In my previous article published in November of 2017 I covered a lot of territory; however, the basic point of the article was to look at the valuation of Valeant (VRX) using managements projections at the end of 2016; for the years 2017 to 2020.
At that point 2016 was the base year and I created a pro forma to extrapolate Valeant's financials out to 2020 using the growth rates management was projecting at the end of 2016. In my articles I always provide the caveat that I have no formal financial training and it's possible I could make mistakes and in the comments section of my previous article a significant mistake was pointed out. I accounted for debt based on my (parochial) understanding at the time that it represents principal only. I found out that in the business world interest is included in what is called debt and I had double counted the effects of net debt in my valuation at that time. For most businesses this would not be a significant issue and might even be a decent margin of safety factor. It's a huge drag on the valuation of a highly leveraged company like Valeant.
In the following revised pro forma 2016 to 2020 I fixed the double counting of debt issue and I also eliminated financials for the year 2017 for clarity as the 2020 end point is merely an extrapolation of 2016 (adjusted for divestitures) using managements 2017 to 2020 growth projections (provided at the end of 2016).
In my previous article I went into detail as to how I extrapolated from 2016 to 2020. In short I used "Segment Financials" provided in an SEC filing and I adjusted 2016 to account for divestitures. I then extrapolated to 2020 using the growth rates projected at the end of 2016. One significant factor that required substantial guess work was the profitability of U.S. Diversified in 2020. It's very high profit now due to minimal expenses to support the LOE's; however, profitability was already coming down as the LOE's stopped contributing and I could only ball park what it would be in 2020. I also started with a 36% tax rate which is what I would use for a normalized tax rate. It appears VRX actual (Canadian) tax rate is much lower so I added a 16% tax rate which I deemed appropriate at the time. On the recent earnings call management guided to a 13% tax rate for 2018 and I think that's what it was in 2017. I'm sticking with 16% to be safe and this is what I will base valuations on later in this article.
Management has provided new mid-term guidance in the recent 2017 earnings announcement in a different format than the 2016 guidance. Here is the new guidance:
Here's the important part. Sitting here today, we expect our reported revenue to grow at a CAGR of between 4% and 6% off of the midpoint of our 2018 guidance through 2021. Further, we expect our reported adjusted EBITDA to grow at a slightly faster CAGR, 5% to 8%. Please note that in the case of both revenue and adjusted EBITDA CAGRs, we do not expect the growth over the period from 2018 to 2021 will occur in a linear fashion.
For example, the impact of the Class of 2018 LOEs will dampen but not overwhelm revenue growth in 2019 versus 2018. For the avoidance of doubt, we expect reported revenue to grow beginning in 2019 versus 2018, and for growth to accelerate as our new product launches take hold. The crux of the biscuit is that we now have line of sight to the return to growth.
2018 Financial Outlook
Valeant has provided guidance for the full year of 2018, as follows:
Full-Year Revenues in the range of $8.10 - $8.30 billion
Full-Year Adjusted EBITDA (non-GAAP) in the range of $3.05 - $3.20 billion
So from the first portion of guidance we get new growth rate projections that are based on the midpoint of 2018 guidance. The second portion is their 2018 guidance and the midpoint of revenues is $8.2B, the midpoint of EBITDA is $3.125B. The "Operating Income" from my pro forma above is based on "segment profits" that start with operating income and were adjusted for some one time and non-cash expenses and are roughly equivalent to EBITA. The midpoint of revenue growth is 5% and midpoint EBITDA growth is 6.5%.
Using the new guidance we can extrapolate revenues out to 2021 of ~$9.49B and EBITDA of ~$3.77B. Compare this to my pro forma projections for 2020 based on 2016 guidance of revenues of ~$10.77B and operating income (roughly the same as EBITA) of $4.60B and this guidance amounts to (~12%) decline in revenue guidance and a year later and an (~18%) decline in profitability and a year later. In other words these new projections amount to a fairly sizable reduction in mid-term guidance from last year. There has been a lot of discussion about bearish LOE guidance for 2018 causing the markets negative reaction to earnings; however, I suspect this walk back in mid-term guidance may be a more significant issue.
This update allows me to fix the valuation issue caused by double counting debt in my November valuation attempt and also to provide an updated valuation based on new mid-term guidance. Here is a corrected DCF based on last year's mid-term 2016 to 2020 guidance:
This DCF produced a current fair value of ~$86 per share based on an 11% discount rate. A second back of the napkin check I like to use is applying reasonable multiples to projected earnings to ballpark a stock price at that time and then discounting that stock price back to current market value. Given Valeant's massive debt I subtract projected net debt from future earnings. Using 2020 16% tax rate earnings of $3,735 a multiple of 15X gets $56,025 and a 20X multiple gets $74,700. I ball parked net debt of $21,500 at that time resulting in cash to owners of $34,568 at the 15X multiple and $53,200 at the 20X multiple. Dividing these by 350M shares outstanding gets a share price range of $99 to $152 in 2020. Discounting this back to present value at 11% would result in a current fair value of ~$72 to ~$111. Keep in mind this is based on last year's mid-term growth projections.
Now let's look at a DCF based on the current mid-term growth projections:
So we go from ~$85 per share to ~$56 per share current fair value based on discounted cash flow analysis. Using the same back of the napkin check as above (further reduced net debt to $20,500 to account for an additional year of debt reduction) I get a current fair value range of ~$52 to ~$83 per share. This is down from ~$77 to ~$111 per share based on last year's guidance.
While the decline in mid-term financial guidance and the associated fair value is substantial; the current market price of $15 per share is still orders of magnitude below even the reduced fair value range. This suggest the market is pricing in a non-zero chance of bankruptcy. Given EBITDA has trended from: $5B in 2015 to $4B in 2016, $3.4B in 2017 and is now projected to hit ~$3.1B in 2018 the market is clearly worried about this trend and will likely want to see it reversed before awarding VRX a market value on the order of the values calculated earlier assuming managements current mid-term financial guidance does not get substantially reduced again next year.
To wrap this exercise up there were two big culprits responsible for the financial decline of 2017. The LOE's which management clearly projected and investors were expecting and a 36% YOY decline in their Dermatology business that I don't know that management fully understood or fully included in their end of 2016 guidance. I would have to go through their disclosures to investors from year end 2016 to present to see to what degree they foresaw the magnitude of decline in Dermatology. Given financial analysis is not my day job that will have to wait for another article if someone else doesn't beat me to the punch.
Given the magnitude of the decline in mid-term guidance from end of 2016 to end of 2017 I think figuring out what went wrong and why is relevant. On the other side of the coin they did manage to beat guidance on debt reduction. Unfortunately until the current and projected trend in EBITDA reverses the reduction in debt isn't enough to soothe Mr. Market's fears. I remain long and they do provide realistic information about near term catalyst to replace the dermatology losses in 2019 and beyond that give me hope the turnaround only hit a speed bump and is not derailed; however, the issues that lead to the substantial reduction in mid-term guidance bear keeping an eye on.
