Is The Valeant Selloff Ignoring Long-Term Profits?

| About: Valeant Pharmaceuticals (VRX)


Along with VRX’s price downfall, debt seems to be the major worry of Valeant investors.

The panic has brought about overreactions, in my opinion.

Investors are rightfully concerned with VRX’s debt. However, debt increases do not necessitate a selloff.

And I'll show you why.

My main reason for writing this article is a response to what I consider an ineffective hedge for Valeant (NYSE:VRX) investors as per the recommendation of an article titled "So You Wanted to Stay Long Valeant." I will explain the reason for the hedge - in this case a collar - being a poor idea for VRX holders. And then I will present an alternative.

But neither of these hedges can be analyzed without proper context. Let's start with the issue of debt.

The Two Phases of VRX

In a functioning market, companies find themselves in one of two phases:

  1. Profit maximization
  2. Debt reduction

These are the Yin and Yang of the market. In the profit maximization phase, a company raises debt to improve its future cash flows. In the debt reduction phase, a company uses current cash flows to repair its balance sheets.

When is the best time to invest? In the profit maximization phase, a company's future cash flows are increasing, thereby increasing the company's discounted cash flow evaluation, which in turn should increase the company's stock price. In the debt reduction phase, a company shifts focus away from its future cash flows - and therefore growth - in favor of paying down debt.

Hold VRX during the Profit Maximization Phase

Unless you're holding a stock that pays dividends, which VRX is not, you want to ditch companies in the debt reduction for companies in the profit maximization phase. For VRX, raising debt is normal and not a concern until that debt ceases to yield improved future cash flows. This is the main bearish argument of VRX: The debt is not paying off.

That might be true for the moment. And we must wait and see if VRX has really topped off in profit maximization and should switch to debt reduction. Investors seem to think it should, as VRX is up 5% on mention that VRX is selling one of its assets to pay down debt.

The fundamentals show that VRX is at an impasse. Hence the large divide between sentiment and the call for hedges on the stock. These are my favorite stocks to play in the long term, as the proper hedges will pay off no matter which direction the stock goes.

Upside and Downside

Let's take a quick look at the upside and downside here. One thing investors often forget about debt is that it defines the lower limit of the stock price. Shareholder equity allows you to calculate the value of each share if the company decides to sell all its assets and close business.

Shareholder equity has been falling for VRX:

The current ratio looks worrisome. However, the calculation for the lower limit is $17.23 (common stock equity divided by shares, or book value per share). This gives VRX holders a max downside of 34%.

It's tempting to want to hedge against such a large downside. But collars are not the ideal methods - especially with VRX, which has a larger upside than downside. A collar limits your downside and upside at a large cost, leading to a tiny ROI.

When you consider the upside, holding VRX outright is a better strategy than a collar. The risk-reward ratio is 24%, in favor of the upside. The calculation is based on the current discounted cash flow valuation, which is $37.33.

I calculated this through VRX's growth rate, CROIC, and FCF growth. While VRX's growth is still negative, it is returning to positive levels. FCF is still on the rise:

Using a rolling average, we can see that VRX is still doing well with its current investments:

The lack of growth has hurt EBITDA/EV and earnings, but these appear to be short-term snags. Consider EBITDA/EV, which has fallen only slightly in comparison to the stock price. This implies an overreaction:

Much of the selloff was related to the poor earnings report. Oddly enough - and this is rare - Wall Street estimates for VRX's EPS are quite accurate. Note that the estimates for the next quarter's EPS report are back to normal levels:

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A rolling average of earnings, which smoothens out the rare surprises and misses, shows that VRX is rolling along:

Things do not appear as bad as the stock price makes them seem. Options traders recognize this, and calls are being bought up faster than are puts:

With an upside of $37.33 - 42% - and a downside of $17.23 - 34% - this makes sense. Options traders are typically more rational than stock traders, as they have limited risk. Fear always beats greed - this is a product of evolutionary psychology in which we prefer to limit the downside at the expense of limiting the upside.

For VRX, this makes little sense, as the upside/downside ratio is in the bulls' favor. The collar is an excellent example of suboptimal investing. A collar is the combination of two losing strategies: The covered call and the married put.

The Collar - A Losing Hedge

A covered call limits your upside. If VRX breaks out, you will only see a portion of the profits. Covered calls only make sense in a few situations, namely when a stock is showing predictable, steady growth, which allows us to pinpoint stock prices in the coming months; for biotech stocks, which can rally on clinical trials, earnings, and other news, the covered call only limits your gains.

Married puts are also poor in that the insurance you pay for the downside protect is usually at a significant premium. When the put/call ratio is under 1.0, this is especially so. Investors must remember that at the other side of your trade is a market maker - someone who want to ensure they are making a profit on everything they sell.

When a stock is putting investors in fear mode, market makers are not going to sell you a cheap put. Options are rarely cheap, especially on stocks with high volatility. Buying a put to limit your downside ignores this fact and ignores the fact that the downside is already limited by shareholder equity calculations - a stock rarely ever falls to zero.

Thus, the calculated theoretical downside protection is just that - theoretical. A married put is always bought at a premium. You never want to be on one side of an options trade if you can avoid it.

So here's David Pinsen's collar strategy:

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The facts: You spend $2,690 for a max possible profit of $810. The play equates to cutting your held 100 shares of VRX to 37 shares and 0 shares after VRX hits $35. In addition, you've now given your strategy extra headwinds: Your breakeven for this strategy is $26.90.

This is a hedge that gives you limited upside and still loses money from a downside movement. It also requires a significant opportunity cost because you are forced to hold 100 shares of VRX. One of the main problems here is that the premium gained on the call is nearly half of the premium spent on the put.

A Better Hedge

A proper hedge shouldn't limit your upside, shouldn't cost you a premium, and shouldn't force you to hold a stock that does not pay a dividend.

The following hedge might seem strange at first, but it is vastly superior to any of the standard hedging methods. First, you have to be bold and realize that holding VRX is meaningless when it does not pay a dividend. A synthetic strategy is superior - but we are not doing that here.

What I wish to present is a hedge that can be opened at a net credit, gives you limited downside, and also offers unlimited upside. We drop the stock, therefore significantly reducing the opportunity cost of holding a non-dividend stock. Instead of holding stock, we use a credit spread to finance a ratio backspread.

In this strategy, we are long and short on both calls and puts, allowing us to avoid playing into one side of the market makers' trades. The hedge is opened at a net credit, allowing us to profit if VRX trends sideways (this is what a covered call is supposed to do but fails to do when mixed with a married put). If VRX rallies, however, we do not miss out on the upside:

Click to enlarge

The facts: We are essentially long 140 shares of VRX. Because gamma is positive (not that the collar has zero gamma), this turns into 200 shares when VRX exceeds $27.5. In addition, we are long vega (the collar is not), which allows the strategy to profit from VRX volatility increases - movements in either direction.

The margin requirements here will be under $1,000, cutting the opportunity cost from the collar by 2/3. But most importantly, we are exposed by all the upside and only some of the downside. This strategy covers the next earnings report, and you have the choice to roll over the credit spread after the upcoming expiration for yields that - unlike the covered call - do not limit your upside.

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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.