Last week, Valeant (NYSE:VRX) was exposed for all with eyes to see for the hugely overvalued stock I said it was in October, when VRX was bouncing around $100. Then, I said that even if VRX were completely honest, its fair value was below $10. The day of the earnings release, I got an article out reporting on the disaster, reaffirmed my prior valuation, and made some correlations of the VRX problem to that of stocks in general.
Now that a little time has passed, this article provides more detailed analysis and synthesis of the VRX situation and further discussion of its relevance to the S&P 500 (NYSEARCA:SPY) and other stocks.
Valeant - a put-together company with nothing much at the core
As Wikipedia demonstrates, from the start of VRX, there was not much 'there' there. The four companies that merged to found VRX were nothing special, and may or may not have net been profitable. The company then became a roll-up, all the while showing no great success. It then merged with, or technically was acquired by, Biovail. Biovail was a red flag to those of us in the industry, given issues its former CEO, Eugene Melnyk, had with regulators.
After that merger, the acquisition story exploded. It looked to me like a pyramid, where progressively larger deals were needed to pay off existing interest payments and meet any principal repayments.
Legal alert: this is not to say there was anything illegal about the company's actions or those of anyone in the company - and that's the nub of the problem as far as it relates to the broader market. But, it looked like an extremely aggressive strategy to me at the time.
Matters got too frenetic to be credible to yours truly. Quoting Wikipedia:
Since the 2010 merger, Valeant has aggressively expanded through acquisition. It makes about 25 deals a year, according to CEO Mike Pearson, most of which are too small to require financial reporting. Deals usually focus on specialized high-margin markets such as dermatology and eye care. A total of 14 purchases were publicly announced from 2010-early 2013.
25 deals a year is ridiculous. You just cannot keep track of things at that pace, either as an analyst or, in my view, as CEO or a board member.
And so it came to be that despite aggressive price increases, VRX was unprofitable last quarter, at least based on its preliminary unaudited numbers.
And the story worsens after Q4 into the current quarter.
Valeant's preliminary unaudited numbers for Q4 were bad, but what's coming looks worse
Here's why I think that VRX is basically functioning for its lenders, and thus I'm thinking that a reasonable target price has sunk below single digits, i.e. to bankruptcy levels. And, note well, I'm not short VRX or any VRX-related derivative, I'm not in league with any other person or entity who will profit from a further drop in VRX stock, and so on.
As VRX's corrected Q4 press release says, the company using the GAAP accounting it has not emphasized reported a loss of $336 million, which is 98 cents per share (USD). This is off of $2.75 billion in sales. This takes into account the prior expenditure of tens of billions of dollars of borrowed funds via a predetermined amortization schedule, which I will discuss later may be too generous to VRX.
So with its stock price around $27/share now, and Q4 results annualizing at almost a $4/share loss, we now have VRX saying this about Q1, which is nearly complete:
Pearson [the CEO] continued, "In discussion with the Board, we have assumed lower growth in our U.S. dermatology, gastrointestinal, and woman's health portfolios, as well as certain geographies like Western Europe, while keeping our expenses largely unchanged. We plan to work hard to improve these metrics by delivering higher revenues and reducing our costs and, if successful, we hope to beat this guidance in the quarters to come. In the meantime, we are comfortable with our current liquidity position and cash flow generation for the rest of the year, and remain well positioned to meet our obligations."
Quantitatively, Q1 looks to be horrendous. From $2.75 billion in (preliminary) sales in Q4, the company is guiding to $2.35 billion in Q1.
That's a $400 million decline, which comes almost completely off the bottom line, as the shortfall is occurring at the highest-margined areas.
Given 345 million shares used to compute Q4 results, I think it's reasonable to think of Q1 as reflecting something like $2/share in negative income.
Annualize that, and understand that there is minimal good news coming in the pipeline.
Why should operations not just deteriorate from here?
Why GAAP accounting may understate VRX's losses
How a company accounts for a transaction in which it writes a huge check to another company in return for a product or all that company's shares is a tricky matter. After all, what's really going on is a balance sheet matter - one asset is being exchanged for another. How it will all work out cannot be predicted in advance. So the accountants have agreed not to charge the entire cost of the acquisition as a loss on the P&L at the time the money was "lost" from the company and transferred to the other company. Instead, they guess at the useful life of the acquired asset and give the acquirer the opportunity to use the acquired asset(s) profitably. As that asset produces the anticipated profit, which exceeds the proportional (amortized) cost of the acquisition (also taking into account the interest cost), then the deal is watched by analysts and investors and can get a 'thumbs up.'
This technique of amortization allows you and me to have a 'quick and dirty' way of tracking if a company's acquisitions were profitable. Did the company overpay? If it did, then we see that. If there is some reason that the amortization schedule was unduly aggressive, the company can make the specific case to shareholders and to the world. But VRX is not doing so. It is simply continuing to focus our attention on non-GAAP measures, which in its world that the NYT called "fantasy" omit any thought of amortization. In that "fantasy" world, the revenues and profits from all its deals that were paid in whole or in part by debt came free, as the money that was paid for the acquisition really came from the Tooth Fairy.
Yet, the company and analysts do not exclude the interest payments made on the debt from non-GAAP numbers. Somehow, for no reason at all, those cash payments are relevant, but the cash payment made to incur the debt never gets accounted for under non-GAAP "accounting."
Anyway, since the money came from lenders who are watching matters much more closely than I am, I can just imagine that unless a lender happens also to be a common shareholder, the request from VRX to allow it forbearance for delayed filing not only of its 10-K but also its Q1 10-Q has to be alarming.
They all are looking and dissecting the numbers I've mentioned above. If VRX has overpaid so much for its acquisitions that it is on track to perhaps lose $2 per share just this quarter, with no obvious reason that I can see that this number should suddenly get better.
This implies that the lenders are not going to sit around passively and let VRX gradually, slowly amortize the money it spent ("lost") on those acquisitions - money it mostly or entirely never earned.
The dynamic I expect is that increasingly, and perhaps rapidly and stochastically, VRX is likely to find that lenders want to get out of their exposure. If this is the best of times for pharma pricing and market share, why hang around? If a lender has a credit that's been earning a high spread over its cost of funds for several years, then if it can get out close to 100 cents on the principal dollar, it has beaten a benchmark of the same loan to the US Government. If the lender is new to VRX, say via the Salix deal, it may well be dismayed by the horrible turn of events since it did the deal. Why would it want to hang around?
Who is the big loser here? The common shareholder. Remember, VRX has a giant negative tangible net worth. If it is overstating the (guessed at) value of its intangibles and goodwill on its balance sheet, as appears almost certain as I see it, then it also probably has a negative net worth, period.
So I think that there's a good possibility that at the end of the day, VRX shares can drop to near zero.
Why is this important?
I addressed this in last week's article. To summarize those points, it's important because if that occurs, there will be some forced selling by owners of VRX shares and perhaps debt. (I would look at any reflex selling of biotechs as a buying opportunity, as VRX has little in common with the strong, large biotechs I write about and both own and trade.) The other point was that VRX is an extreme example of the current financial markets in the US, and to some degree the economy.
Let me expand upon that second point.
A lesson for VRX is that GAAP accounting is more reliable than non-GAAP, in general. With 97.9% of the '500' reporting, S&P gives TTM GAAP EPS of the '500' as $86.47. Supposedly, this reflects above-average, though declining, profit margins. With 2.1% of companies yet to report, I'll just call the P/E 24X. Based on numbers I've seen and referred to in a recent article, a normalized profit margin suggests a normalized P/E of 30X right now.
Now we have to do what I argued needed to be done with VRX, namely adjust the P/E for debt load. With corporations having well above-average financial leverage, and existing within an economy where consumers and governments also have above-average debt loads, then it follows that P/Es should be below average, not above average. The exception would be emergence from a severe recession, where GAAP P/Es had been devastated by a combination of write-offs and cyclically depressed operating earnings; i.e. below-average profit margins.
Then we should adjust for what I pointed to was wrong with VRX, namely the quality of its assets. In the case of VRX, it was its mediocre product portfolio. In the case of the SPY, it's basically the nominal growth rate of the economy. Based on recent past performance, the number of years that have passed since the Great Recession, and the strenuous efforts that "the powers that be" have made to avert another recession, I'm comfortable projecting a nominal sales growth for the '500' of 3-4% per year.
It would take several years for a profit margin of, say, 10% to drop at a 3-4% rate to 8% - maybe 5-6 years. If that occurred with sales growth of 3-4% a year, then 5-6 years from now, the SPY would still be at the same price if its P/E stayed at 24X. All an investor would have would be dividends. Then we can start working on normalization of the P/E. That process can occur quickly; of course, it can and I think probably would occur simultaneously with a no-profit growth scenario, especially because the Street is projecting rapid profit growth for at least the next two years.
So, without belaboring the cautious point of view I have about the SPY and the rest of the S&P 1500, which trades at higher valuation than the SPY, I take the message of VRX as follows, in summary.
Concluding points - be wary of high valuations
VRX was vastly overpriced above $100 with no allegation of impropriety, as I demonstrated back in October. Now that issues have arisen and the company cannot simply file a 10-K and wants to delay filing its Q1 10-Q, the questions of impropriety cannot be dismissed as the rantings of a short seller; we will see what eventuates on that front.
More relevant to me is that the company has turned unprofitable in Q4, and is projecting much larger losses in Q1. This trend suggests that VRX accumulated its massive debt load while overpaying for its assets. With unimpressive assets in the pipeline, VRX's debt load could rapidly be treated as current rather than amortized slowly over time as would be the normal treatment if the acquired assets were good or the company had other means of repaying the loans.
This in turn can mean that rather than emphasizing non-GAAP earnings by excluding amortization charges from the non-GAAP "earnings" presentation, it may be more reasonable for VRX, or at least investors, to include (much?) more rapid amortization schedules to account for insolvency/dilution risk.
Thus I think that there is no clear lower limit for VRX's stock price; it could go anywhere (even up).
With regard to the SPY and even more richly valued, smaller-cap indices, Warren Buffett has now joined my little effort to denigrate non-GAAP numbers and emphasize GAAP. GAAP is imperfect, but it's much better than self-serving non-GAAP numbers.
When looking at the SPY coldly using GAAP EPS, the message I take away is clear. Profit margins are declining from near-record levels but are reportedly historically high, and historically they have always A) mean-reverted and B) declined below average. At the same time, P/Es are near or at bubble levels. The consequence: high risk of anything from a rapid decline in share prices or lagging even the returns from safer muni bonds for years to come, as profit margins and P/Es may both normalize downward.
Thus I favor a cautious strategy toward equities, and use tougher criteria than during the money-printing phases of the bull market to initiate or increase a position in a stock. A final message from VRX: it does not matter how many bulls there are pushing a stock, an index or a commodity upward. One needs to be true to one's own valuation criteria.
VRX looked bizarre to me the whole way up, and its decline has been no surprise to me. It was the acceptance of and promotion by the Street of non-GAAP "earnings" from the company that led the stock to its exalted P/E, in my view. When I assess where the shares could trade, the fact that they are close to already having declined a massive 90% means nothing to me. They were simply bizarrely valued at the very high levels.
The SPY is obviously a much better and less risky asset than VRX. However, my patiently cautious approach toward equities in general is: try not to lose money, and it's informed by watching GAAP earnings for the SPY and other stock indices.
In all stock markets, some stocks look better to different investors than others. So I continue to like my favorite biotechs with a very patient, long-term approach, but stocks tend to move together, not solely on each individual issue's own merits. Thus, overall caution begets caution on overall exposure to individual issues.
In conclusion, the Valeant gamble of growth via debt-fueled acquisition, which began with a combination of four smallish companies and exploded onto the scene with countless deals, large and small, may be failing big time. Editorially, I hope that there is a "there" there within VRX, that no laws were broken and that no ethical misdeeds occurred. As an analyst, I have to keep an open mind and let matters play out. So we shall see. But my view from October that VRX had a fair value below $10 has been modified, and I think that a price below $2 is possible, perhaps very possible, and perhaps sooner rather than later.
For the overall market, there is a conflict between nominal GDP growing at 3-4% per year, a TTM P/E of 24X with historically elevated profit margins, and a bond market priced for slow-to-no growth or inflation. This is occurring in a setting of high debt levels within business, government and consumers.
The high GAAP P/E on the SPY and indices of smaller stocks means to me that the SPY can drop if growth surges. That phenomenon could induce a rising rate, shrinking profit margin situation reminiscent of the 1966-82 period. Or, a continuation of very slow nominal GDP growth could pressure earnings so that they either keep falling or simply fall well below expectations.
Thus my take-home for all equities from the evolving sad situation at VRX is that GAAP valuations matter. When they are high relative to documented growth in a high-debt situation, caution is the watchword, no matter how well a stock or an index "acts."
Disclosure: I am/we are long GILD,REGN.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.