Let me get this out of the way right at the start: I am neither a Valeant (NYSE:VRX) bull, nor a Valeant bear. I was once an investor in the company and did fairly well - I did not get out at the top (I'm not nearly that talented at timing my investments), but my returns were quite positive, so I do not harbor any negative feelings toward the company or its management.
I wanted to use the fairly simple DCF sensitivity analysis model I developed to analyze Valeant Pharmaceuticals. I had no idea going into the exercise what the result would be and no bias to try to engineer a specific outcome. Part of me expected the model to spit out a huge target price and part of me expected a negative target price (indicating a stock that will likely end up at or close to zero).
Note: I invite you to read my original article that outlines the DCF sensitivity analysis methodology. The basic idea is that since the results of a DCF analysis can be heavily skewed by making minor changes to the terminal growth rate or WACC (weighted average cost of capital), I have used a range of long-term growth rates and discount [WACC] rates in my analysis below. By using one's own estimate of long-term growth and an appropriate WACC (discount) rate, each individual investor can come up with their own target price for the security in question.
Looking back at the past five years of history, Valeant was able to maintain a fairly consistent ratio of Operating Cash Flows to Earnings - the average was 21.5%, which also happens to match the result from 2016. This is the value that was assumed moving forward. The lack of capex (R&D) spending is a well-known part of Valeant's strategy and while this may increase in the future, using the five year average of 4% of revenues seemed like a safe bet.
Although analysts expect a decrease in revenue this year of nearly 9%, they forecast modest growth for 2018. Trying to estimate Valeant's future sales seems like a very difficult task given the current political uncertainty, drug-pricing macroeconomic environment and potential future asset sales. My base case uses a 2.5% long-term growth rate, but the results table located at the end of the article provides model prices given a range of growth expectations (from 2-4%).
Choosing an appropriate discount rate for Valeant is also a challenge. Given the company's market capitalization is now below $4 billion and it has nearly $30 billion of debt outstanding, the "true" cost of Valeant's capital would technically be almost entirely the after tax cost of its debt (Valeant's tax rate is uncommonly low, so it does not get nearly the same tax benefit on interest payments as many other firms). Earlier this month, it issued medium-term notes with interest rates of 6.5-7%. For my base case scenario, I chose to use a discount rate of 8%, which is likely on the low side for a company with Valeant's recent baggage and uncertainty (again - you can choose a rate as low as 6.5% in the table at the end of the article).
If Valeant had no net debt, these free cash flows discounted to today at a rate of 8% would have a value of approximately $85 per share. Unfortunately for Valeant shareholders, Valeant's net debt of over $29 billion completely erodes this value. Given the above variables, the model's target price is $0.50 per share, suggesting that the present value of future cash flows, once adjusted for debt, is basically zero.
Summary of DCF Model Results:
To get a positive model price, one needs to assume either a very low discount rate (7.5% or less) or a more aggressive long-term growth rate (above 3%).
One critical piece to understand is that due to the high amount of leverage on the company's balance sheet, any minor change to the variables in the model can make a significant difference to its target price. For instance, lowering the discount rate from 8% to 7% (while keeping everything else the same) increases the target price from $0.50 (the road to potential bankruptcy) to $18.33 (more than 50% upside based on the current share price).
Valeant shareholders will likely argue that future asset sales will reduce this debt load. And they are likely correct. However, one would expect that divestitures will also reduce future revenues and cash flows (if a product or brand did not have future cash flow potential, why would another company pay for it?), thereby lowering the current value of Valeant's future free cash flows.
Maybe Valeant can grow organically (without further acquisitions) by more than 2.5% in perpetuity. Maybe its true cost of capital is 7% or less. Or maybe it will be able to sell a number of its products or divisions at hefty multiples. Each of these outcomes could make Valeant a strong investment at current prices. However, based on the results of my DCF analysis, under most scenarios, it is difficult to see how shares of this company have meaningful positive value.
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.