Without any doubt, David Maris' Valeant (NYSE:VRX) report made a big splash. While this article will not play the attack-the-messenger game, it would not be complete without mentioning a few details about the analyst himself, as David Maris is not new to the Valeant story. Due to a research report issued on Valeant's predecessor company, Biovail, back in 2006, he went through the following nightmare:
In 2003, Mr. Maris put out a sell report on Biovail, a Canadian drug company. He fixed on the company's bizarre explanation of why it had missed its earnings estimates: a truck carrying a supposedly huge amount of medicine crashed at the very end of the quarter. Mr. Maris detailed why this was wildly implausible.
Desperate to deflect the attention, Biovail took the offensive. It sued Mr. Maris and Bank of America in early 2006. It also sued SAC Capital Advisors, the hedge fund, and Gradient Analytics, an independent research firm, claiming a giant conspiracy to drive down its stock price with false reports.
For a time, Bank of America stood by Mr. Maris. But it eventually caved and fired him - two weeks before the end of 2006, enabling it to not pay his bonus. Mr. Maris is now in arbitration, seeking $21 million in back pay. (Source)
However, Biovail's former CEO Eugene Melnyk, along with the company as a whole and other officers, was accused of accounting fraud and the company finally settled with the SEC.
With his report, Mr. Maris undoubtedly has earned some credibility - but not the favor of Wall Street:
Mr. Maris was right on the facts. He was right on the stock. He was right with the law.
For his success, he was sued, fired and stripped of compensation. He also lost access to the world of bulge-bracket Wall Street, was shunned by some institutional investors, and because of the settlement for which he said he felt he had no choice than to enter, he couldn't sue Biovail to seek vindication.
Interestingly, even former Biovail CEO Eugene Melnyk seems to have an axe to grind with Valeant, as he was in the news for accusing the company of tax fraud in 2014.
According to his recent tweets, David Maris seems to have been skeptical about Valeant for some time, as he retweeted the short sellers' articles and even went so far to "disqualify" a bullish fellow analyst and to attribute a "low IQ" to Valeant's CEO Mike Pearson:
(Kudos to Brian Firestone for digging these up!)
However, Mr. Maris probably did not follow the company closely enough to spell "Philidor" correctly.
You can make of this background information what you like. Personally, I'm not suggesting any interpretation, but thought it would be interesting to share. With absolute certainty, David Maris is not just the average Wells Fargo equity analyst initiating Valeant with an underperform rating.
The report, which I was able to get a copy of, is about 30 pages long and filled with complex accounting issues. There certainly is too much data to analyze within a single Seeking Alpha article, so I necessarily have to focus on only a few points. Some of Mr. Maris' arguments are well known, but some are actually new and interesting to consider both for longs and shorts. For example, David Maris is skeptical of Valeant's "cash EPS" calculation, believes management has destroyed value and thinks that there is not enough clarity on the Walgreens (NASDAQ:WBA) cooperation to gauge its impact on future growth. Far more important (and partly new to the story), however, are his points on deferred tax liabilities, gross-to-net adjustments and the F- and Z-score calculations. We will look into some of the details later, but first let me say that there can be little doubt about the analyst's negative bias. Here are a few examples:
- When discussing the drug pipeline, he says: "In a recent analyst meeting, Valeant disclosed that it had 32 products in a listed pipeline chart of U.S. prescription and generic drugs." He then goes on to examine some of these compounds and complains that Valeant did not disclose sufficient details on 28 of these products. He does not mention at all the true extension of Valeant's pipeline:
(Source: investor presentation)
- He compares provisions for doubtful accounts (as a percentage of accounts receivable) from 2004 to 2007 to the current value. But he does not mention that today's Valeant is a totally different company.
- He complains that "Valeant has not explained how the unwinding of a business that represents only approximately 7% of total revenue [i.e. Philidor], and is, according to Valeant, less profitable than traditional prescriptions, results in a 36.6% reduction in EPS." But Valeant has actually explained this point pretty precisely in a recent presentation (slides 18-19).
Here is the shortcut proof that Mr. Maris is missing something: Basically, he is implying that, through Philidor, Valeant might have been making 36.6% of its earnings on 7% of revenues, i.e. $525 million of net earnings on $600 million of revenues. Which is totally impossible, given that average costs of revenue are already 25%. (More on this here - see also the comment section.)
- He questions the value of the enormous goodwill on Valeant's balance sheet by explaining that "when Valeant buys a company and then cuts R&D, it reduces the value of some of those future products". He presumes that cutting some R&D projects out of a large acquired pipeline should inevitably lead to impairments. In my opinion, this is a totally ridiculous assumption, given that eliminating projects with negative ROI expectations and focusing resources on those with high ROI expectations is what every R&D organization should do - which would be at the very least value-neutral. Of course, we are talking about expectations and these are inherently subjective, but assigning a fixed value to every project and taking it stubbornly to its final stage certainly creates only questionable value. Finally, when Valeant buys such a pipeline, it already allocates the goodwill to those programs with high ROI expectations and zero goodwill to those it will cut. So at the time of the acquisition, as a consequence of R&D program cuts, there is no goodwill to impair at all.
- When talking about Sprout and the slow ramp of Addyi, he only mentions filled TRx and casts doubts on the drug's sales potential - without mentioning at all what the company showed in the presentation linked above (slide 50), i.e. that actual prescriptions given to patients were over five times the filled ones.
- Talking about the potential risks for Valeant from an IRS investigation into previous tax filings, Mr. Maris provides the example of GlaxoSmithKline's (NYSE:GSK) 2006 IRS settlement of $3.4 billion. Yet, the analyst does not explain that this largest IRS settlement ever covered a period of 16 years. In 2006, GSK made pre-tax profits that were roughly equal to Valeant's current annual revenues. So even a negative outcome for Valeant would certainly represent a far lower burden than the GSK settlement, and I really don't see any other reason to mention it as a possible outcome than to scare investors.
- He calls the cash from operations/interest paid ratio "encouraging" in 2009, when it was 86. What would a "good" interest coverage ratio look like according to Mr. Maris? When a company earns 500 times the interest paid?
- David Maris states: "We believe that a substantial portion of Jublia's growth was fueled by Philidor and anticipate a significant negative impact to Jublia from the termination of Philidor and shift to Walgreens." Yet, IMS figures for the first few weeks of the Walgreens cooperation are already available and show a 30% increase of Jublia scripts. To support the projected TRx stagnation, David Maris shows a graph of Jublia scripts until November 2015. This is not only inaccurate, this is disinformation while knowing better.
- Mr. Maris' financial model for the next several years does not include early debt repayments despite Valeant's explicitly stated intention to do precisely that - and despite the cash flows model created by Mr. Maris himself sees enough flexibility for early repayments.
- Mr. Maris provides a few interesting tables with F- and Z-score calculations that should help to identify fundamental financial risks. The Beneish model provides the probability of accounting misstatements (which is very low for Valeant and has improved over the past few years). And while the Z-score sees a 58.4% risk of bankruptcy, it must be said that this score is heavily influenced by the stock price itself. E.g., based on Q3/15 data, Allergan (NYSE:AGN) has a 40% chance of going bankrupt, according to the Z-score. Furthermore, in all these calculations except one, Mr. Maris did not consider the substantial headwind to Valeant's revenue growth in 2015 coming from the Salix inventory overhang, which obviously also impacted cash flows and many important ratios like DSO, sales/accounts receivable and debt/earnings.
How Mr. Maris effectively makes the bull case
My readers will probably think that I am wearing my usual rose-colored glasses, but I have to tell you that after reading the report I am actually more confident than before that Valeant is trading at a hefty discount to its intrinsic value.
Besides raising (some inedited) questions without, however, providing tangible proofs for any potential fundamental problem, David Maris effectively projects adjusted EPS for 2020 of $14.76, which is 40% higher than his own 2015 estimate. So he sees Valeant not going belly up, but growing, albeit at a much slower pace than before (and much less than consensus that stands at over $22 for 2020).
Most importantly, he sees 2017 free cash flow of ~$13.40 per share - which is actually based on solid GAAP cash flows and deliberately ignores Valeant's intention to repay some of its debt early. To be fair, he also ignores potential fines and settlements. However, these would not impact the company's future earning power and in most past cases haven't had a lasting impact on market valuations.
David Maris' own DCF calculation leads to a current fair value of only $66.45 per share. However, if we look at the projected free cash flows, we see that Mr. Maris himself projects Valeant to generate a total of ~$26.5 billion of FCF between 2016 and 2021, which would be ~$75 per share or 10% more than where he sees the current fair value. So, in his opinion, Valeant would be fairly valued at a price equal to the net cash generated over the next ~5 years!
Really? Where is the trick that leads to the low target price? - First, Mr. Maris uses EBITDA. This leads to unfavorable outcomes for companies with very low tax rates. (Whereas the low tax rate is factored in when using FCF.) Second, he uses an EV/EBITDA multiple of 7 to calculate terminal value instead of Valeant's long-term average of 10. At first sight, this may appear reasonable, given the substantial, undeniable uncertainties faced by the company, but it appears excessive when we compare EBITDA to FCF: In fact, according to Mr. Maris, in 2021, Valeant should make EBITDA of ~$8.1 billion and FCF of ~$5 billion. So his terminal value of 7 x EBITDA (= $56.6 billion) equals just ~11 times FCF. And this figure is not the market cap, but the enterprise value, i.e. it includes debt. Which will be ~$14 billion in 2021, according to Mr. Maris' own model. Therefore, Mr. Maris sees Valeant trading for ~$120 per share in 2021 (= market cap of ~42 billion), i.e. at just 8.4 times FCF/share. This represents only slightly more than half of the current average peer valuation of ~15 times FCF.
I think we can all agree that this is far too low - if Valeant emerges from its issues as a solid going concern. If not, even the $66.45 price target will have been far too high. In either case, Mr. Maris' valuation doesn't make any sense.
In fact, if you believe Mr. Maris, yours will inevitably become the story of the man who drowned while crossing a river that on average was only 6.645 inches deep. If Valeant goes belly up, you will have paid too much. If it doesn't, you will have missed a golden opportunity. Based on Mr. Maris' report, Valeant is either a fraud and a zero - or it is worth about twice his target price.
It would also be interesting to have a FCF to EBITDA reconciliation for Mr. Maris' estimates, as it is not clear how he can project ~$5 billion of FCF and $8.1 billion of EBITDA at the same time.
His 2021 net income forecast is $1.846 billion. To get EBITDA, we have to add his estimated D&A of $3.505 billion, which gets us to $5.351 billion. Then we add $1 billion (~7% interest on Mr. Maris' average debt for the year of ~$15 billion) and get to $6.351 billion. The remaining difference of ~1.75 billion must be taxes. - But this doesn't add up because he forecasts only $1.85 billion of net income - as if Valeant paid a 48.6% tax rate.
Yet his report explicitly explains the terminal value forecast of $56.6 billion as the result of 7 times EBITDA. So EBITDA must be ~$8.1 billion (which is confirmed in another table). But this can't be true - if the net income estimate is correct.
If we start our reconciliation attempt from the other end, i.e. EBITDA, we get the following:
- D&A $3.500
- Interest $1.000
= EBT $3.600 billion
Applying a 15% tax rate (higher than Valeant's usual rate of <10%), we get a net income of $3.060 billion, i.e. far more than Mr. Maris' projection.
So it still doesn't add up. The only possible solution is that Mr. Maris used an extremely high interest rate and an equally high tax rate. For example:
- D&A $3.500
- Interest $1.500 (10% on $15 billion)
= EBT $3.100
- Taxes 40%
= Net income $1.860 billion
Only with a 10% debt interest rate and a totally unrealistic 40% tax rate, his calculation works out fine. Which is somewhat puzzling, given that Mr. Maris on page 19 of his report explicitly states that he did not "take into consideration potential increases in Valeant's tax rate". But how would he then reconcile his own EBITDA estimate of $8.1 billion with his own net income estimate of $1.8 billion, given his own D&A estimate of $3.5 billion and his own debt projection of ~$15 billion in 2021?
Nowhere in his 30 page report David Maris provides a detailed P&L forecast for the next years. He only includes tables with EBITDA, FCF, D&A, debt and net income forecasts. Nowhere he explains the underlying assumptions of his FCF, EBITDA and tax calculations. The fact that he apparently uses an above average tax rate coupled with an extremely high interest rate at the very least should have been explained, given that Valeant has never paid such high taxes or interest rates.
If we apply a 15% tax rate and a 7% interest rate, Valeant's 2021 net income should be 65% higher than Mr. Maris' projection.
This higher net income leads us to the following FCF projection:
Net income $3.060
+ D&A $3.500
- Capex $0.400
= FCF $6.160 billion ($17.55/share)
This is almost 25% higher than Mr. Maris' FCF projection for 2021 and still far below consensus - as all this is based on Mr. Maris' own, very pessimistic growth projections.
Yet it is not the only problem with Mr. Maris' FCF projections. In fact, in his final DCF, he states that he is using "unlevered FCF", i.e. FCF before deducting interest payments. However, from his own table, we can only deduct that he is really using levered FCF, because he provides a precise reconciliation:
Given that the whole calculation is based on net income, i.e. on income after taxes, the resulting FCF already includes debt service and, hence, is levered, not unlevered.
However, in his DCF, Mr. Maris then calculates the total present value of all future cash flows, adds his terminal value estimate of 7 x 2021 EBITDA and finally deducts debt. So this appears to be partially wrong: While EBITDA is unlevered, the FCF figures used by Mr. Maris actually are levered. If unlevered FCF had been used correctly, the resulting equity value and target price would have been substantially higher (especially since he appears to use extremely high interest rate assumptions for Valeant's debt service).
Given the many shortcomings of Mr. Maris' analysis and the evident negative bias, I am confident that Valeant investors have nothing to fear and Friday's market reaction was far overdone. We only need to forecast slightly stronger growth and factor in early debt repayment to easily justify a present value north of $130. Mr. Maris projects net cash accumulating on Valeant's balance sheet until the cash pile reaches $16 billion in 2025. I really don't see Mike Pearson sitting on that much cash without doing acquisitions or repurchasing shares. So it's not hard to see much stronger growth than David Maris.
In fact, if we forecast $20 of FCF/share in 2021 and apply a below-average multiple of 13, the projected 2021 target price of $260 implies a 25% CAGR on the current share price and still an excellent 15% CAGR on $130. This should compensate for a lot of the risks currently seen in the company.
Disclosure: I am/we are 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.