Valeant Pharmaceutical's (NYSE:VRX) story has been well documented and quite heated. One of the most well-known hedge fund managers in the world finds himself right in the middle of a massive financial meltdown of Enron type proportion.
Unless you believe in efficient market theory, we all understand that the market does a poor job evaluating the intrinsic value of a business. Most astute investors, especially value investors, don't care much at all about what value the market has assigned to a certain equity investment. The key is figuring out what said investor believes the value to be. And as Bill Ackman has said himself, if you do your homework and put a good valuation on the company, Mr. Market will eventually agree with you.
Fortunately for my investment career, I've had the opportunity to read Seth Klarman's book, Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor. If you haven't read it, find a way to get your hands on this book. It's currently on eBay for $1,750, or if you obtain it online illegally, be sure to send Seth a check. Mr. Klarman goes through various details of how to value a business, metrics to use and even tells the Ben Graham story about Mr. Market and his irrational behavior creating opportunity for the value investor.
As I've watched the Valeant story unfold after very luckily publishing an article minutes before the market opened on March 15th, the day Valeant took a 50% haircut. As I've thought about the scenario, I remembered one small, but very important section of Mr. Klarman's book. Towards the end of Chapter 8, the book discusses the "reflexive relationship between market price and the underlying value" of an investment. I would estimate 95% of the book discusses various ways the intelligent investor can find areas where Mr. Market is wrong. But, Mr. Klarman's reference to George Soro's theory of reflexivity in chapter 8 seems to be dead on with what we are seeing with Valeant.
Theory of Reflexivity
The value of a business is based on a discount cash flow model, a multiple of free cash flow or some other fundamental analysis, correct? Wrong, in certain situations according to George Soros and Seth Klarman. George Soros makes a point in his analysis that a stock price can at times significantly influence the value of a business. Klarman says "investors must not lose sight of this". Surely this isn't right is it? Bill Ackman can explain until he's blue in the face that Valeant is an $80 billion business (like it at $250 a share). We can go through the analysis of platform value and all the great acquisitions that were made, but none of that matters when you have $30 billion in angry creditors calling and Mr. Market saying he doesn't trust you and wants no part of your business.
Klarman speaks specifically about this scenario in his book that was written 25 years ago. Klarman states, "most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy...[if] the stock market says there's no problem, there's no problem. The same holds true for a highly leveraged company with an upcoming debt maturity. If the market deems the company creditworthy, the company will be able to refinance and fulfill its prophecy. If the market votes a thumbs down on the credit, that prophecy will also be fulfilled".
The market has clearly voted thumbs down on Valeant. There are not significant debts coming due this year, but the Company is in default. The massive price drop, accounting irregularities (which are yet to be determined), inability to meet reporting deadlines and the firing of the existing CEO make this situation a total mess for the creditors. I'm not going to attempt to cover the operations issues in this article. We saw this week the Company fired the entire sales team for Addyi. The worst part of the story was that the entire sales force were contracted, outsourced staff. Nice, outsource your most critical function. That's not going to win any CEO of the year awards.
At a minimum the creditors hamstring the Company and renegotiate more favorable terms (i.e. worse terms for the Company). Active creditors may be more inclined to force a liquidation of the Company which may result in making the creditors whole, but would leave very little for the equity holders. I can almost promise you the creditors, who control the show at this point, just want their $30 billion back.
I cannot predict the future unfortunately, but I do believe based on the circumstances of this situation, the risk for further downside is substantial. This stock will continue to be crazy volatile over the next several weeks and potentially months. If you currently hold shares, God help you that the Company can meet its April 29th extended 10-K filing deadline and can reach as reasonable agreement with creditors. Time is running out and Mr. Market has spoken. No one cares about projected free cash flow, platform value and any other dreams of the future, this situation needs to get resolved yesterday. The stock would seem to be about as low as it can go, but those are obviously famous last words. At $10 a share, the Company would be leveraged almost 10-1 with debt and at that point I think you're looking at creditors locking the doors and selling the office furniture. Do not underestimate Mr. Market's ability to determine the fate of your future!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.