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Valeant Stock Analysis At $32

|Includes: Bausch Health Companies Inc. (BHC)

What a mess this company is. Is the stock undervalued? Hard to say. Could be or could go bust given $31b debt load.

A comment on accounting. It's fine. The accounting for a severely acquisitive firm is extremely complex. Amortization of intangibles causes people concern. But they may be writing down the asset value (which flows through the income statement and gets deducted from Goodwill on the B/S) but the initial value of that asset was also based on certain assumptions. So even though it seems like its a real write down, it isn't clear if the initial value was a fair reflection of the NPV of future profits from the drug anyway. Put another way, the earnings from B&L are real, but the write down of intangibles obscures the number, so full deduction doesn't seem fair either. Allergan does the same thing. So does Berkshire. That's the reason many people will argue the shorts were wrong. There was no channel stuffing and the earnings weren't manipulated either. That's why Pershing Square added to their position as did Sequoia. No one expected Senate to put so much pressure on drug companies to reduce prices.

The true earnings power of the company is tough to figure out. But let's try.

Approx. $7b of revenue will be unaffected by drug price controversy: U.S. B&L will do approx. $1.1 billion next year Salix will do approx. $2.6b EM will about $2.1b ROW/Australia/Canada about $1.4b $5b of revenue from Derm, Oncology, Neuro and Generics will be affected by pressure on drug prices: U.S. Derm consensus is $2.8b Neuro/Generics consensus is $2b Oncology is $0.3b That's how you get to $12b in revenues for 2017 (as Pearson said in his testimony). Let's apply a 30% haircut to derm, neuro and oncology. So our new 2017 revenue number will be $10.7b. Let's say blended net margins come down to 25%, since Neuro/Derm/Generics were the most profitable. EBITDA comes in around $5b. Leverage is around 6X, a little high but still manageable. Net income comes in at $2.7b. So the stock is trading at 4X earnings. 8X EV/EBITDA. Now if EBITDA comes in below $5b, $VRX might be in trouble.

Neuro/Oncology/Generics could take a bigger haircut than 30%. If the haircut is 50%, net margins might go down even further. So not hard to see a sub $5b EBITDA number. Salix and B&L are growing, so they may be able to compensate for declines in other segments.

I think a 30% haircut is reasonable, although may not be conservative enough for the short term. The Pharma business reminds me of the banking business just before the financial crisis. Banks were earning ROICs that were disproportionately high. The financial crisis brought that into check, so now many banks are trading at low single digit P/E multiples since the govt. has mandated restrictions on leverage and higher capital requirements. So now for Pharma, the cost of capital is rising. So the multiples will come down as margins get compressed. No drug executive wants to be singled out for a Senate hearing. The Senators destroyed Pearson and Schiller to the point of it being a public shaming. The big difference here though is that Pharma produces innovative medicines that save lives, so everyone is aware that a decent profit margin has to exist in this industry. It will always be (here in the U.S.) an industry with great economics. 25% net margin is a big drop from 40%, but admittedly it could go lower even. One thing is for sure - the bull market in Pharma is OVER. It's time to be short - particularly companies like Horizon Pharma and Endo, although cost of borrow is quite high now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.