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Summary

  • Valeant's largest shareholder's fate has become inextricably intertwined with Valeant. Valeant is 23% of their portfolio and they own 10% of Valeant. They can't exit without ruining their returns.
  • This led to a highly desperate defense at the Ruane, Cunniff, Goldfarb annual meeting.
  • Article discusses why Pearson is no "Outsider".
  • Several inaccurate and misleading statements on Valeant and Allergan from the transcript are pointed out.
  • Goldfarb revealed that Valeant's debt resides in the US. Treasury is targeting this tax trick in its regulations that don't require Congress - expect Valeant to take a major hit.

Introduction

Several Valeant investors have been inspired into invest in Valeant Pharmaceuticals (NYSE:VRX) because Ruane, Cunniff, Goldfarb (henceforth abbreviated as RCG) is Valeant's largest shareholder. To understand why this is the case, let us look at RCG's past. Over the weekend RCG released its annual meeting transcript. Valeant is mentioned 59 times and Allergan (NYSE:AGN) 29 times in the transcript. The incorrect and misleading statements that I will point out in the transcript might disappoint many RCG fans.

Ruane, Cunniff, Goldfarb background

The Ruane in RCG was Bill Ruane who died in 2005. He was a classmate and close friend of Warren Buffett and knew that Buffett was a genius right from the beginning. Right from the beginning of RCG, Buffett's Berkshire Hathaway (NYSE:BRK.A) was a large holding of RCG. For instance, in 1999, Berkshire Hathaway was 38% of RCG's portfolio. This heavy concentration in Berkshire led to outside returns for RCG from inception until 10 years ago. Ruane was a very good investor in his own right. While he was at RCG, RCG made some fine stock picks.

Fast forward to today. In this year's annual meeting, the people who spoke the most were Rory Priday, followed by RCG President, Robert Goldfarb. Priday is the analyst assigned by RCG to follow Valeant, he graduated in 2009 with a Bachelors degree in history from Harvard and joined RCG immediately thereafter. It seems Priday covers pharma, auto parts and energy for RCG. In the rest of this article I will point out incorrect statements by Rory Priday and Robert Goldfarb that bother me.

Ruane, Cunniff, Goldfarb's problem

Since RCG owns 10.2% of Valeant, if they reduce their position, they would have to make an SEC filing. Any news that RCG is selling Valeant would cause panicked selling by others. This would cause Valeant's stock to fall leading to severe underperformance by RCG because Valeant has grown to be 23% of RCG's portfolio. RCG has already been trailing the market badly this year. These are their returns.

To June 30, 2014 Sequoia Fund S&P 500 Index*
3 Months -0.86% 5.23%
6 Months 0.92% 7.14%
1 Year 18.42% 24.61%
5 Years (Annualized) 19.13% 18.83%
10 Years (Annualized) 8.67% 7.78%

Below, I will describe the inaccuracies in what Priday and Goldfarb said at their annual meeting.

Incorrect claim on Restasis patent expiry

Rory Priday said this about Allergan in the transcript:

The one thing we worry about, because we looked at Allergan before, is that it does have some drugs that could potentially face genericization. Restasis was one that we were particularly worried about. That is its biggest eye drug. The company staved that off. It may be able to have that drug for two or three more years without those worries.

But Allergan in slide 11 of this May 12 presentation, says that Restasis is patent protected until 2024.

There is also a Seeking Alpha article specifically on Restasis written by a patent attorney that explains that patents protect Restasis until 2024.

Restasis is Allergan's blockbuster drug. Can RCG find out how many Valeant products go out of patent by 2024?

Valeant's leverage

Rory Priday said:

So this year, if you were to exclude some of the cash payments for the restructuring charges that it is going to have to pay, Valeant might generate cash flow approaching $2.5 billion to $3 billion. The debt is five to six times cash flow.

It is not 5 to 6 times cash flow. It is 6.5 times cash flow. Prior to selling the injectables to Nestle, the midpoint of Valeant's initial adjusted OCF forecast for 2014 was $2.6B and debt was $16.9B. 16.9 / 2.6 = 6.5. Valeant raised its forecast after Q1 results to $2.7B - $2.8B. But lowered it sharply after Q2 results.

This ratio would not have improved after the injectables sale. The adjusted OCF forecast after the injectables sale was $2.3B - $2.6B for 2014. If Priday had said 6-7 instead of 5-6 times cash flow, it would have been accurate.

One more important thing to note: Valeant's weighted average debt maturity is extremely low, it is just 5 years. Valeant likes to live dangerously.

Allergan growth rate

Goldfarb asks this rhetorical question:

Bob Goldfarb:

Rory, did you think that Allergan's forecast of its own earnings growth that it issued this past Monday was credible?

Rory Priday:

My personal view is that maybe the company was a bit aggressive on the top line. You saw AstraZeneca do the same thing with Pfizer. You do not want to get bought; so you have to put out a pretty rosy forecast. That said, the company has great assets, and the top line, even if it does not grow 10%, could grow in the mid-to-high single digits.

Allergan's forecast is far more credible than Valeant's. Allergan reported 16% revenue growth and 24% profit growth in the latest quarter. It is forecasting at least 20% profit growth every year out to 2019.

What is not credible is Valeant's forecast. Valeant claims high single-digit organic growth in 2015 and 2016. This is from a company that grew organically at 0% in 2013, 1% in Q1 2014, and 2.4% in Q2 2014 (if you include the filler business that they ran into the ground).

So Goldfarb and Priday don't find Allergan's forecast credible, but sing Valeant's praises. Allergan has had 12 FDA approvals in the last 3 years leading to accelerating revenue growth. Valeant has been losing on the organic growth front and has been hiding financial data that other pharmas disclose. If such data is disclosed (such as pricing information), investors can plainly see a rotting business model.

Note that Goldfarb and Priday made their statements on May 16 - well before Allergan announced the job cuts and increased their forecast even further on July 21.

They will say anything to shore up Valeant, they are so madly in love with Valeant's CEO, Michael Pearson. They didn't find Allergan's pre-July 21 EPS targets credible. Just look at how good Allergan's Q2 results were. Valeant is in a hurry to buy Allergan because Valeant's business is rotting away quickly while Allergan's is growing rapidly. Valeant shareholders desperately want that transfer of wealth from Allergan shareholders.

Tax inversion pioneer

Robert Goldfarb claimed Michael Pearson may have been the first person in the pharma industry to get a tax inversion. Pearson was praised multiple times in the transcript for this great achievement. Goldfarb said:

Greg, did anybody before him do an inversion in the pharmaceutical industry, do you know? David? He may have been the first one. It is very controversial right now, this practice of acquiring a company in a low tax domicile. But Mike made it clear from day one when he merged with Biovail that the main purpose of the deal was to secure the competitive advantage of having the lowest tax rate of any pharmaceutical company in the world.

Pearson wasn't the first one. Biovail had inverted to Barbados. The architect of Biovail's tax inversion was their erstwhile CEO, Eugene Melnyk. Melnyk recently revealed that he has been the whistleblower for the IRS against Valeant. Melnyk believes Valeant will lose its tax rate because of the reasons outlined in this article. Melnyk says that Valeant is using the tax strategy marketed by a very aggressive investment banker - Melnyk and others had rejected that strategy when it was proposed to them by the banker.

In this Bloomberg article, I also saw that Covidien (NYSE:COV) had a Bermuda tax inversion because its infamous parent, Tyco, had inverted to Bermuda in 1997. Covidien is the medical device company being acquired by Medtronic (NYSE:MDT).

The foreign domicile came about when corporate predecessor Tyco International Ltd. carried out its own inversion to Bermuda in 1997. Covidien spun off as an independent Bermuda company a decade later, and switched to Ireland in 2009.

It should concern Valeant investors that the IRS has been chasing Covidien. From the same Bloomberg article:

Covidien and its former parent, Tyco, are still sparring with the Internal Revenue Service over the allocation of profits following the Bermuda inversion. The IRS said last year that Tyco saddled its U.S. units with phony debt, leading them to take improper interest deductions of $914 million between 1997 and 2000, Covidien said in a February filing. The IRS is seeking that amount plus $154 million in penalties, Covidien said. Tyco and Covidien contend the deductions were appropriate and are fighting the case in U.S. Tax Court.

If the IRS prevails, it probably will challenge some $6.6 billion of interest deductions taken by Tyco's U.S. units in subsequent years, Covidien said in the filing. As a former division of Tyco, Covidien said it's partly responsible for the company's tax liabilities before 2007.

Returns on R&D

As Charlie Munger says people will believe whatever they want to believe. Remember that RCG hasn't invested in pharma before (except for a brief flirtation with JNJ 20 years ago) and they don't have pharma investing experience or pharma analysts. I believe due to these factors, RCG just echoes whatever Pearson writes in his shareholder letters regarding pharma R&D (e.g. R&D output without input). Goldfarb said:

Big pharma made tremendous returns on capital. The problem really has not been the patent lives. The problem has been the poor record of drug discovery by big pharma. There have been very significant drug discoveries but mostly by the biotech companies.

Why do those pharma companies with a "poor record" have far better returns on capital than Valeant even today? How can you call Valeant's model superior when it has a poor return on capital?

Botox is produced by a biological process. Does that make Allergan a biotech? Isn't DARPin competing with the biologic Eylea?

Isn't Humira a biologic produced by Abbvie (NYSE:ABBV)? Does that make Abbvie a biotech?

Does Goldfarb have any data to back him up? Valeant did not have data. Valeant took a Forbes article that praised Allergan's R&D productivity as being at the top of the industry and stripped out Allergan's name from the data that it put into an investor presentation.

RCG seems extremely desperate to shore up Valeant. Remember that neither RCG nor Bill Ackman have invested in the pharma industry before. (RCG did invest in JNJ briefly in the 1990s in the wake of the Clinton health-care scare, when drug company P/Es fell to around 12). In my opinion, RCG and Bill Ackman are way outside their circle of competence here.

Remember that less than a quarter of non-Ackman Allergan shareholders voted for the special meeting. (31 - 9.7 / 100 - 9.7) = 23%.

Valeant to get smacked by Treasury soon ("earnings stripping")

I had always wondered how Valeant could claim an incredibly low tax rate. Well, Goldfarb shed some light on this matter. He said:

And the debt makes them even more tax efficient because the debt resides in the United States. The interest is deductible and creates tax losses in the United States so that Valeant has been able to transfer its IP to low tax venues. The company does incur a tax liability on that transfer, but the tax deduction of the interest on the debt and the resulting NOLs have enabled the company to transfer the IP or to license the IP without having to pay cash taxes.

Of course, at the time, Goldfarb didn't know that the Treasury Department would be blocking this maneuver. It has been reported in the media that the Treasury is planning to disallow precisely this loophole because it doesn't require Congress approval. Treasury plans to issue regulations using existing law. Some of those ideas are discussed here. Looks like the tax trick described by Goldfarb above is called "earnings stripping". That is one of the items that Treasury is rumored to be removing because it has the authority to remove it under existing law.

It seems the Treasury, as a matter of form, is waiting until the Congress adjourns before it issues these regulations. I expect Valeant to take a nasty fall when that happens because nobody has as much debt as Valeant. Valeant's biggest shareholders are very proud of its tax rate as a competitive advantage. Well, the competitive advantage is not durable as they will find out when Treasury issues its regulations.

Using Buffett's name

I believe that before people drag Warren Buffett's name to talk up Valeant stock, they should at least ask poor Buffett what he thinks of Valeant. Given what he has said about EBITDA in the past, I believe Buffett will see through Valeant's accounting smoke in an instant (i.e. Valeant's huge amortization and restructuring charges are nothing but pre-paid or post-paid R&D expenses. Valeant says ignore them, just look at "cash EPS"). Bill Ruane and Jonathan Brandt are the only RCG people with personal connections to Buffett (it seems Jonathan Brandt's father and Buffett were roommates).

Nevertheless, one of the subtle ways in which Goldfarb tries to boost Valeant using Buffett's name is by saying Valeant is similar to 3G Capital. There is a big difference between the food and beverage business and the pharma business. This is what Goldfarb said:

I know some of you were at the Berkshire annual meeting, and there was some discussion of 3G, the Brazilians who have been extremely successful. Anheuser-Busch InBev is their biggest success, but 3G has had others. I do not think that the Valeant playbook is that different from the 3G playbook.

After 3G took over Burger King (NYSE:BKW), Burger King upgraded many of its restaurants and added to the menu. That is, Burger King increased the value offered to the consumer. On the other hand, Valeant says "bet on management, not science". Valeant's theory is that the same old drugs can be sold at much higher prices. The value delivered to the consumer goes down with the price hikes and without R&D. The free market will eventually punish Valeant and reward inventors of new drugs - just as the free market has rewarded Burger King for offering more value to consumers.

Private equity's most favored playground is the food industry. Their least favored playground is the pharma industry. 3G is a private equity company. It is completely wrong to say that the 3G/private equity model can work in pharma. The private equity industry has been around for decades and they have figured out that there is no industry where financial engineering has as little effect as pharma.

Whatever "playbook" Valeant had, it ran Medicis into the ground. The injectables acquired from Medicis were sold quietly to Nestle. The details of the sale are murky - as pointed out by Allergan and John Hempton. The introduction by Allergan of the Voluma filler into the market resulted in sharp market share gains for Allergan at the expense of the older fillers. Allergan's filler business in Europe in Q2 grew at the rate of 40% compared to market growth of 20%.

More usage of Buffett's reputation with Outsider hints

I am getting tired of people using Buffett's name to promote their cause. Ackman goes on TV and says Berkshire Hathaway is a rollup like Valeant and that his purchase of Allergan is like Buffett's purchase of Coke.

There are others who say Valeant is like 3G and drop hints that Pearson is an Outsider. Ackman showed a slide where he put the names of the 8 CEOs from the Outsiders book and added Pearson's name at the bottom. There are a lot of differences between Pearson and the Outsiders. None of the Outsider CEOs made hostile acquisitions.

For example, the Outsiders book admits that Washington Post (NYSE:GHC) had industry-low levels of leverage:

... during her tenure, the Post consistently maintained the most conservative balance sheet among its peers.

The book also says this about Katherine Graham's capital allocation approach which is vastly different from Michael Pearson:

...was characterized by industry-low levels of dividends and debt, an industry-high level of share repurchases, relatively few acquisitions,...

The problem with the Outsiders book is that the author was from the private equity industry and in the very few cases where he got the opportunity he praised debt as much as possible. That is why people come away with the impression that using a lot of leverage is a great idea. The Outsiders book reminds me of the Agatha Christie novel where the narrator himself turned out to be the murderer (I think it was The Murder of Roger Ackroyd).

Buffett recommended Outsiders because it featured Tom Murphy and Katherine Graham who were his closest friends, it also featured Henry Singleton whom Buffett admired, it also featured Buffett himself. So Buffett was connected to 4 out of 8 CEOs in the book. Buffett had invested in General Dynamics (NYSE:GD) and Washington Post.

Buffett and Singleton achieved success by investing insurance premiums cleverly in the stock market. Singleton also bought back huge amounts of stock when Teledyne's valuation was depressed. Buffett and Singleton had the ability to zig when the market zagged. Tom Murphy and John Malone rolled up the broadcast and cable industries under FCC mandated protection before others realized how attractive those industries were. Those industries had local monopolies protected by FCC licenses and were not subject to R&D attacks by competitors. Even now the media industry uses very high leverage because of such protections. Malone made other brilliant moves such as taking stakes in fledgling entertainment companies Discovery, BET, etc. in return for carrying them on his vast cable network.

In the General Dynamics case, the author used 3 CEOs because the first CEO, Bill Anders, served for just 3 years. That first CEO sold off half the company after the end of the Cold War in his first two years. The next CEO took the proceeds and gave out huge dividends and made large share repurchases. These asset sales followed by dividends and share repurchases received praise from investors. How are they related to Valeant? Valeant wants a big empire whereas General Dynamics shrank itself dramatically. The book says this about General Dynamics:

"General Dynamics did not need to employ significant financial leverage or with one very large exception, issue equity."

In the General Cinemas case, the CEO made 3 major acquisitions in 3 different industries over a period of 43 years - in soft drink bottling, retailing, publishing. How is that relevant to Valeant? Valeant needs an acquisition every year.

That leaves just Bill Stiritz in the food and beverage industry. Note that Stiritz's outperformance over his peers was just 2.3% per year (20% versus 17.7%).

Why hasn't anyone asked Buffett what he thinks of Valeant? Buffett may be horrified to hear that Goldfarb connected Washington Post with Valeant (Buffett and Katherine Graham were best friends). RCG had followed Buffett into Washington Post, but left quickly (exited more than 30 years ago if I remember correctly). Can you imagine Katherine Graham doing a hostile takeover?

Instead the media chases after Ackman, camera in hand, and publishes whatever he says. For instance, the NYT initially said that voting for Allergan's special meeting required the stock to have been held for two years. Instead of reading Allergan's bylaws and seeing that this was not true, they must have published whatever Pershing Square told them. This might mislead arbs into believing that the deal was more likely that it actually would be.

Past RCG returns irrelevant

I find it strange that RCG presents returns since 1970 when they have nothing to do with reality. RCG needs to be renamed to Goldfarb Investments because both Ruane and Cunniff are no longer alive.

RCG's market-beating returns were produced when Ruane ran the outfit and Berkshire Hathaway was growing by leaps and bounds. Both those factors don't exist any more. If RCG wants to present returns since 1970, RCG should mention these two factors. That would tell investors why returns were so high before and why they have only tracked the S&P over the last 10 years. It is misleading to present returns since 1970 when the people and factors responsible for it are no longer around.

RCG's predicament

Come to think of it, it is understandable that RCG invested in Valeant because they don't have any pharma investing experience or pharma experts. RCG is dabbling outside its circle of competence. They have been enticed by Pearson's proposition of pharma-like returns without requiring the ability to understand drug pipelines or R&D or medical research publications.

Just because RCG cannot understand drug R&D doesn't mean Pearson is right. Even a basic return on capital calculation shows Pearson is wrong, but then, as Charlie Munger says, people will believe whatever they want to believe.

Source: Misleading Statements In The Ruane, Cunniff, Goldfarb Annual Meeting Transcript Regarding Valeant And Allergan