Valeant Stock Analysis At $32

May 02, 2016 2:58 PM ETBHC8 Comments
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Contributor Since 2016

I am a value conscious investor looking for bargains.


1) Price is what you pay, value is what you get

2) Success in investing is limiting losses when you're wrong, and maximizing gains when you're right

3) Start with business model.  Margins reflect value add a company's products bring to the market place.  Does the Gross Margin and the Product match?  High GMs accompany differentiated products with limited competition that do not compete on price.  Low GMs accompany undifferentiated products that compete on price, CAPEX spend, cyclicality.

4) How is the business financed?  Be wary of companies with a lot of debt.  Great businesses do not require huge debt to generate high returns on equity.  There is no achievement in generating high ROEs by levering up like banks, leasing businesses (car rental, equipment rental, aircraft rental).  ROA should be telling here.

4) A company's value changes because the NPV of future profits changes.  NPV of future profits is a function of changes in revenues, gross margins, OPEX, leverage, taxation.  A company's value appreciates when the NPV of profits goes up due to revenue growth, GM expansion, OPEX reduction, leverage (refinancing) / tax (change of domicile) reduction.

5) Markets look forward.  Bottoms coincide with maximum pessimism while tops coincide with maximum euphoria.  

6) A stock is not undervalued because it is cheap and it is not overvalued because it is expensive (based on traditional valuation metrics).  Similarly, a stock is not undervalued because it has gone down a lot or overvalued because it has gone up a lot.

7) Look at market cap when valuing companies.  Don't be overly influenced by management projections, analyst reports, share buybacks, cash on B/S, price movements, other people in the stock. 

8) Companies with significant debt can go bankrupt.  Cash burn typically determines if they go bankrupt before the cycle (for their industry or the economy) turns.

9) Undervalued stocks can get cheaper, overvalued stocks can get more expensive. 

10) Keep emotion out of investing.  You will be wrong.  Unpredictable things will happen.  Stay vigilant to anger, anxiety, exuberance.  Stay vigilant to thesis creep.

11) Leverage will kill you sooner or later.  Companies have large operating and financial leverage. 

12) Have a thesis.  If the thesis plays out, stay with it.  If it doesn't exit.  Always have a thesis.

13) Understand the business you are invested in.  It's valuation and what can go wrong.  Know the business inside out.

13) Don't trade. 

14) Diversify.  There are many good ideas in the market.  Don't put your eggs in one basket.

15) Failing businesses rarely turnaround.

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.

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