- Valeant guided to 2018 EBITDA of $3.05-$3.20bn, $200mn below my expectation of $3.4bn.
- $200mn shortfall is due to higher LOEs and projected FX losses.
- Valeant shares remain cheap even on the lower projections, but potential upside is lower.
Valeant (VRX) released their 2017 earnings statement and 2018 EBITDA guidance on Feb. 28th. Their 2017 results were strong, with EBITDA of $3.64bn is in the middle of their guided range of $3.60-3.75bn. This result was especially impressive as they met their guidance given in February 2017 despite selling several assets through the course of the year.
Valeant's guidance for 2018 EBITDA was however much lower than I had expected. CFO Paul Herendeen guided to EBITDA of $3.05-3.20bn, as shown in the charts below.
I had expected $3.4bn, as I wrote in this article that I published in October. In that article I raised the possibility that CFO Paul Herendeen, who is fond of saying that he views "guidance as a commitment," may guide to a lower number of $3.3bn to err on the side of conservatism.
But the current guidance, with a midpoint value of $3.1bn, is materially lower than my forecast, and this difference cannot be put down to CFO Herendeen's conservatism. The main difference is that the projected headwinds from LOEs are c. $200mn higher than I had expected. The EBITDA from the 2017 cohort of LOEs is expected to be $287mn lower than in 2017, while I had a $210mn headwind. The big difference arose in the 2018 cohort of LOEs however. Their EBITDA is expected to be $113mn lower than in 2017, whereas I had no "2018 cohort" of LOEs.
In my forecast I projected that the B&L & Salix businesses would grow at 5% and 9% respectively, based on the guidance given by Valeant management in the table below from page 14 of the same Q4 2016 earnings presentation in which their LOE forecasts were first introduced.
My growth projection was at the headline level, as the table implies, and I did not have a separate entry for the profit headwinds for products that had not yet been identified as LOEs. But Valeant's 2018 guidance first subtracts the headwinds from LOEs of seven new products as shown in the table below, and then they apply their growth rate to the non-LOE products.
For example, Salix 2017 EBITDA of $860mn grown at 6% (per their new guidance) would generate a $51mn increase in EBITDA uplift for 2018. But this 6% growth is after the LOEs of Apriso & Uceris, and if we net out the c. $61mn LOE headwind from Apriso & Uceris then overall Salix should see a $10mn EBITDA decline in 2018. This is not the 8-10% growth shown in the table above! It is also the root cause of the difference between my forecasts for 2018, and management's guidance.
This deserves a rant.
It is easy to produce high growth numbers when you can selectively ignore products whose profits are dropping. Unfortunately, this appears to be the approach that they have taken, and I find it very disappointing. I expect that Joe Papa and Paul Herendeen knew that they would fall short of prior predictions six months ago, so I believe they should have disclosed this new information to the market. I know that these estimates were not guidance and so they probably are not under legal requirement to disclose any changes to their view, but if they want to rebuild shareholder trust in their firm amongst prospective long-term shareholders, then they should proactively disclose as much information as possible that is pertinent to the long-term analysis that such shareholders like to do.
OK, rant over.
The other aspect of the guidance that I find unusual is that the FX impact is guided to be +$170mn tailwind for revenue, but a $55mn drag on EBITDA. I don't understand how this works, and I would like a further explanation from the management team.
The good news
The guidance aside, the results were decent. In addition to hitting their 2017 guidance management have now started to outline a path back to growth. This inflection point is the critical path for Valeant, as I outlined in my article from a month ago, and the chart below is an indicative look at Valeant's long-term potential.
Even at this lower level of profitability, Valeant is still very cheap. I focus on cash flow to shareholders, and at $3.2bn of EBITDA Valeant should generate c. $1bn of cash flow in 2018 (after interest, capex, contingencies & restructuring). At the current share price of $15.50 VRX stock is priced at 5.5x cash flows. If EBITDA grows at >5% through 2021 then cash flows to shareholders should grow at >10% as the financial leverage works in our favor; such dynamics deserve a cash flow multiple of at least 10x, which is a $30 share price.
An alternative approach to valuation is to assess the value of the company to a potential bidder. As an enterprise (i.e. before debt) Valeant generates $2.5bn of post-tax, unlevered free cash flow. There are many potential bidders for Valeant that are all flush with cash, and on financial metrics a deal at $35/share, which is 15x unlevered free cash flow, would be attractive for both parties.
I'm still holding, but with some reservations
In sum, I continue to believe that Valeant stock is a good investment. But my fair value has dropped from $50-60/share to $30-40/share as the baseline level of profitability is lower than I had expected. I am disappointed that management have not been as honest with potential shareholders as they could have been - and my regrets here are compounded by the fact that many sell-side analysts and their clients appear to have been privy to this information, which explains the lower consensus estimates, and yet the broader market was not.
In light of this, I am kicking myself for not reducing my position when the stock was trading at $22-23/share at the start of this year. And if the share price rises above $20 in the next few months I will look to reduce my holding, unless there is new news that rebuilds my confidence about Valeant's future prospects. If the share price continues to hover in the mid-teens over the next few months I will continue to hold my shares, as I believe that Valeant will beat guidance through the course of this year, and that will cause the share price to move back to the $20+ range.
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