a massive rally that blew past its old mid-2007 peak of $19.51 to close the year at $28.47 up 102.63% from the previous year. The catalysts were many: drug collaborations with Dong-A and Watson (WPI), strong revenue guidance (please note - due to the sales practices of this company, all references to "revenue" in this essay really mean "net sales"), redomestication from Bermuda to Ireland, purchase of P&G Prescription Drugs business for $3b financed with $4b from a bank syndicate, and a $445m SEO. All hell was turned loose on WCRX's financial statements, which became a frightful mess of post-acquisition accounting, among other things. Today, robot traders routinely spit WCRX out as an Irish company even though its drugs are marketing primarily in the US and continental Europe, and I would not be surprised if one could find evidence that it trades with the likes of Allied Irish Banks (AIB) and other Irish names.
The Underlying Trend, Prevailing Bias, and the Flaw. Trying to value WCRX is like trying to aim at a moving target. Essentially, WCRX's 2010 financial statements are really the financial statements of two companies, that is, WCRX pre P&G, and post. When about 33% of the company's assets and 60% of its revenue has recently been acquired, there is almost no meaning to doing growth analysis, and given the transactions detailed above, good luck trying to do a pro forma. Still, I believe my competitive advantage is in cutting through noise, so here I present to you the simplified version of WCRX according to me:
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A few notes:
- I reduced WCRX's drug portfolio to its top 5 revenue generators, which account for 81.5% of revenue.
- I then added 3Q10 to the 9 month figure to bootstrap a full year figure; this is wrong on so many fronts, but yet feels right in its simplicity. This bootstrap figure was helped by the fact that growth/decline trends have not changed much over this year with the single exception of Doryx, only 6% of the portfolio.
- It is interesting that most of the drugs that I left out in this manner were also experiencing YoY declines in the neighborhood of 20-30% - if they are irrelevant this year, they'll be nothing next year.
- "Qtr increase" and "9m increase" are percent increases over the same period in 2009 (directly taken from their 10Q)
- I allocated current SGA, amortization, and cost of sales values according to their contribution to revenue in order to arrive at a per-drug EBIT of $702m for the subset of top 5 drugs that will essentially carry WCRX's future.
Identifying the prevailing bias is easy. According to some calculations, PE stands at 35 now, up from just 14 a year ago. And no wonder; wouldn't you reward lavishly a company that has done this in the past five years:
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However, I submit that the underlying trend is rather more sinister and difficult to grasp:
- Products. Loestrin and Estrace, the only growing products worth 15% of the portfolio, have seen slowed growth this quarter compared to the past nine month's growth. Shrinkage in sales for Actonel and Doryx, worth 42%, hasaccelerated this quarter compared to the last 9.
- Positives: New product development in the Actonel, Asacol, and Loestrin lines may buffer the slowdown or even turn it around.
- Negatives: Listening to the conference call, one learns that ex-US sales of Actonel, worth $500m this year, will essentially be obliterated next year thanks to generics. Remember that Actonel alone in our analysis is responsible for $359m of the total $702m EBIT. Further, Loestrin, Actonel, and Asacol, together worth 71% of revenues, all have US patent expiry in 2013 and 2014 (and you wonder why P&G sold it for 1% goodwill?).
- Demand. WCRX is seeing a string of its distributors reducing inventory levels, making it more likely that the "contraction in pipeline deliveries" (see the notes above) causing the slowdown in revenue will continue. Further, the CEO himself noted that thanks to healthcare reform, "we saw filled prescriptions of certain of our products move from being covered as managed care RXs to being covered by managed Medicaid, same RXs, but moving from a high value sales bucket to a lower value sales bucket."
- Tax. The market is still valuing WCRX based on pretax earnings, largely because management is focusing on revenue and pretax earnings figures. This is ludicrous. Nominally, WCRX resides in Ireland, and enjoyed a fantastic 5.7%-7.8% tax rate in 2009. Compare to 2010, post its P&G acquisition with extensive operations in the rest of Europe including tax-loving France, its effective tax rates are now 37.1%-49.3%, an inconvenient truth nobody picked up on in the earnings call. Mind you, this tax rate was after favorable rulings in Switzerland, and favorable transactions in Puerto Rico, and before impending excise taxes from 2011 in Puerto Rico again (though the amount is likely minimal). Valuing a $702m EBIT stream with a 6% tax rate is a very different proposition from valuing it with a 40% tax rate.
- Leverage. You thought the housing crisis was nuts? WCRX intentionally pulled off a dividend recap borrowing $2.25b to repay $2.15b of shareholders equity, leaving the balance sheet filled with 100% debt and $-0.1b in equity. Any loss in WCRX (say, for example, losing $500m of business?) will be preposterously magnified for equity and junior debt holders. Oh, and interest expense, at 7.5% on a $5b long term debt schedule, could be $375m before accounting for tax savings.
Valuation. This part is extremely rough. Giving WCRX the benefit of the doubt, assuming no shrinkage in its revenues (the best case scenario), assuming no time value of money, no interest expense, taxing a $702m income stream for the 4 remaining years of patent life leaves us with $1.8b for the intangible assets of the top 5 drugs. Let's be generous and say that all the other drugs put together are also worth $1.8b. Add the $1.8b current assets and the $0.4b long term assets and the asset side of the balance sheet is really worth $5.8b, on debt of fully $6.1b. I know that at the end of the day the cash pile built up from the amortization of intangibles and goodwill, with a total value of $3.5b, will have some value so let's just throw that on to the asset side for fun ignoring doublecounting issues. The equity of WCRX is, at very best, worth $3.2b. At worst, this company is plain and simple 10 different kinds of bankrupt.
Where is the Reflexive Connection? For a start, that seasoned equity offering, but also the dividend recap. Both, especially when combined, provide self-reinforcing opportunities for share investors in WCRX to continually improve the financial position of its balance sheet so long as more suckers keep buying in. However I am intrigued by the fact that WCRX is still sitting on a cash hoard of $1.1b looking for potential investment opportunities. This is the one thing that could well undo a short: with an extremely knowledgeable CEO and management team (evidenced from their conference call), they would be able to act upon and maximize the value of a potential opportunity either arising externally or from their own R&D efforts. Thus, keeping the money instead of paying it out while they await these opportunities is a reflexive phenomenon that draws these opportunities to them as well as allows them to take advantage of it and in so doing make the exercise worthwhile (remember, since the cash is 100% borrowed any way, the high-yield interest expense is simply coming out of the shareholder's pockets).
Short WCRX. And I just can't wait for the next investor's call. However, I would get out of this short the moment any acquisition opportunity for them seems to be surfacing - the prevailing bias is still that WCRX can still maximize investment opportunities, and you don't want to fight that.
Disclosure: No position and no plans to initiate any positions within the next 72 hours.