VRX - Valeant Pharmaceuticals International Inc.

[Spekulatius]

I'd say trust but verify, especially when you deal with rollups. I don't think it's possible to verify the organic growth rates from VRX numbers. I did note in the 10K that they lost roughly 300M$ in revenue due to reduced Zovirax sales (I assume this is patent expiration related). I wonder if this kind of stuff is included in the 6-8% growth rate or not.

 

I can say for sure that a business that has 27B$ in assets and a 8B$ revenue run rate cannot make a 20% ROI. I would also argue against assuming the the rest of the industry is run by dummies. The LT track record of AGN is actually quite good, even prior to the takeover boost.

 

If you have not, I think it would be worth checking the "same store sales" and "pro-forma" organic growth rates that are provided in the 8K filings for the earnings releases.  Further, you should review the earnings call slide decks where management reviews the earnings growth rates of previous acquisitions (e.g. 2Q13).

 

As I recall, when you put out your "ballpark numbers" you were assuming much lower EBIT margins than the VRX model.  You are obviously skeptical (as are many in the industry) that running a pharma business with 20% SG&A and 3-5% R&D is a sustainable business model.  I understand the skepticism and would encourage you to review the extensive disclosure that VRX management provides in the aforementioned 8K filings. 

 

I looked at the presentations, but I don't think there is much value doing so. Presentations always show the things and numbers that management want's you to see. I think there is much more value going through the 10q's and 10k with a fine comb and form your own opinion, based on the numbers and your own interpretation. Look for example in the following excerpt from VRX 10k:

 

incremental product sales revenue of $271.2 million in 2013, related to growth from the existing business, excluding the declines in Developed Markets described below. In the Developed Markets segment, the revenue increase was driven primarily by price, while volume was the main driver of growth in the Emerging Markets segment.

Those factors were partially offset by:

•

decrease in product sales in the Developed Markets segment of $293.9 million, in the aggregate, in 2013, primarily related to a decline in sales of the Zovirax® franchise, Retin-A Micro®, BenzaClin® and Cesamet® due to the impact of generic competition;

•

a negative impact from divestitures, discontinuations and supply interruptions of $67.8 million in 2013. The largest contributors were the discontinuation of Dermaglow® and the divestitures of certain brands sold primarily in Australia;

•

a decrease in alliance and royalty revenue of $53.0 million, primarily related to the $45.0 million milestone payment received from GSK in connection with the launch of Potiga® recognized in the second quarter of 2012 that did not similarly occur in 2013;

•

a negative foreign currency exchange impact on the existing business of $24.4 million in 2013; and

•

a decrease in service revenue of $9.5 million in 2013, primarily due to lower contract manufacturing revenue from the Laval, Quebec facility, which was acquired as part of the acquisition of the Dermik business from Sanofi in December 2011.

 

The important part is highlighted in bold. My take is that if you exclude everything that shrinks from you calculation, it's easy to show growth. Your take may be different. Maybe there is a good explanation to do and calculate the number the way management does, maybe not. I have a hard part deciphering this.

[giofranchi]

I looked at the presentations, but I don't think there is much value doing so. Presentations always show the things and numbers that management want's you to see.

 

Spekulatius,

this is precisely the matter: without trusting management, any investment is impossible. Please understand me: you may very well jump in and out of stocks… and you might be able to do it very successfully… But anyone who has ever managed a business knows you simply don’t want to own a business, unless you have not only trust but also admiration in the people you partner with.

 

If you are doubting what Mr. Pearson says… well, everything else is just useless: stay away from VRX! ;)

 

Instead, I trust and admire him. How? Well, by listening at what he says (I highly recommend to read all the transcripts of past conference calls!), and by reasoning about what he does.

 

Listening at what he/she says and reasoning about what he/she does: that’s the way I judge and choose every partner of mine.

 

Gio

 

[txlaw]

Munger on pharmacy company tax rate:

http://video.cnbc.com/gallery/?video=3000272546

 

And WEB on tax reform and tax-driven mergers (he mentions VRX and PFE):

http://video.cnbc.com/gallery/?video=3000272539

 

Very interesting to hear WEB say that this could potentially catalyze corporate tax "reform."

[txlaw]

Munger on pharmacy company tax rate:

http://video.cnbc.com/gallery/?video=3000272546

 

And WEB on tax reform and tax-driven mergers (he mentions VRX and PFE):

http://video.cnbc.com/gallery/?video=3000272539

 

Very interesting to hear WEB say that this could potentially catalyze corporate tax "reform."

 

Or at least catalyze discussion of corporate tax by Congress.

[Liberty]

http://dealbook.nytimes.com/2014/05/05/ackman-urges-allergan-board-to-begin-deal-talks-with-valeant/

 

 

Ackman's letter:

 

http://www.sec.gov/Archives/edgar/data/850693/000119312514181838/d721048dex995.htm

[loganc]

Jim Grant provides some commentary about VRX in the following clip (starting @ 4:00):

 

http://t.co/YWOteFQtll

 

If this is the best the bears can do, it seems pretty flimsy to me.  The GAAP earning power is weak?  I think there are a few people that have managed companies with "weak GAAP earnings" and generated extraordinary returns - see "The Outsiders." 

 

Would anyone be willing to provide the copy of Grant's Interest Rate Observer where the short thesis for VRX is described?

 

Edit:  I am not a credit investor.  The comments about the bonds not being an attractive investment are duly noted.  The fact that the bonds are overvalued or that VRX has "used" bondholders is really not a concern to me.  I think Malone has and is operating in a similar fashion.

[equitynyc]

edited

[loganc]

@equitynyc Many thanks for posting.

[original mungerville]

Wow, that's it? That's the best he can do? 

 

Who knows, he could be right, this could be another Enron... but wow, I thought he would have a better argument. The  notion that GAAP earnings are the only way to measure progress is absurd, and that the company providing a suite of other measures is necessarily a bad thing.

 

I mean often GAAP earnings reflect reality, but certainly not always. We have to look no further than Berkshire Hathaway and the concept of "look-through earnings" of public investees (such as Coke) where despite GAAP earnings only providing Berkshire with dividend income from Coke, Buffett encourages shareholders to look-through to Berkshire's pro-rata share of Coke's full earnings (both retained and declared as dividend) to help understand its value to Berkshire. You would think Grant would at least make an argument that none of the measures of earnings provided by management are any good. But he doesn't, he just takes cheap shots at them not getting into detailed analysis.

 

Its a bit weird actually. Now he could be right, but the argument certainly is not convincing. The revenue recognition thing is something to think about though. Any views on that?

[loganc]

Here are a few of my comments about the Grant thesis.  Full disclosure, I am a "retail" investor and have only done research about VRX over the past 1.5 weeks.  I have not finished my work on VRX, but my conclusion is that the "research" presented by Grant's is sloppy, at best.

 

Good Points:

 

Pre-acquisition, Medicis had recognized revenue not when it shipped its products to its distributor, McKesson Corp., but when McKesson sold those products to doctors. Post-acquisition, Valeant began booking sales as soon as the McKesson-destined products went out the door. In response to a query from the SEC, management defended the new practice. (Valeant’s pricing policy, as distinct from Medicis, allowed greater certainty as to revenue was the essential response.) One is left to wonder what changes Valeant has chosen to effect in the numerous smaller acquisitions that never produced a similar regulatory paper trail.”

 

I noticed this change in how revenues were being booked booked, but I haven't yet had time to figure out that question.  This is a legitimate point.

 

Bad Points:

 

The closer you look, the more you see what sets Valeant apart from its pharmaceutical peers. R&D spending is one of these eccentricities. Last year, Valeant invested just 2.7% of its sales into research and development compared to an average of 13.8% of sales for Johnson & Johnson, Pfizer Inc. and Merck & Co.

 

Basically, this is a restatement of the "bull" case for VRX.  The fact that VRX spends a low percentage of sales on R&D is reflective of the fact that they are disciplined in their capital allocation.  Their goal is not to spend a certain percentage of sales on R&D.  They are not just spending money on a pipeline in hopes that serendipity will strike and a great blockbuster will emerge.  Their goal is to reinvest capital in high return projects.  Further, VRX is assembling a portfolio of durable assets that will not be subject to patent cliffs.  It is really a fundamental mistake in analysis to compare VRX with a large scale pharma company, despite the name.

 

 

You begin to wonder if anyone outside the front office actually understands what the company’s about or what it earns (about which more in a moment). Consider, says Lorenz, “the 2012 Valeant purchase of Medicis Pharmaceutical Corp. for $2.4 billion cash (Valeant always pays cash).

 

Again, this is basically stating the bull case.  VRX runs a decentralized organization.  I suggest that the Grant's analysts read the Outsiders or maybe read a few Berkshire letters.  And, why is it bad that VRX prefers to pay cash for deals?  It seems to me that a shoddy roll-up that is about to come off the wheels would rather pay in stock.  Doing deals in cash is good for share owners and not bad. 

 

So, then, what does Valeant really earn? “Cutting through GAAP and non-GAAP earnings,” Lorenz proposes, “let’s settle on free cash flow—that is, cash flow from operations less capital expenditures. In 2013, free cash flow amounted to $927 million, or $2.89 per common share, up from $549 million, or $1.80 a share, in 2012. The 2013 reading would give Valeant a less-than-lordly free-cash flow yield of 2%. Unlike R&D expenses, which are debits in the free-cash-flow calculation, funds spent on acquisitions don’t impact free-cash flow. As Valeant conducts its R&D via M&A, free-cash flow, if anything, flatters Valeant’s ability to generate cash.”

 

The FCF calculation presented above is not even relevant to the current operation due to the fact that the B+L deal was closed in August and therefore the B+L results (as well as other acquisitions made during 2013) were only partially included in the FCF calculation.  There are other things wrong with the Grant's article, but this is pretty terrible analysis.  Of course a company will look overvalued if you only include the results of a very large acquisition for a small portion of the total year results.  This kind of analysis is worse than any sort of negligent goodwill/intangible accounting that VRX is purported guilty of.

 

Again, this was a quick response.  There are other things in the analysis that I take issue with.  I would appreciate hearing any response to my thoughts. 

 

[original mungerville]

Yup, its pretty f8ck%n bad to put it politely. I would like to know more about the revenue recognition thing though - that could be an issue. Does Ackman address this? I don't remember him addressing this directly in his presentation.

[loganc]

Its a bit weird actually. Now he could be right, but the argument certainly is not convincing. The revenue recognition thing is something to think about though. Any views on that?

 

I am still working on figuring this out.  One thing I read in the filings (I don't recall where) seemed to indicate to me that they were reducing the amount inventory held in the channel.  Again, I have work to do on this issue but I think it is correct to be a little concerned about this issue.

 

[Liberty]

Good Points:

 

Pre-acquisition, Medicis had recognized revenue not when it shipped its products to its distributor, McKesson Corp., but when McKesson sold those products to doctors. Post-acquisition, Valeant began booking sales as soon as the McKesson-destined products went out the door. In response to a query from the SEC, management defended the new practice. (Valeant’s pricing policy, as distinct from Medicis, allowed greater certainty as to revenue was the essential response.) One is left to wonder what changes Valeant has chosen to effect in the numerous smaller acquisitions that never produced a similar regulatory paper trail.”

 

I noticed this change in how revenues were being booked booked, but I haven't yet had time to figure out that question.  This is a legitimate point.

 

This is mentioned here:

 

http://seekingalpha.com/article/2073923-why-chanos-and-grant-are-wrong-on-valeant

[loganc]

 

I noticed this change in how revenues were being booked booked, but I haven't yet had time to figure out that question.  This is a legitimate point.

 

This is mentioned here:

 

http://seekingalpha.com/article/2073923-why-chanos-and-grant-are-wrong-on-valeant

 

Thanks for posting, sir.

[wbr]

Forget VRX or POST and don't even think about buying any company where Malone is involved!

 

Let's all just invest in companies that look good on a GAAP earnings basis like... Gazprom!

[peter1234]

I am actually with gio on this one. You must trust the CEO to buy into this one. But it would be nice to be able to verify the numbers and assumptions.

 

Problem with aggressive debt financed roll-ups is that verifying the numbers is hard if not impossible.

 

I find it hard to believe that a company can have organic growth while only spending 2-3% on R&D. Common sense would make me expect a company in steady/slowly declining organic state.

 

Maybe everyone else is just throwing money out of the window. But the difference between 2-3% and 15-25% just feels too aggressive.

 

In general, I think it is a brilliant approach. Cutting overhead and lowering taxes makes sense. Just basically eliminating R&D and still achieving higher organic growth than the industry I have a harder time to believe.

 

;)

[giofranchi]

Just basically eliminating R&D and still achieving higher organic growth than the industry I have a harder time to believe.

 

Yet, they are more like consumer products than drugs… How much does P&G / Unilever spend in R&D? What’s P&G / Unilever organic growth?

 

Gio

 

[peter1234]

Gio, good points.

 

Here is my attempt to provide some data points:

 

From 2013 figures...

 

Unilever: 14% Advertising & Promotion, 2%    R&D, 4% organic growth

P&G:      12% Advertising & Promotion, 2.5%  R&D, 3% organic growth

 

Valeant:  ?    Advertising & Promotion, 2-3% R&D, 7-10% organic growth

 

So... assuming Valeant is comparable to Unilever and P&G, Valeant will invest the same in R&D and realize 2x the organic growth.

 

Very impressive if they can pull this off.

 

:) :) :)

 

 

[giofranchi]

So... assuming Valeant is comparable to Unilever and P&G, Valeant will invest the same in R&D and realize 2x the organic growth.

 

Very impressive if they can pull this off.

 

:) :) :)

 

Yes... You might be right... Anyway, I would be very pleased with a 3%-4% organic growth at VRX. ;)

 

And don’t forget VRX constantly buys products they think they can improve and better advertise and promote. Companies like P&G and Unilever don’t benefit from this kind of “activist” approach to managing newly acquired products.

 

Gio

[Liberty]

Allergan Q1 results:

 

http://agn.client.shareholder.com/releasedetail.cfm?ReleaseID=845882

[Spekulatius]

The problem with the outsider approach is survivorship bias. For every Liberty Media, General Cinema etc. there are probably 5x companies that looked good for a while but then withered or imploded.

 

In general, I think it is a brilliant approach. Cutting overhead and lowering taxes makes sense. Just basically eliminating R&D and still achieving higher organic growth than the industry I have a harder time to believe.

 

Tyco for example claimed the same thing. They cut the fat (or so they claimed, but acquisition charges turned out to be real operating expenses and the charges itself were cookie jars to boost earnings) and they sure cut R & D to the bone claiming they can always acquire products cheaply.  They also acquired a mountain of debt etc. Many similarities are there. For me, it's really hard to tell the difference between a successful rollup and a fraud or failing one. With respect to VRX, the jury is still out, imo and I am on the cautious sides there.

 

VRX is not a consumer product company, but it's R&D spending is comparable to consumer stables companies. Anybody knows which percentage of VRX products are under patent protection and will eventually become generic? That is key number, and I haven't seen it in the -10K. Every dollar of revenue from patent protected product will eventually go away (except for maybe a 10-20% residual) will eventually need to be replaced. This is not true for consumer stables, where the brands are essentially annuities.

[giofranchi]

The problem with the outsider approach is survivorship bias. For every Liberty Media, General Cinema etc. there are probably 5x companies that looked good for a while but then withered or imploded.

 

Imo this makes no sense at all! Anyone who runs a business knows it is method and discipline you look for. Not results! It is character you should be looking for. A good track record is not to be overlooked, but it is just the frost on the cake. Whenever you find the right method, the right discipline, the right character, and they are not easy at all to find!, you’d better partner with that person. At a fair price, of course, always at a fair price! This is how I do business in general, and investing makes no exception.

 

Gio

 

[giofranchi]

Tyco for example claimed the same thing. They cut the fat (or so they claimed, but acquisition charges turned out to be real operating expenses and the charges itself were cookie jars to boost earnings) and they sure cut R & D to the bone claiming they can always acquire products cheaply.  They also acquired a mountain of debt etc. Many similarities are there.

 

Hey! I admit I have never looked carefully into Tyco, I have never listened to even one conference call of theirs, nor read an AR of theirs. Therefore, it is really hard for me to confute such a comparison… Yet, I repeat: I have listened to Mr. Pearson speaking in all VRX conference calls of the last two years, and I have read much of the documentation they have published: the result today is I like the method, I like the discipline, and I like Mr. Pearson’s character.

 

Of course, I might be wrong. But, if I am a poor judge of people, why should I be successful in business? ???

 

Gio

 

[Phaceliacapital]

VRX is not a consumer product company, but it's R&D spending is comparable to consumer stables companies. Anybody knows which percentage of VRX products are under patent protection and will eventually become generic? That is key number, and I haven't seen it in the -10K. Every dollar of revenue from patent protected product will eventually go away (except for maybe a 10-20% residual) will eventually need to be replaced. This is not true for consumer stables, where the brands are essentially annuities.

 

It's around 2% - 2.5% until 2016 and something like 0.5% in 2017. I think those numbers are pro forma for B&L.

 

[giofranchi]

VRX is not a consumer product company, but it's R&D spending is comparable to consumer stables companies. Anybody knows which percentage of VRX products are under patent protection and will eventually become generic? That is key number, and I haven't seen it in the -10K. Every dollar of revenue from patent protected product will eventually go away (except for maybe a 10-20% residual) will eventually need to be replaced. This is not true for consumer stables, where the brands are essentially annuities.

 

It's around 2% - 2.5% until 2016 and something like 0.5% in 2017. I think those numbers are pro forma for B&L.

 

In their latest presentation (on page 31) they define 85% of their products as “durable”. And durable products are:

- Physician Dispensed ($1.5 billion in sales)

- Consumer Products ($1 billion in sales)

- Emerging Markets ($3.1 billion in sales)

- Off-Patent Rx Brands ($1.7 billion in sales)

 

The remaining 15%, classified as “non durable”, is:

- On-Patent Rx Pharma ($1.3 billion in sales)

 

Total sales $8.5 billion.

 

Gio