The Go-Go Years
Soon after Bill Gates first met Warren Buffett in 1991, it seems he asked Buffett for the best business book. Buffett recommended Business Adventures by John Brooks and gave Gates his own copy of the book. Bill Gates read the book and says that John Brooks became his favorite business writer. A few years ago I had purchased the more famous book by John Brooks, "The Go-Go Years". I hadn't read The Go-Go Years and the book had been gathering dust, but since Buffett and Gates thought so highly of John Brooks, I read it this weekend.
The Go-Go Years has a great chapter on conglomerateurs and their accounting. The 1960s had a great bubble in M&A. Conglomerates appeared on the scene, they claimed "synergies" and had skyrocketing "earnings" by doing hostile M&A.
There are striking parallels to Valeant Pharmaceutical's (NYSE:VRX) business model and the adoration of this business model by naive investors. John Brooks has been called one of the finest business writers, and I can't hope to match his prose. So I will quote extensively from Section 3 of that chapter. I highly recommend the chapter to anybody who wants to understand new-fangled acquisition-based business models. This is how Brooks explains that M&A bubble:
"The crux of the matter was that never before had a company's reported earnings per share meant so much in terms of its stock-market price. As we have seen, the average investor of the sixties was a comparative novice, interested in just three figures concerning a company whose stock he owned or was considering buying.
The three figures Brooks refers to are the stock price, earnings per share, and the P/E ratio. He says that calculating the P/E ratio "marked the outer limit" of the investor's "investment sophistication".
Unfortunately, in the case of conglomerates this degree of sophistication was inadequate. Where a series of corporate mergers is concerned, the current earnings per share of the surviving company loses much of the yardstick quality that the novice investor so trustingly assumes. The simple mathematical fact is that any time a company with a high multiple buys one with a lower multiple, a kind of magic comes into play. Earnings per share of the new, merged company in the first year of its life come out higher than those of the acquiring company in the previous year, even though neither company does any more business than before. There is an apparent growth in earnings that is entirely an optical illusion.......
I believe this is what we see in current serial acquirers like Valeant. By acquiring R&D, R&D gets capitalized instead of expensed. Valeant makes a large, lump sum one-time payment whereas other companies make small monthly payments. To make a fair comparison to other pharmas, we should not deduct R&D as an expense for other pharmas, instead we should capitalize it! In my opinion, the various restructuring, integration and amortization charges and frequent "one-time" writeoffs barely receive attention in earnings presentations and earnings releases. Voila! Valeant's "cash EPS" keeps leaping. The book continues:
Indeed, the accountant, through this choice and others at his disposal, was often able to write for the surviving company practically any current earnings figure he chose... All of which is to say that, without breaking the law or the rules of his profession, the accountant could mislead the naive investor practically at will.
The conglomerate game tended to become a form of pyramiding, comparable to the public-utility holding company game that flourished in 1928, crashed in 1929, and was belatedly outlawed in the dark hangover days of 1935. The accountant evaluating the results of a conglomerate merger would apply his creative resources by writing an earnings figure that looked good to investors; they reacting to the artistry, would buy the company's stock, thereby forcing its market price up to a high multiple again; the company would then make the new merger, write new higher earnings, and so on. The conglomerate need neither toil nor spin - only keep buying companies and writing up earnings. It was magic, until the pyramid became top-heavy and fell.
For example, LTV's stock price went from $170 to $16 when the bubble burst. LTV's founder and leader, James Ling, was called the king of conglomerateurs in the book. The book has more disaster examples.
Recall that Valeant's EV/EBITDA is around 16 even though its revenue growth rate is 2%.
As I see it, Valeant's financial statements are so complex, nobody wants to go there. I believe that is why everybody focuses on Valeant's cash EPS, just like the 1960s. Humans haven't changed that much since the 1960s. The book explains:
...the crucial new element in the stock trading was the financial and accounting naiveté of the millions of new investors. Naiveté led to a search for simplicity, and simplicity, as we have seen, was found in focusing attention on the bottom line.
Capitalizing versus expensing
A few months ago, I had written an article with an example that illustrates the optical illusion of capitalizing versus expensing. This is how Valeant reports a "cash EPS" that is far removed from its true earnings. On the subject of Worldcom's merger accounting, a Berkeley accounting professor advised in 2002 that detecting danger requires comparing the financial statements of companies in the same industry:
It can be hard to detect by looking only at the financial statements of the company in question. Detecting the trick requires investors to hold companies' financial statements next to rivals' and question capitalized costs that are out of line, says Brett Trueman, professor of accounting at University of California-Berkeley.
The accounting scandals of the early part of the last decade are well known to investors. But there aren't many investors who were also around in the 1960s. This is what John Brooks says in the book:
Not until 1970 - when the conglomerates had collapsed, and the public had been shorn - would the A.P.B muster its courage to take, too late, a strong and responsible line on merger accounting.
Some things never change. Every bull market shows how the accounting standards of the day fall short.
Williams Act of 1968
The Williams Act was passed in 1968 to deal with hostile acquisitions by conglomerates. The Act deals with "trading by persons in possession of material, nonpublic information relating to a tender offer." In an earlier article, I had said that the Williams Act used the term "tender offer" instead of "acquisition offer" because connotations had changed. Reading The Go-Go Years makes it clear to me that "tender offer" in those days really meant "hostile acquisition".
Will the judge in the Valeant-Ackman insider trading case read The Go-Go Years? The Valeant-Ackman defense hinges on the interpretation of the term "tender offer". Would Allergan (NYSE:AGN) be able to use people involved in the passage of the Williams Act as witnesses if any of them are alive?
Valeant-Ackman say that they did not take steps towards a tender offer, but I believe that "tender offer" really meant a hostile acquisition in the vernacular of 1968.
The Williams Act came at the tail end of the hostile M&A bubble of the 1960s. Reading The Go-Go Years informed me about the background in which the law was formulated and passed. If Valeant-Ackman's 9.7% stake is not allowed to vote by the judge on October 28, Valeant-Ackman will need 55% (90.3% * 0.55 = 0.5) of the remaining shareholders to vote in their favor if they want to win as this article points out:
A few technical notes, according to Allergan sources: Because this is a special meeting, Valeant needs a majority of all 297.2 million outstanding shares. Had Valeant tried to swing a takeover during Allergan's regularly scheduled annual meeting in May, it would have only needed a majority of the votes cast at that time.
Valeant, Endo spike and Ratan Capital
I was motivated to write this article by the spike in Endo Pharmaceuticals (NASDAQ:ENDP) when it announced its hostile intent to acquire Auxilium Pharmaceuticals (NASDAQ:AUXL) earlier this week. Endo is headed by Rajiv DeSilva, Michael Pearson's former deputy at Valeant. Endo's stock price shot up when DeSilva joined Endo even as its revenue remained flat; it was widely assumed that DeSilva would apply mentor Pearson's blueprint to Endo. Note: I have not researched Endo like I have researched Valeant, I am just talking about investor perception. I don't know how closely Endo hews to Pearson's theories.
Looks like Endo must have been driven up by Valeant believers. For example, this 13-F of Ratan Capital shows that they hold Endo stock and call options. Ratan Capital's claim to fame is riding the Valeant tiger; Ratan Capital is credited in the Bloomberg article by Julian Robertson for introducing and recommending Valeant to the Tiger hedge fund family. In Q2, Ratan Capital bought even more Valeant. They also initiated Allergan - call options and stock in Q2. Adding up those three positions (Allergan, Endo, Valeant) comes to 35% of the $705 million portfolio. They look like a one-trick pony in my opinion.
I find it interesting that the investors most captivated by Pearson are those who have never done any R&D themselves. Some of these hedge fund managers and analysts who are Valeant fans, don't even have a science or engineering or medical degree, forget about any R&D experience. I think that is why they are easy prey for Valeant slogans such as "R&D output without input", "bet on management, not on science", etc. They have gone straight from a finance or liberal arts degree to money management. I think it would have helped if they had worked in a real company in the real economy.
I believe it is quite dangerous when such young, inexperienced people control huge sums of money and issue judgments on R&D. The Bloomberg article linked earlier discusses how the head of Ratan Capital is unable to manage that tiny employee base of five people leading to extremely high employee attrition in the $750 million fund. One of the reasons cited for the attrition was cost-cutting and "bare-bones insurance plans" - I hope our newly minted Allergan investor remembers that at the Allergan special meeting.
I have never seen a return on capital calculation made by a Valeant bull. Their only bullish arguments are excerpts of Pearson's shareholder letters. Unlike other pharma CEOs, Pearson speaks and writes eloquently in the lingo familiar to Wall Street, endearing Valeant to investors who don't understand R&D. As others and I have said in the past, Valeant's return on capital is a fraction of that of Allergan.
How long will the hedge funds hang on?
In the last week of Q2, Paulson revealed his 2% Allergan stake. This made VRX and AGN spike. VRX which traded at $120 before Paulson's announcement, closed Q2 at $126. Thus, Paulson saved the quarter for VRX investors (and therefore "made in Q2" Allergan investors such as Ratan Capital). As a sidenote, Paulson has said he would be OK with Allergan staying independent as long as Allergan makes an acquisition of its own.
But VRX is back at $120 as Q3 draws to a close and the market has only gone higher. For example, today was another record-breaking day for the DJIA and S&P 500. The under-performance of funds such as Ratan Capital and Ruane, Cunniff, Goldfarb (abbreviated as RCG) continues. The rocket ride of VRX since 2009 concealed the under-performance of the rest of the portfolio of Ratan Capital and RCG. Now that VRX has been trailing this year, Ratan Capital and RCG are trailing the market quarter after quarter. VRX is RCG's first major investment without Bill Ruane who died in 2005.
There is only so much under-performance investors can tolerate. Sooner or later the dam will break and funds that are heavily concentrated in VRX will have to sell. Watch out when that happens!
Market thinks AGN-VRX deal won't happen
The market believes the AGN-VRX deal will not happen. Today VRX closed at $120.52 making its offer worth $172 per AGN share. AGN is at $170. That spread is extremely low given the status quo, it only means that the market is valuing Allergan on a standalone basis and ignoring Valeant's offer.
I think Allergan will continue to go higher independent of Valeant's stock price. Allergan's Ozurdex was approved by the FDA on June 30 and Allergan has a great ophthalmology salesforce that has been selling Restasis and glaucoma drugs to would-be Ozurdex customers. So that will add to their Q3 results too. By holding the line on expenses coupled with great revenue growth, Allergan is generating tremendous operating leverage.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.