VRX - Valeant Pharmaceuticals International Inc.

[Liberty]

You cannot compare creams and contact lenses with hurricanes and floods, because imo it is conceptually wrong.

 

The predictability of creams and contact lenses should be compared to the predictability of FFH’s investments in its portfolio (bonds and stocks), while the predictability of what Valeant has to pay on its debt (a sure thing) should be compared to the predictability of what FFH has to pay on its float (here instead we have the possibility it doesn’t have to pay anything!).

 

Sure. My point was mostly that you can't look at the glass half full on one side and at the glass half empty on the other. Different businesses have different risks. Maybe I wasn't clear enough with my analogy.

 

Last time I checked MKL’s stock portfolio was a larger percentage of their equity than FFH’s… But now I will check again! ;)

 

I haven't looked at these companies in a while, but when I did FFH had assets to equity of something like 4.5 and MKL was at 3.5. Now they're closer. This leverage magnifies moves, hence hedging can sometimes be useful defensively if you don't want to delever.

 

Also, FFH tends to invest a good part of its equity in cigar butts, turnarounds, and other difficult situations. These are more fragile by definition if there's a big shock to the economy. Markel tends to prefer boring good quality businesses for its equity. That makes a difference.

 

Not saying one approach is better than the other, and I didn't mean to turn this into a thread about FFH and MKL.

 

My important points are those you didn't quote, about float and debt and what you can buy with each.

[giofranchi]

One last thing about the difference between debt and float, and then I will leave it at that: if we have a shock in the market, and the financial system gets into trouble, like it tends to happen with some regularity, banks in dire straits could change their requirements to extend credit... And usually they change requirements for the worse... Transfering the pressure on the debtors!

 

This is something float is immune from... On the contrary, a solid underwriter could take advantage of a dislocation in the market and get better terms for new contracts or the renewal of old ones...

 

Imo, a big difference!  ;)

 

Gio

[Liberty]

One last thing about the difference between debt and float, and then I will leave it at that: if we have a shock in the market, and the financial system gets into trouble, like it tends to happen with some regularity, banks in dire straits could change their requirements to extend credit... And usually they change requirements for the worse... Transfering the pressure on the debtors!

 

This is something float is immune from... On the contrary, a solid underwriter could take advantage of a dislocation in the market and get better terms for new contracts or the renewal of old ones...

 

Imo, a big difference!  ;)

 

Gio

 

Sure. And insurance is a cyclical commodity business with no barriers to entry and heavy regulation. I'm not saying insurance float is bad, just that it isn't the holy grail. It has good sides and bad sides. If it was this great in itself, more than just a handful of insurance companies in the whole industry would be doing great things with it.

 

And Valeant isn't exactly keeping its debt in a revolving line of credit at the whims of the bank. Long-dated bonds have predictable maturities and interest rates.

 

Valeant's CFO has also said that he thinks it's pretty much assured that Valeant will eventually be investment grade. That'll help its access to capital too, when/if that happens.

 

As for economic shocks, well, look at Allergan's revenues in 2008-2009. Merely flat (actually grew a little). And this is during the worst crisis in many generations. And allergan is a decent proxy for the kind of durable portfolio of assets that Valeant is building.

[giofranchi]

What do you mean? Are you going to buy a company that has 30bn of debt when we're 7 years into a bull market? ;)

 

You and original mungerville might think this is strange, but my idea is that today an investment in VRX is much safer than it was when VRX stock price was around $120…

 

Why?

 

Because now we have the evidence the market still likes VRX’s deal making very much, despite all the attacks VRX business model went through in 2014, and despite renowned investors like Grant and Chanos having publicly shorted the stock.

 

This evidence is important to me: never before in its history VRX business model had been put to the test like it was in 2014, and now we have at least some evidence VRX has passed that very demanding test with flying colors!

 

So, let’s put it this way: first I doubled my money in VRX, then I watched from the sidelines when I thought the picture was too hard for me to judge, now that, despite all the doubts raised, VRX seems able to proceed undisturbed, I have decided to invest again.

 

With caution, because its debt is very high indeed, but I want to be again a VRX’s shareholder.

 

Gio

 

[giofranchi]

And insurance is a cyclical commodity business with no barriers to entry and heavy regulation.

 

Again the fact insurance is a commodity business should be compared to the act of selling bonds in the market or going to the bank asking for a loan: which is the easiest thing anyone can do? To write profitable underwriting contracts, or to go to the bank asking for a loan? ;)

 

Gio

 

[giofranchi]

PROVENGE® (sipuleucel-T) Demonstrates Sustained Immune Response Two Years after Treatment in Biochemically-Recurrent Prostate Cancer

 

http://ir.valeant.com/investor-relations/news-releases/news-release-details/2015/PROVENGE-sipuleucel-T-Demonstrates-Sustained-Immune-Response-Two-Years-after-Treatment-in-Biochemically-Recurrent-Prostate-Cancer/default.aspx

 

 

Gio

[Liberty]

What do you mean? Are you going to buy a company that has 30bn of debt when we're 7 years into a bull market? ;)

 

You and original mungerville might think this is strange, but my idea is that today an investment in VRX is much safer than it was when VRX stock price was around $120…

 

Why?

 

Because now we have the evidence the market still likes VRX’s deal making very much, despite all the attacks VRX business model went through in 2014, and despite renowned investors like Grant and Chanos having publicly shorted the stock.

 

This evidence is important to me: never before in its history VRX business model had been put to the test like it was in 2014, and now we have at least some evidence VRX has passed that very demanding test with flying colors!

 

So, let’s put it this way: first I doubled my money in VRX, then I watched from the sidelines when I thought the picture was too hard for me to judge, now that, despite all the doubts raised VRX seems able to proceed undisturbed, I have decided to invest again.

 

With caution, because its debt is very high indeed, but I want to be again a VRX’s shareholder.

 

Gio

 

It definitely is more proven now, but I think it was proven enough before (but that's my determination, you can have your own).

 

But IMO it isn't $80-100 USD more proven compared to back when it was around 100-120 a few months ago (esp. since the USD was a lot lower compared to the CAD that I use and the Euro that you use, so it's actually another double+ in a few months for us).

 

Anyway, glad our little discussion made you reconsider. The ability to change one's mind is a good quality to have, and I've changed mine often reading things on this forum.

[original mungerville]

We are not the only ones concerned about the debt levels. Sequoia, their largest shareholder, who Pearson is attentive to, is as well. 6 months ago they stated debt levels then were at the high end of their comfort level. Today we have double the debt but potentially more earning power. Unless Sequoia has started selling their stake, this could be north of 25% of their fund at this point with double the debt levels (although earnings power has increased). It will be interesting to see if they start selling due to the position size and/or debt levels, or not.

 

From these price levels of the stock, I am proceeding with caution as well, but I think this is a very rare opportunity and we need to debate whether we are being silly or not focusing too much on the debt relative to the upside.

 

The LEAPS are something I have wondered about (limited downside, big upside) as a hedge against the debt levels. Even though these are extremely expensive, could they make sense now. We should discuss these as a potential way to go in big, even at these levels, while limiting our downside.

 

Any views?

[giofranchi]

The LEAPS are something I have wondered about (limited downside, big upside) as a hedge against the debt levels. Even though these are extremely expensive, could they make sense now. We should discuss these as a potential way to go in big, even at these levels, while limiting our downside.

 

Any views?

 

I wouldn't even know how to trade in LEAPS…

 

I will proceed as I have said: established a 2.5% position today, and will keep adding a 1% each month as that cash comes in, until I reach a large enough position to have a meaningful beneficial impact on my firm’s portfolio, if everything goes according to plans (20-25% annual increase in Cash EPS for the next 8-10 years); but not too large a position as to cause significant damage, if something wrong and unexpected happens.

 

I repeat: I am confident enough with such a strategy, because, despite the heavier debt load, I think VRX’s future today is much clearer than it was just some months ago (to me at least! ;)).

 

Gio

 

[Liberty]

We are not the only ones concerned about the debt levels. Sequoia, their largest shareholder, who Pearson is attentive to, is as well. 6 months ago they stated debt levels then were at the high end of their comfort level. Today we have double the debt but potentially more earning power. Unless Sequoia has started selling their stake, this could be north of 25% of their fund at this point with double the debt levels (although earnings power has increased). It will be interesting to see if they start selling due to the position size and/or debt levels, or not.

 

From these price levels of the stock, I am proceeding with caution as well, but I think this is a very rare opportunity and we need to debate whether we are being silly or not focusing too much on the debt relative to the upside.

 

The LEAPS are something I have wondered about (limited downside, big upside) as a hedge against the debt levels. Even though these are extremely expensive, could they make sense now. We should discuss these as a potential way to go in big, even at these levels, while limiting our downside.

 

Any views?

 

You seem to be looking at the debt in absolute numbers quite often. Why? The number 30bn is meaningless on its own.

 

The question that matters is: What did they get for this new 15bn of debt? If they got 15bn of value or more, then it's a wash or a gain.

 

If you think their forecasts and models are conservative (they've pretty much always over-delivered in the past and don't take into account known things like the tax rate), and you saw them say that they expect to be below 4x debt-to-EBITDA next year, then the real question becomes "is 3-point-something debt-to-EBITDA too high for Valeant?".

 

IMO <4x leverage is just fine for Valeant. What we're seeing now is a temporary spike, but just like you don't judge the market only at extremes, you shouldn't judge Valeant's debt load only at extremes. They went above 4x with B&L and then quickly delevered, and now they're doing it again.

[giofranchi]

IMO <4x leverage is just fine for Valeant. What we're seeing now is a temporary spike, but just like you don't judge the market only at extremes, you shouldn't judge Valeant's debt load only at extremes. They went above 4x with B&L and then quickly delevered, and now they're doing it again.

 

Yes, of course! This is the scenario “everything goes according to plans”! ;)

 

Gio

 

[Liberty]

IMO <4x leverage is just fine for Valeant. What we're seeing now is a temporary spike, but just like you don't judge the market only at extremes, you shouldn't judge Valeant's debt load only at extremes. They went above 4x with B&L and then quickly delevered, and now they're doing it again.

 

Yes, of course! This is the scenario “everything goes according to plans”! ;)

 

Gio

 

Sure, but when the plan is conservative, with a large margin of safety, and something that has been done multiple times by the company before, I don't think it's crazy to use the plan as a base case.

 

The whole point of spending months/years studying a company, digging up every insight possible about management and the assets, etc, is to get to a point where you either trust or don't trust management and the business (and if you don't, you don't invest!). When Prem says something, you tend to trust him because you've build up that trust over time. It's not just blind trust, right? To me, it's not crazy to trust Pearson at this point (trust but verify, of course).

 

Salix appears to be going through a one-time, solvable problem. A salad oil scandal, if you will. The only reason the debt looks this high is because Salix EBITDA is depressed temporarily, but if it wasn't the case, they couldn't buy the company at this price. Maybe there are more problems, but I still trust VRX to make the best of the situation if that happens. I guess we'll find out over the next year or two how it works out.

[original mungerville]

We are not the only ones concerned about the debt levels. Sequoia, their largest shareholder, who Pearson is attentive to, is as well. 6 months ago they stated debt levels then were at the high end of their comfort level. Today we have double the debt but potentially more earning power. Unless Sequoia has started selling their stake, this could be north of 25% of their fund at this point with double the debt levels (although earnings power has increased). It will be interesting to see if they start selling due to the position size and/or debt levels, or not.

 

From these price levels of the stock, I am proceeding with caution as well, but I think this is a very rare opportunity and we need to debate whether we are being silly or not focusing too much on the debt relative to the upside.

 

The LEAPS are something I have wondered about (limited downside, big upside) as a hedge against the debt levels. Even though these are extremely expensive, could they make sense now. We should discuss these as a potential way to go in big, even at these levels, while limiting our downside.

 

Any views?

 

You seem to be looking at the debt in absolute numbers quite often. Why? The number 30bn is meaningless on its own.

 

The question that matters is: What did they get for this new 15bn of debt? If they got 15bn of value or more, then it's a wash or a gain.

 

If you think their forecasts and models are conservative (they've pretty much always over-delivered in the past and don't take into account known things like the tax rate), and you saw them say that they expect to be below 4x debt-to-EBITDA next year, then the real question becomes "is 3-point-something debt-to-EBITDA too high for Valeant?".

 

IMO <4x leverage is just fine for Valeant. What we're seeing now is a temporary spike, but just like you don't judge the market only at extremes, you shouldn't judge Valeant's debt load only at extremes. They went above 4x with B&L and then quickly delevered, and now they're doing it again.

 

Liberty,

 

Read my statement - I state debt has doubled but acknowledge that earnings power has increased. I did not say my concern (or Sequoia's) re the debt will cause a change in my general long Valeant position. Of course its the relative amount of debt that matters, not the absolute number. But if things went bad with say this Salix acquisition, the stock would go down very significantly. Much more than if they issued equity to buy Salix - this we can agree on.

 

Now coming back to the important point I was making and making it even more explicit. We know short term options trade on volatility, etc. LEAPS to a lesser degree. However, theoretically, the more debt a company incurs, and I think we agree that Valeant is at a temporary maximum amount of debt here (certainly Sequoia would not let them take on more than this - I am sure of that) because I do expect, like you, for this to come down to under 4x (mainly because I just have full faith in Pearson) - anyway, the more debt a company incurs, the more volatility in its earnings potential (positive or negative) given the leverage.

 

Just based on this, given debt has just doubled and is at a temporary peak, I am trying to draw your and the board's attention to the idea that, especially at such temporary peaks, the LEAPs might make more sense than the stock (despite the LEAPs being damn expensive) - given the greater upside, and the capped downside.

 

What do you think?

[Liberty]

I don't know anything about options.

 

My comment wasn't just about your last one, but about many from you and others that I've seen about absolute numbers of debt. Rather than relative debt to earning power and the quality of what the debt has been exchanged for.

 

I'm happy they didn't issue equity. A business of this quality, showing such strong growth (organic and otherwise) and deleveraging quickly, shouldn't issue equity when it's trading as such low multiples.

 

If the stock price goes down for any period of time because of some hiccup, they'll probably do buybacks (something they've mentioned in the past year, but the price has risen a lot since), another way to create value.

 

What would worry me is deterioration in business fundamentals and/or management starting to do stupid things. I haven't seen that so far, so I'm happy to hold for the long-term.

[LC]

Just to add to the option discussion because on the surface it seems intriguing. This is going to be a really elementary post because I'm just walking myself through the thinking (sorry to dumb down the discussion here, folks!)

 

The rationale is that, like OM says, there is a temporary spike in debt. This makes the equity more volatile. As the debt is reduced, the equity should be worth more both because of reduced interest and volatility. However the downside is that if Salix or another material business unit performs poorly they will have difficulty reducing the debt.

 

So if we look at the January 2017 Leaps the pricing at various strikes are as such:

 

Strike - Price - Breakeven

$150 - $69 - $219

$180 - $52 - $222

$200 - $42 - $242

$220 - $33 - $253

$250 - $25 - $275

 

So just take the $200 strike option since it is closest to the current share price. To breakeven in 2 years you need the stock to rise 21% or about 10%/year.

 

2014 cash EPS was $8.34. Prior to the Salix announcement they were trading at $175 or 21x cash EPS. Let's say that multiple holds.

 

At our $242 breakeven they need to generate $11.50 of cash EPS.

 

They guide to $2.30 in cash EPS for Q12015, or $9.20 annualized (will most likely be higher, but let's take it conservatively). They also guide that Salix will increase cash EPS by 20% in 2016, which comes to $11.04 cash EPS in 2016. At our 21x multiple that is ~$230/share. Obviously tons and tons of assumptions in this but just to frame the issue. Perhaps if you want to use call options, you want to buy options with a breakeven under $230/share?

 

[original mungerville]

LC,

 

Post makes sense, however last paragraph is a little too conservative.

 

This thing can grow owner earnings at 25-30% a year. He was projecting $12 per share for 2016, however he said with the strong growth, that would be higher. So call that $13, THEN add 20% for Salix, so I am getting more like mid 15s will be Valeant's upcoming updated guidance for 2016. (These are not GAAP earnings though).

 

 

[giofranchi]

IMO <4x leverage is just fine for Valeant. What we're seeing now is a temporary spike, but just like you don't judge the market only at extremes, you shouldn't judge Valeant's debt load only at extremes. They went above 4x with B&L and then quickly delevered, and now they're doing it again.

 

Yes, of course! This is the scenario “everything goes according to plans”! ;)

 

Gio

 

Sure, but when the plan is conservative, with a large margin of safety, and something that has been done multiple times by the company before, I don't think it's crazy to use the plan as a base case.

 

The whole point of spending months/years studying a company, digging up every insight possible about management and the assets, etc, is to get to a point where you either trust or don't trust management and the business (and if you don't, you don't invest!). When Prem says something, you tend to trust him because you've build up that trust over time. It's not just blind trust, right? To me, it's not crazy to trust Pearson at this point (trust but verify, of course).

 

Salix appears to be going through a one-time, solvable problem. A salad oil scandal, if you will. The only reason the debt looks this high is because Salix EBITDA is depressed temporarily, but if it wasn't the case, they couldn't buy the company at this price. Maybe there are more problems, but I still trust VRX to make the best of the situation if that happens. I guess we'll find out over the next year or two how it works out.

 

Liberty,

Basically I agree with you.

But, as I have always said, I look both for a great entrepreneur and for a business model I like and I am comfortable with.

 

Just like you are probably more comfortable with the VRX business model, I am on the other hand more comfortable with the FFH business model...

 

But I think I am fine with that, because the "base case" for VRX is an annual growth of Cash EPS in between 25% and 30%... Therefore, I don't have to invest large sums of capital to make VRX very meaningful for my firm's portfolio overall results: VRX's growth alone will guarantee very good returns ;)

 

Cheers,

 

Gio

[original mungerville]

I don't know anything about options.

 

My comment wasn't just about your last one, but about many from you and others that I've seen about absolute numbers of debt. Rather than relative debt to earning power and the quality of what the debt has been exchanged for.

 

I'm happy they didn't issue equity. A business of this quality, showing such strong growth (organic and otherwise) and deleveraging quickly, shouldn't issue equity when it's trading as such low multiples.

 

If the stock price goes down for any period of time because of some hiccup, they'll probably do buybacks (something they've mentioned in the past year, but the price has risen a lot since), another way to create value.

 

What would worry me is deterioration in business fundamentals and/or management starting to do stupid things. I haven't seen that so far, so I'm happy to hold for the long-term.

 

Well, I apologize if I don't like the debt - it sure did not help Fairfax 10 years ago, I can tell you that. Sequoia doesn't seem to necessarily like all the debt either. Would I rather they issue equity or debt at that price, I don't know, good question. If all goes well, certainly their P/E will rise further as will the E, so the stock price should do very very well over the next 2 years. This is why the LEAPS are interesting, but you don't know anything about options and don't mind the debt because everything will work out perfectly. Do you think you will be able to see deterioration in the fundamentals before Wall Street?

[giofranchi]

Well, I apologize if I don't like the debt - it sure did not help Fairfax 10 years ago, I can tell you that.

 

This comparison with FFH continues to be misplaced imo.

 

The danger with VRX’s debt is if a large acquisition doesn’t ultimately work as expected, because then interests on its debt remain, while the expected earnings don’t materialize…

 

FFH’s problems, instead, could be caused by underwriting losses, like it happened 10 years ago, and not by its portfolio of investments, the returns of which have never been negative since 2000 (with the only exception of 2013). Also today FFH’s portfolio of investments is very conservative, and I don’t think anyone is really worried about it being too risky… On the contrary: many have worries it is too conservative!

 

Instead, if FFH loses too much money on its insurance operations, it would be like paying an exorbitant interest on debt, and if debt is high, that could cause much damage. If FFH’s float costs 10% and it makes 7-9% on its portfolio of investments… Well, we are obviously in trouble… Just like it happened 10 years ago!

 

Imo this difference should be clear, because I don’t think the underwriting strength and capabilities of FFH today could be remotely compared to what they were 10 years ago… Being them so much improved, the risk tied to FFH’s large float is greatly diminished.

 

Gio

 

[giofranchi]

In other words, if we assume (not saying it is true! Only an assumption!) that FFH underwriting risk today is zero (meaning that from now on they will be able to underwrite profitably), just like many feel about BRK and MKL underwriting risk, I would say FFH might be as risky as VRX, if its whole portfolio of investments were in stocks plus wholly owned businesses, and if VRX weren't paying any interest on its debt.

 

Gio

 

[Happy]

I just want to point out the fact that at the current stock price their past offer to Allergan is already worth more than what Allergan got bought for and what VRX wasn't willing to overbid. And that is just a few months after the deal. In 3-5 years the numbers might look significantly worse for having issued equity. Obviously it's not Apples-to-Apples as they couldn't have bought Salix if the Allergan deal went through, but it does represent some kind of opportunity cost.

 

So I for one am glad that they paid with debt and no equity as long as it is still feasible which they do think it is and which they have shown to delever from in the past. With a business of this quality the cost of issuing equity can be very, very high over time.

Their approach is aggressive, but I think their business model can stand it. But that certainly is a judgment call.

[original mungerville]

Well, I apologize if I don't like the debt - it sure did not help Fairfax 10 years ago, I can tell you that.

 

This comparison with FFH continues to be misplaced imo.

 

The danger with VRX’s debt is if a large acquisition doesn’t ultimately work as expected, because then interests on its debt remain, while the expected earnings don’t materialize…

 

Gio

 

Gio, what happened to FFH 10 years ago is a large acquisition did not work out, while the other almost simultaneous large acquisition took a long time to work, and FFH used a lot of debt, and interest on that debt remained while expected earnings did not materialize.

 

So, its not misplaced! :)

[original mungerville]

Well, I apologize if I don't like the debt - it sure did not help Fairfax 10 years ago, I can tell you that.

Also today FFH’s portfolio of investments is very conservative, and I don’t think anyone is really worried about it being too risky… On the contrary: many have worries it is too conservative!

 

Imo this difference should be clear, because I don’t think the underwriting strength and capabilities of FFH today could be remotely compared to what they were 10 years ago… Being them so much improved, the risk tied to FFH’s large float is greatly diminished.

 

Gio

 

Gio, forget FFH today. I am talking about acquisitions made 15 years ago where FFH was still having trouble finishing the turnaround and regaining stability 10 years ago from these. Because those were done with debt and the interest remained - just like what could happen to VRX if something went wrong, although I do not expect this. It puts the company and stock in the toilet for many many years when this goes wrong.

[original mungerville]

I just want to point out the fact that at the current stock price their past offer to Allergan is already worth more than what Allergan got bought for and what VRX wasn't willing to overbid. And that is just a few months after the deal. In 3-5 years the numbers might look significantly worse for having issued equity. Obviously it's not Apples-to-Apples as they couldn't have bought Salix if the Allergan deal went through, but it does represent some kind of opportunity cost.

 

So I for one am glad that they paid with debt and no equity as long as it is still feasible which they do think it is and which they have shown to delever from in the past. With a business of this quality the cost of issuing equity can be very, very high over time.

Their approach is aggressive, but I think their business model can stand it. But that certainly is a judgment call.

 

I agree.

 

To all:

 

1. I am saying debt is probably at some sort of temporary peak (relative to current earnings) at this point;

 

2. Given this, if something doesn't work out, it will take quite some time to work off the debt; also given this, if things workout well, despite the recent run in the stock, I could see the stock run just as much over the next 2 years; what I don't see as likely is the stock staying within 10-20% of the current price - either above or below;

temporary peaks in leverage tend to have this effect; 

 

3. This is the scenario where LEAPS should generally be given consideration as for the same amount of downside, they can provide more upside than the stock. (Where LEAPS lose money relative to the stock is when the stock price stays in a trading range of say 20% for an extended period. This does not seem likely with VRX in my view).

 

 

 

[giofranchi]

Gio, forget FFH today. I am talking about acquisitions made 15 years ago where FFH was still having trouble finishing the turnaround and regaining stability 10 years ago from these. Because those were done with debt and the interest remained - just like what could happen to VRX if something went wrong, although I do not expect this. It puts the company and stock in the toilet for many many years when this goes wrong.

 

Ok… I get your point… I only wanted to make it clear there is a great difference between float and debt… Like you say, debt might have caused FFH lots of pain in the past, while float basically never did. ;)

 

Gio