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Valeant Is A Short Regardless Of Accounting Manipulation

|Includes: Valeant Pharmaceuticals International, Inc. (VRX)
  • Non-GAAP earnings over state Valeant's profitability
  • Textbook Free Cash Flow calculation should not be applied to Valeant's "business model"
  • Even based on textbook Free Cash Flow generation VRX is highly overvalued

Although there are Pharmaceutical companies that have engaged in highly productive R&D operations in recent years; Valeant's management team has correctly identified that R&D productivity across the Pharmaceutical industry is sub par. Given the industry's lack of R&D productivity they have adopted a business model of foregoing R&D investment in favor of M&A activity to drive growth. While there are certainly synergies to be achieved in acquisitions, a debt funded M&A growth strategy is difficult to justify in an industry in which most assets have definable cash generating lives. Admittedly, slashing R&D spending in a company with revenue generating assets will drop more cash to the bottom line. However, this strategy overstates Valeant's sustainable Free Cash Flow (NYSE:FCF) generation. Most importantly, VRX's current valuation not only assumes the current unsustainable FCF will continue it also assumes terminal FCF growth well above that of the health care industry and more than double global GDP growth.

Textbook FCF calculation overstates VRX's sustainable cash generation. Looking at 1Q14 for example, outside of the $79mn spent on PP&E and Intangibles (capex), the company had $304.9mn of acquisitions net of divestitures in the Q. Normally, such spending should be excluded from the FCF calculation, but VRX has a stated strategy of foregoing R&D investment and focusing instead on M&A. If VRX had invested that $304.9mn in R&D (which is accounted for in the Income Statement) its net loss (the first line in the CF statement) would have been even greater, reducing Operating Cash Flow. Therefore, to get a better sense for the company's true cash generation acquisitions should be subtracted as well (especially since they are debt funded and further subordinate shareholders' claim on cash generated); leaving FCF of $100.2mn, about $0.30 per share (Note: VRX burned $24mn of cash in the Q). Finally, while I understand there is some seasonality for many of VRX's products, annualizing the FCF generation (adjusted for the M&A in lieu of R&D strategy) VRX has a FCF yield of 1% on its market cap and 0.71% on its EV at its current valuation .

Current valuation assumes VRX generates dramatic growth of textbook FCF. Beyond the aforementioned accounting manipulation (I won't call it a trick investors should know better), based on the standard definition of FCF VRX shares appear overvalued with a current FCF yield of 3.14% on Market cap and 2.2% on EV.

As Exhibit 1 below shows, taking VRX's TTM textbook definition FCF and entering it into 5 year DCF calculation, at an 11% discount rate (pretty standard for Specialty Pharmaceutical companies given the business risk) the current share price implies 8.8% FCF growth for the next years with the same rate applied to the company's Terminal growth. In an industry of lived cash flows (branded drugs face generic competition and generics face increased competition over time reducing cash generation) that is an "optimistic" terminal growth rate. In fact, in a company that did engage in substantial R&D analysts would have to conclude that "pipeline" value was embedded in the share price.

Exhibit 1: Discounted cash flow generation required to achieve current valuation

Valeant Pharmaceuticals Inc.          
$ Millions           Terminal Value
6/13/2014 6/13/2015 6/12/2016 6/13/2017 6/13/2018 6/13/2019 6/12/2020
Time 1.0000 2.0000 3.0027 4.0027 5.0027 6.0027
Discount Factor 0.90 0.81 0.73 0.66 0.59 0.53
Year 1 2 3 4 5 6
FCF (CFO-Capex) 1,354.68 1,473.90 1,603.62 1,744.75 1,898.30  
FCF Growth Rate (%) 8.8% 8.8% 8.8% 8.8% 8.8% 8.8%
Annual NPV $ 1,220.43 $ 1,196.25 $ 1,172.22 $ 1,148.99 $ 1,126.23 $ 51,225.45
Total NPV $ 57,089.57
Discount Rate 11.00%
Net Debt (16,810.60)
Total Value $ 40,278.97
Shares out 333.57
Total Value Per Share $ 120.75
Current Share Price* 120.75
% Upside (downside) 0.00%
*Price as of market close 6/12/2014

Source: Valeant Pharmaceuticals Inc. SEC Filings

Ultimately, it appears Valeant's current textbook FCF generation overstates its ongoing cash generation. Yet, regardless of management's Non-GAAP accounting tactics and overstated FCF; VRX shares appear priced for growth that is not achievable with its business model and is extremely difficult to achieve with even a highly productive Pharmaceutical R&D business model.

Disclosure: The opinions expressed are my own, but are based on mathematical reality. I have no positions in VRX although after writing this analysis I am considering expressing a short position in some manner in the next 72 hours or so.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a short position in VRX over the next 72 hours.