VRX - Valeant Pharmaceuticals International Inc.

[Liberty]

I agree with all of Liberty's comments.

 

Even if "organic growth was suspect", my point has been that there is nothing magic about setting the threshold at 0 growth. Like Valeant is a failure if organic growth is negative, or Valeant is likely a success if organic growth is positive. That's how many organizations think, certainly those who have historically invested heavily in R&D - they need to think that way to justify it. So for the bears, hopefully that has not infected your thinking. Rationally and at Valeant, its all about IRRs first and foremost. You can have great IRRs even with negative growth.

 

Having said that, it sure as hell looks like they do not have negative organic growth given results of the past 12 months! Their organic growth seems to have been very significant and well above almost everyone's expectations.

 

Organic growth can be misleading anyway. A few years ago, organic growth was much lower. Why? Part of the reason is they had big tail products rapidly losing revenue, so it masked the growth in other parts of the business.

 

But like all shrinking problems, these tails products are now much smaller, so the organic growth of the rest is showing through.

 

As long as they paid low-enough prices for these tail products, they are creating value even while shrinking. That's all that matters.

 

Pearson has been clear on this: The reason why they can buy these tail products cheaply and make money on them is because most other pharmas don't want them anymore because they make the numbers look bad for Wall Street.

[KCLarkin]

You can have great IRRs even with negative growth.

 

True, but then you are on a treadmill. You need to keep doing acquisitions just to maintain earnings. And if you have to make acquisitions, it is harder to be patient for acquisitions with good IRR. Combine this with debt and you are playing a dangerous game.

[rpadebet]

You can borrow all day long as long as you have lenders who will lend with zero organic growth. the risk here is refinancing. will they be as incentivized to re-lend when the broader market is in the crapper?

 

If your bet is that they will pay off all the debt by then and wouldn't need much refinancing, then you know what you are betting on.

 

If they did Allergan, it would have been just great. The size, the durability of Botox etc were very enticing. But they didnt get it for a reason...don't you think? Big acquisitions are hard. there is some market efficiency there at that size. Even Salix, they were not able to buy at the price they wanted, ENDP was there and helped bump up the eventual price paid. VRX will counter they will just cut more.... remains to be seen.

 

 

I think AZ_Value was getting at that when he said long investors needs to understand the risks they are taking...

 

1. You are betting on many many tuck ins at good prices

or

2. you are betting on a big acquisition in a distress sale and hoping to pay better than others but less than what gets you 25%

or

3. you are betting on organic growth bailing you out (delevering) until the refinancing risk is reduced

 

Its just not only fraud you should be worried about....

there are many other things that can go wrong at these valuations even if this isn't a fraud.

 

Gio is right, the correct price for fraud is zero. but if it is not a fraud, the fair price needs to be adjusted for the risks being taken.

 

This stock is a hedge fund motel now, everybody and their brother and sister are in on it. Can you tell me, with all the publicity they have got recently with Ackman and Allergan and female viagra, there is no fluff in the current valuation?

 

[Liberty]

If the discussion is shifting to "are there risks", then yes, of course. Find me a business where there aren't.

 

But the fact is, they are growing well, their new products are getting traction, they are over-delivering on promised synergies, and they are deploying a lot of capital. So in a scenario where you reverse all these things, then of course things would go badly. But that's not where we are.

 

This stock is a hedge fund motel now, everybody and their brother and sister are in on it. Can you tell me, with all the publicity they have got recently with Ackman and Allergan and female viagra, there is no fluff in the current valuation?

 

I value things based on what I think the business is worth, not on whether they are well known or not. Otherwise nobody here would've made money on Bank of America, AIG, WFC, Apple (some of the biggest businesses in the world), or any of the Malone companies, which also are hedge fund hotels.

 

What keeps VRX valuation low is not that it's obscure, it's that most people don't understand the model, they think it's just over-levered slash & burn, and because there is reputational risk for big money in investing in it (if you fail unconventionally, that's bad).

[original mungerville]

You can have great IRRs even with negative growth.

 

True, but then you are on a treadmill. You need to keep doing acquisitions just to maintain earnings. And if you have to make acquisitions, it is harder to be patient for acquisitions with good IRR. Combine this with debt and you are playing a dangerous game.

 

There is no need to "maintain earnings" if your IRRs already incorporated organic growth below the magic zero threshold. Its all about returns, its not about growth.

[original mungerville]

long investors need to understand the risks they are taking...

 

1. You are betting on many many tuck ins at good prices

or

2. you are betting on a big acquisition in a distress sale and hoping to pay better than others but less than what gets you 25%

or

3. you are betting on organic growth bailing you out (delevering) until the refinancing risk is reduced

 

1. Yes, I am betting that is possible. I think 3-5 tuck ins at $1-2 billion per year will be enough.

 

2. No, I am not betting on this - albeit I think the opportunity will come along at some point over the next 2-5 years (which will reduce my dependancy on the rate of annual tuck-ins required in #1 above).

 

3. No, not at all as explained several times. Having said that, they are reporting huge organic growth and surpassing my expectations significantly in 2014.

 

Why would you assume we have not already thought about these important issues/drivers of our investment?

 

 

[Guest Schwab711]

The fact is, there is not a single long that can prove or even estimate what the current IRR is. If it is reasonable to assume that 25% IRR is possible if acquisitions perform >= expectations at the time of the deals then they are likely underperforming that target at the moment. There are only 3 non-trivial acquisitions, Salix, Endo, and BOL (and maybe Medicis as a 4th). I have read through most of this thread and I haven't seen anyone attempt to estimate the amount of R&D costs slashed so far. This would seem pretty crucial to the long thesis to prove that current profits are not just due to R&D cost-cutting. Right now, the only profits I see are from the R&D cost reductions (and R&D cost cutting may be greater than profits).

 

As I pointed out in the BOL correction post, a large majority of revenue for VRX depends on patent protection. This revenue/profit loses value each year we move closer to the expiration date. To earn 20% returns, these expiring revenue streams need to earn ~6.2x their initial purchase price in the next 10 years (1.2^10). They are nowhere close to this pace according to their acquisition payoff slides.

 

Then, of course, I provided some proof that their presentations show that BOL is actually decreasing revenues even though they continually state they are up 8%-12%. This meets crickets.

 

Finally, I provided reasons for why Munger's model of 25% IRR is completely wrong. Cost cuts can only provide a one-time gain (like cigar butt stocks). This gain is spread over many years. You cannot continue to cut each year. This is unsustainable and the returns from cuts gradually decrease towards 0% annualized, no matter how large the cut is (are companies still earning "returns" from layoffs 10-20 years ago?). (change in costs)/(change in time), change in costs is flat and time is increasing.

 

The formula I provided is based on Buffett/Munger's work stating that returns will tend towards ROIC (adj for reinvestment rate) over any reasonably long period of time. This is basically the holy grail formula of value investing (you'll recognize the form from your textbooks discussing how ROE is calculated) for predicting expected returns, which indeed makes it nice. Further, you cannot just separate operating returns and taxes and calculate IRR separately. If you believe you can, please show your work. For many reasons, you cannot separate them as you did without creating a very complicated formula. If you use the formula I provided, you'll see that Pearson/VRX either has to be an oracle with regards to market-timing (which they are not) or they will have to acquire businesses that average ~20% ROIC and 100% reinvestment of those earnings (or some other valid combination).

 

As an example of why Munger's #3 on taxes doesn't make sense. We could extrapolate that logic to assume that Bermuda insurers with business in the US earn >30% returns, which is obviously not the case.

 

Also, I do understand how they have low tax rates (which is why I mentioned them). As a side note, I find it frustrating that long's immediately discount work without any attempt to validate it. Any time you write more than a few sentences, you leave yourself open to nitpicking of details. Frankly, I don't think it is very productive considering I haven't posted any inaccuracies thus far, even with immense scrutiny over each word I post. Back to the story... It does not change the fact that tax rates will ultimately trend towards the Canadian rate over time or they will have to grow their net debt to be large enough such that interest is ~2x-3x the tax rate. There are obviously consequences with maintaining such high levels of debt and supposedly these are fairly high-margin businesses so it would seem unlikely they'd ever reach that point. Using the formula I provided shows that having the tax rate increase over time, by definition, means you cannot capture the full benefit of the tax advantage (which is <10% IRR anyway since it's dependent on earnings actually existing). I also don't think the tax advantage is sustainable since many pharmas have already inverted or will in the near-future (unless congress signals lower corp taxes).

[jay21]

Schwab, theoretically I don't understand your point about cost cuts and how it relates to IRR. Cost cuts improve IRRs holding all else constant. We can debate the magnitude, but cuts improve IRRs.

 

And costs cuts can last indefinitely. If the industry operates with too many layers of bureaucracy and you cut one layer, you created sustainable margin improvement increasing your cash flows relative to the industry.

[rpadebet]

long investors need to understand the risks they are taking...

 

1. You are betting on many many tuck ins at good prices

or

2. you are betting on a big acquisition in a distress sale and hoping to pay better than others but less than what gets you 25%

or

3. you are betting on organic growth bailing you out (delevering) until the refinancing risk is reduced

 

1. Yes, I am betting that is possible. I think 3-5 tuck ins at $1-2 billion per year will be enough.

 

2. No, I am not betting on this - albeit I think the opportunity will come along at some point over the next 2-5 years (which will reduce my dependancy on the rate of annual tuck-ins required in #1 above).

 

3. No, not at all as explained several times. Having said that, they are reporting huge organic growth and surpassing my expectations significantly in 2014.

 

Why would you assume we have not already thought about these important issues/drivers of our investment?

 

I am not assuming you haven't "thought" through these...From your posts it is clear you are much smarter than that. Sorry if my post seemed condescending in that way.

 

I "thought" through these too when I was long...

 

But a continuing investment necessitates "thinking" through it continuously. The past is gone, what matters is the future.

3-5 tuck in @1-2b ,does that sound easy to you? They did Sprout for 1b. By the most optimistic accounts it is a call option with some downside legal risk. Does that sound like a confident investment or a bet? If they had better opportunities why go with this one?

 

And going with your own estimates of cash eps, they have to do more and more @same sizes or same @ bigger sizes. It gets progressively tougher. The current 20-25 EBIT/EV valuation means it is like a treadmill they are on, as someone already pointed out.

[rpadebet]

Yes Schwab, I agree with many things you said there, but don't understand the Cost cuts logic completely,

 

There are two types of costs: a) one time costs b)recurring costs

 

If you cut recurring costs like CEO of target company,HR of target company etc, then it doesn't impact IRR as the profit margin is maintained every year

 

If you cut one time costs like avoiding a necessary R&D expense or maintenance expense, then it could be a one time cut as next year that expense could come back. IRR is hurt then. I am assuming you were referring to such costs.

 

 

 

[Guest Schwab711]

Schwab, theoretically I don't understand your point about cost cuts and how it relates to IRR. Cost cuts improve IRRs holding all else constant. We can debate the magnitude, but cuts improve IRRs.

 

And costs cuts can last indefinitely. If the industry operates with too many layers of bureaucracy and you cut one layer, you created sustainable margin improvement increasing your cash flows relative to the industry.

 

Point 1, absolutely, I admit as much. However, they become infinitely small over time, in my opinion. I only intended to show that they are nowhere near 5% compounded, which was stated as fact. Just plug some numbers in over whatever time periods to see what a reasonable estimate is.

 

Cutting total costs 30% over 10 years => (1/.7)^(1/10)-1 = 3.6% compounded. Well below 5% and it seems extremely optimistic that they can cut total costs by 30% every 10 years and for every acquisition.

 

Cutting costs 10% over 5 year = > (1/.9)^(1/5)-1 = 2.1%

 

Now imagine if costs can only be cut once and you realize them over the life of the holding. No matter how big the original cost cut, the additional returns will eventually trend towards 0% (though it will appear as a large boost to profits early and then a plateau). Cost cuts are definitely important, but they are small cigar butts.

 

I can see an argument that some costs are continuous in the sense of opportunity costs, but those costs do not exist if you were to internally develop the product yourself (as other pharmas do). I admit this is somewhat of a poor explanation, but I don't think you can count continuous cost cuts just like I don't think the tax advantage can be calculated through simple subtraction. I'm definitely open to correction here.

[jay21]

Let me put some numbers to it to see if I can make sense of it. You pay 10 times earnings for a nongrowing stream of cash. A 10% IRR. Cost cuts improve the profile to double your earnings, now you are at a 20% IRR. Even though it's a "one time" cut you doubled the earning power of the business propelling a doubling in IRR.

 

You won't cut anything in the future but your IRR is now very high.

 

EDIT: to be more granular. $100 in revenue at a 10% margin = $10 in earnings at 10x multiple is $100 purchase price.

 

Double your margin to 20% = $20 in earnings on a $100 outlay = 20% IRR.

[rpadebet]

Schwab, theoretically I don't understand your point about cost cuts and how it relates to IRR. Cost cuts improve IRRs holding all else constant. We can debate the magnitude, but cuts improve IRRs.

 

And costs cuts can last indefinitely. If the industry operates with too many layers of bureaucracy and you cut one layer, you created sustainable margin improvement increasing your cash flows relative to the industry.

 

Point 1, absolutely, I admit as much. However, they become infinitely small over time, in my opinion. I only intended to show that they are nowhere near 5% compounded, which was stated as fact. Just plug some numbers in over whatever time periods to see what a reasonable estimate is.

 

Cutting total costs 30% over 10 years => (1/.7)^(1/10)-1 = 3.6% compounded. Well below 5% and it seems extremely optimistic that they can cut total costs by 30% every 10 years and for every acquisition.

 

Cutting costs 10% over 5 year = > (1/.9)^(1/5)-1 = 2.1%

 

Now imagine if costs can only be cut once and you realize them over the life of the holding. No matter how big the original cost cut, the additional returns will eventually trend towards 0% (though it will appear as a large boost to profits early and then a plateau). Cost cuts are definitely important, but they are small cigar butts.

 

I can see an argument that some costs are continuous in the sense of opportunity costs, but those costs do not exist if you were to internally develop the product yourself (as other pharmas do). I admit this is somewhat of a poor explanation, but I don't think you can count continuous cost cuts just like I don't think the tax advantage can be calculated through simple subtraction. I'm definitely open to correction here.

 

Schwab,

Do you agree CEO and middle management pay+duplicate departments etc can be cut as well? these have a sustainable impact on the profit margin year after year. The size depends on how bloated each acquired company is.

 

Rest I agree, one time costs and necessary recurring costs will have the effect you mentioned.

 

VRX does remove duplicate costs and part of the charm of any roll up is that. How much they squeeze from the rest is open to debate and only management can tell us that. I am also sure most of it is a judgement call as to what is necessary and what is not.

 

Cost cuts maybe the soundest way to show synergies in M&A deals, but the tax effects and revenue growth are necessary too at these prices.

[Guest Schwab711]

Schwab, theoretically I don't understand your point about cost cuts and how it relates to IRR. Cost cuts improve IRRs holding all else constant. We can debate the magnitude, but cuts improve IRRs.

 

And costs cuts can last indefinitely. If the industry operates with too many layers of bureaucracy and you cut one layer, you created sustainable margin improvement increasing your cash flows relative to the industry.

 

Point 1, absolutely, I admit as much. However, they become infinitely small over time, in my opinion. I only intended to show that they are nowhere near 5% compounded, which was stated as fact. Just plug some numbers in over whatever time periods to see what a reasonable estimate is.

 

Cutting total costs 30% over 10 years => (1/.7)^(1/10)-1 = 3.6% compounded. Well below 5% and it seems extremely optimistic that they can cut total costs by 30% every 10 years and for every acquisition.

 

Cutting costs 10% over 5 year = > (1/.9)^(1/5)-1 = 2.1%

 

Now imagine if costs can only be cut once and you realize them over the life of the holding. No matter how big the original cost cut, the additional returns will eventually trend towards 0% (though it will appear as a large boost to profits early and then a plateau). Cost cuts are definitely important, but they are small cigar butts.

 

I can see an argument that some costs are continuous in the sense of opportunity costs, but those costs do not exist if you were to internally develop the product yourself (as other pharmas do). I admit this is somewhat of a poor explanation, but I don't think you can count continuous cost cuts just like I don't think the tax advantage can be calculated through simple subtraction. I'm definitely open to correction here.

 

Schwab,

Do you agree CEO and middle management pay+duplicate departments etc can be cut as well? these have a sustainable impact on the profit margin year after year. The size depends on how bloated each acquired company is.

 

Rest I agree, one time costs and necessary recurring costs will have the effect you mentioned.

 

VRX does remove duplicate costs and part of the charm of any roll up is that. How much they squeeze from the rest is open to debate and only management can tell us that. I am also sure most of it is a judgement call as to what is necessary and what is not.

 

Cost cuts maybe the soundest way to show synergies in M&A deals, but the tax effects and revenue growth are necessary too at these prices.

 

I agree. This is where I'm a lot less confident. I would think there are a sufficient number of companies that could reap these benefits such that it would be built into the purchase price. This is why I didn't state it before, but I obviously cannot prove my belief either. I could see an argument made that VRX is better at identifying these things (with Pearson's' background) such that they will extract more sustained benefit from these types of cuts.

 

I think you are right Jay on the theory behind VRX. However, using VRX's actual acquisition multiples/growth is why I believe returns are much lower than 20% currently.

 

Also worth noting with BOL, VRX added their own eye-care businesses. So even though the generics were removed from BOL, the total revenue should have been relatively consistent. Expectations for revenue were $3.5b/yr at acquisition and BOL is already below that.

 

http://www.bloomberg.com/news/articles/2013-05-27/valeant-agrees-to-buy-bausch-lomb-for-4-5-billion-cash

[Liberty]

Since there's renewed interest, I thought I'd share some notes I took in my investing journal from a talk that Pearson recently gave (I think it was at a RBC event). As far as I know this wasn't linked from the site, but a kind soul sent me the recording.

 

Already guided top line organic growth around 10% in 2015 and 2016, but yesterday Mike Pearson said he could see a path to 10% organic growth to 2020.

 

"Reason I'm optimistic - this isn't guidance - if I look at our launch products, along with our acquisition of Salix, many of these products have 4-5, some have 10 year runs before you have to renew them (contact lenses)."

 

We have strong pipeline. 6-7 products with a billion-dollar potential. Not all of them will be approved or reach potential, but unlikely that none of them will.

 

New bio-true daily contact lenses production lines coming online, can produce about 150m/year per line.

 

B&L has "belief" meetings. Invite 50-60 ophthalmologists, make them wear contact lenses in the morning, tell them about how B&L is reinvesting in contact lenses, etc. In afternoon make doctors remove contact lenses and fill out survey. In every meeting so far, over 90% of doctors have said the lenses are the best by far they've seen.

 

B&L used to be known as company with best optics, but less comfort. Now trying to prove more comfortable. Even on just pilot line, getting great refit ratio (if someone goes back to get refit, they switch to us). Might go to DTC with B&L lenses.

 

Usually takes a dermatology product about 3 years from launch until it starts to slow down, so Jublia very exciting.

 

Derm business doing great. Obviously we won't always grow as fast as Q1, but it'll grow fast. Strong double digit growth for many years to come.

 

We're a very pragmatic company. We do yearly review of our portfolio, as well as when we acquire a company. We invite outside scientists - not consultants - along with management, they go through each project, how risky is it, what label will be like, what commercial opportunity will be. But only scientists are allowed to vote, not management ("I'm not a scientist, what do I know about science?"). And we don't do it with raised hands, do it through anonymous tech. Pipeline items get red, yellow, or green vote. Most yellow we continue. We also don't have a pre-determined budget for r&d pipeline. We add it all up and that's our budget, we don't manage to a percentage.

 

People look at our R&D and say, that's a small percentage. But remember, big portions of our business like OTC/branded generics don't require much R&D. We probably spend 7-8% on R&D when you adjust it. It's low for some, but not as low as some.

 

Only way to create value with acquisition is cash on cash return. Takes years to see if an acquisition is good, can't just focus on next year accretion. We're long-term, not a good company if you just want to own for short-term.

 

When we acquire, we model up revenue and cashflow for 10 years. Need IRR of 20% or more, cash payback of 6 years, etc. We track it every year. Others buy something and then throw away the book and never look at it again. We track everything forever.

 

We don't use bankers because they cost too much. We do it ourselves.

 

2008, my first year, we got CeraVe, we paid $3m. We also bought Dow, this is where Jublia and retinae micro came from. Dow we've paid back 6x cash on cash.

 

I think cash on cash over long term is how you should measure results, not earnings accretion next year.

 

Ex-acquisitions since 2008 we've averaged 8% organic growth.

 

We had two acquisitions fail. Thankfully they were small. One in Canada, paid 6m, did nothing for us, sold for 3m.

 

We insist that every business makes money. Every quarter. Businesses are supposed to make money, that's what we expect. Also expect them to grow. If it doesn't make money, we either exit that business, or fire the person running that business.

 

Quite honestly, in pharma, it's hard to lose money, considering the margins we have on these products.

 

We've divested 8-9 things since I joined. We stated publicly, everything is for sale. If people make us an offer that is higher than what we think it's worth, we'll take it.

There are countries in central europe where we won't exit, but we're not putting more capital in right now because they're not growing.

 

Outside the US, very little pricing that we're getting. About negative 1%. Only place you can rise prices is OTC, but that's tough too. Inside the US, we have 4-5 key business segments. Lots of contracts with managed care. In derm for example, contractually we get about 5%/year. Contact lenses, it's market based, but we're trying to gain market share right now so not much price. It's like an OTC.

 

When we buy new products, if we find they've been mispriced, we'll sometimes do a one-time price increase. For example with Marathon, they had a product that was way lower than competition. Didn't make sense. We raised priced, sales didn't go down. This creates shareholder value because if we paid 2x sale, in reality price was lower because they were leaving money on the table. Sometimes this happens because a product is too small for a big company, and they lose track of pricing.

We've been accused of raising price, but our organic growth is more volume-based than price-based, and will continue to be.

 

How can we make acquisitions and then increase the growth trajectory of products? One thing, we never reduce number of sales reps. Often we add. We think they're very important, especially in categories where relationship with patient-doctor is important.

 

B&L, honestly, was not a great team. We got rid of all the top management. They had about 90 reps running around the country. We now have 180. We got rid of about 1/3 of the original reps and hired better people. They didn't have any metrics, now they know exactly which rep has seen which doctor and when. Change the incentive compensation, used to be highly fixed, now based on results.

For derm, it's about scale. We have almost 500 reps in US, we know all the dermatologists. Next biggest salesforce has about 100.

 

Salix had 167 primary care salesforce for Xifaxan IBS-D. But to do primary care in US you need at least 600, so either you have zero, or you have at least 600. Our approach is we'll go after specialists, and then do DTC. We think this will be patient driven, because when you have IBS-D you know it.

 

How sustainable is the tax rate? We spend a lot of time to make sure we do this right, we're just following the law, not doing anything or risky. Recently we had a board of meeting, we invited external law firms to asses what we're doing. They all came back and said we're doing everything right, middle of the road. So why is our tax rate so much lower if we're middle of road? Because other companies don't work at it. We have people who work US-hours in Ireland, the IP is there and the supply chain is managed from there. You just have to work at it, most other companies don't do it for every product. Also we have a lot of debt, that debt is in the US, that shield income. We don't have inter-company debt, real debt, which is less iffy.

 

US and Japan are the outliers with tax codes, they don't have territorial tax. What will happen in my mind is eventually the US will go territorial. Either every country goes like US, or US changes. That would reduce our advantage by helping other companies, but it wouldn't raise our tax rate.

If we didn't have debt we couldn't shield interest, but even if every M&A in the world dried up, I would still have debt and buy back shares.

 

For finding new CFO we don't hire search firms. They cost a lot of money. Higher success rate hiring people ourselves. Through personal connections, someone you can really trust. We're not looking for the world's best accountant, tax person, or balance sheet treasurer. Howard was not the best of any of those. We're looking for a thought partner, we debated together, he often took opposite position. Looking for a good thinking, problem solver, intellectually get to the right answer.

 

With Medicis, only time we fired sales rep, the approach we took was to get the best reps, we didn't care from where they came, because both reps were overlapping. But this was mistake. Undervalued value of relationships with doctors (dermatologists are particularly loyal). Now keep sales reps.

We like the aesthetics market, but it all depends on price and availability. We won't overpay. If we never get back into it, we're fine too.

 

How will I cash out of my shares? Even when I leave I can't cash out, so I will spend time thinking about after I leave, succession. A few years ago, I'd probably have argued I didn't have any successor within the company. It's the board's decision. I'd argue now that I have at least two successors. One is Howard, who will be on the board, and Ari Kellen, who is a physician by training, but worked with me for 23 years at McKinsey. Really really smart. Better than me in a lot of ways. 2 internal candidates at this point. But this journey has a long way to go. I just signed a 5-year contract, so you're quite stuck with me.

 

What did we learn from Pershing partnership last year? I would never have thought that making false accusations like Allergan did would take hold. Learned that Wall Street, the way it's organized, makes a hostile deal hard to execute and leads you to overpay. They'll extract everything they can from you. It was so obvious to me last year that at $105 we were so undervalued, why didn't everyone rush in? Market not very efficient when you're in one of these types of things. Also learned that investors really don't like the perception that one investor (Ackman) had an advantage, even if it was legal, and it was legal. Final thing I learned, honestly, is that people will pay anything for what they believe is a strategic asset. For us nothing is strategic. Highly unlikely we'll do it again. I never say never, I do what's right for shareholders. Highly highly highly unlikely we'd ever do that again.

 

What we look for in M&A is things that fit our financial profile. Most other company find a strategic and

then try to make the numbers fit. That's how it worked when I worked at McKinsey. We look for 20% IRR cash on cash, 6-year payback at statutory tax-rate, durable assets, etc. First lens is always financial.

 

Hope you enjoyed, took me a while to type it all.

 

[Picasso]

Thanks for posting those notes Liberty.

[cubsfan]

Great notes, very helpful Liberty.

[original mungerville]

Let me put some numbers to it to see if I can make sense of it. You pay 10 times earnings for a nongrowing stream of cash. A 10% IRR. Cost cuts improve the profile to double your earnings, now you are at a 20% IRR. Even though it's a "one time" cut you doubled the earning power of the business propelling a doubling in IRR.

 

You won't cut anything in the future but your IRR is now very high.

 

EDIT: to be more granular. $100 in revenue at a 10% margin = $10 in earnings at 10x multiple is $100 purchase price.

 

Double your margin to 20% = $20 in earnings on a $100 outlay = 20% IRR.

 

Yes, that is right... but Schwabb thinks I said they will cost cut so as to produce an additional 5% IRR compounded every year on an acquisition which is just, well, not a conventional interpretation of what I said, bordering on insane.

[giofranchi]

The fact is, there is not a single long that can prove or even estimate what the current IRR is.

 

Well, then you are suggesting not to invest in a wonderful business, because you cannot prove what the current IRR is?

I guess that’s because of the overconfidence in your ability to prove anything about a business you have not founded, you don’t manage, and about which you have no insider information. In my experience we know much less about a business than we think we do. And this is the reason (one of the reasons at least) I always look for a great and reliable manager in the first place. I take results as he/she reports them to shareholders, simply because there is not much else I could do. Analysts who have never managed a business in their life fool themselves thinking they “can prove” anything about a company… because they read “the footnotes”… while other people don’t! After some months managing a true business, you’d understand how fallacious that idea actually is!

 

Cost cuts can only provide a one-time gain (like cigar butt stocks). This gain is spread over many years. You cannot continue to cut each year. This is unsustainable and the returns from cuts gradually decrease towards 0% annualized, no matter how large the cut is (are companies still earning "returns" from layoffs 10-20 years ago?). (change in costs)/(change in time), change in costs is flat and time is increasing.

 

Also this makes no sense in my experience. It is 10 years now that I own and manage a couple of businesses, and I can assure you that each year I find some new way to cut expenses more or to optimize some processes. And I think it will go on for a very long time!

 

As a side note, I find it frustrating that long's immediately discount work without any attempt to validate it. Any time you write more than a few sentences, you leave yourself open to nitpicking of details. Frankly, I don't think it is very productive considering I haven't posted any inaccuracies thus far, even with immense scrutiny over each word I post.

 

Ah! Once again this is fallacious! Simply because all the shorts are doing is finding some examples they think are suspicious and pointing at them as proof the whole Valeant must be a fraud… To spot something “suspicious” in a company that must provide lots of material to shareholders other than SEC filings, simply because for its business GAAP metrics are not all that relevant, is much easier than to prove the reconciliations between that added material and its SEC filings are correct… A job that without insider information imo is almost impossible to do! But whenever Valeant was asked to provide the evidence that those reconciliations were right, it did so very convincingly.

 

Cheers,

 

Gio

[giofranchi]

Great notes, very helpful Liberty.

 

+1! :)

 

Cheers,

 

Gio

[giofranchi]

We insist that every business makes money. Every quarter.

 

This is something I have come to realize recently, and which has changed my view about the businesses I am really interested in: there must be long term thinking, but I also want to see short term results. I was used to thinking quarterly results don’t matter… but I have changed my mind. Not because quarterly results matter per se, but because a focus on quarterly results (without compromising the long term prospects of the business, of course!) shows a sense of urgency that imo is very healthy.

 

Cheers,

 

Gio

 

[giofranchi]

Hope you enjoyed, took me a while to type it all.

 

Personally, I think Liberty is the most knowledgeable member of the COBF board about Valeant.

 

Cheers,

 

Gio

[Guest Schwab711]

Since there's renewed interest, I thought I'd share some notes I took in my investing journal from a talk that Pearson recently gave (I think it was at a RBC event). As far as I know this wasn't linked from the site, but a kind soul sent me the recording.

 

Already guided top line organic growth around 10% in 2015 and 2016, but yesterday Mike Pearson said he could see a path to 10% organic growth to 2020.

 

"Reason I'm optimistic - this isn't guidance - if I look at our launch products, along with our acquisition of Salix, many of these products have 4-5, some have 10 year runs before you have to renew them (contact lenses)."

 

We have strong pipeline. 6-7 products with a billion-dollar potential. Not all of them will be approved or reach potential, but unlikely that none of them will.

 

New bio-true daily contact lenses production lines coming online, can produce about 150m/year per line.

 

B&L has "belief" meetings. Invite 50-60 ophthalmologists, make them wear contact lenses in the morning, tell them about how B&L is reinvesting in contact lenses, etc. In afternoon make doctors remove contact lenses and fill out survey. In every meeting so far, over 90% of doctors have said the lenses are the best by far they've seen.

 

B&L used to be known as company with best optics, but less comfort. Now trying to prove more comfortable. Even on just pilot line, getting great refit ratio (if someone goes back to get refit, they switch to us). Might go to DTC with B&L lenses.

 

Usually takes a dermatology product about 3 years from launch until it starts to slow down, so Jublia very exciting.

 

Derm business doing great. Obviously we won't always grow as fast as Q1, but it'll grow fast. Strong double digit growth for many years to come.

 

We're a very pragmatic company. We do yearly review of our portfolio, as well as when we acquire a company. We invite outside scientists - not consultants - along with management, they go through each project, how risky is it, what label will be like, what commercial opportunity will be. But only scientists are allowed to vote, not management ("I'm not a scientist, what do I know about science?"). And we don't do it with raised hands, do it through anonymous tech. Pipeline items get red, yellow, or green vote. Most yellow we continue. We also don't have a pre-determined budget for r&d pipeline. We add it all up and that's our budget, we don't manage to a percentage.

 

People look at our R&D and say, that's a small percentage. But remember, big portions of our business like OTC/branded generics don't require much R&D. We probably spend 7-8% on R&D when you adjust it. It's low for some, but not as low as some.

 

Only way to create value with acquisition is cash on cash return. Takes years to see if an acquisition is good, can't just focus on next year accretion. We're long-term, not a good company if you just want to own for short-term.

 

When we acquire, we model up revenue and cashflow for 10 years. Need IRR of 20% or more, cash payback of 6 years, etc. We track it every year. Others buy something and then throw away the book and never look at it again. We track everything forever.

 

We don't use bankers because they cost too much. We do it ourselves.

 

2008, my first year, we got CeraVe, we paid $3m. We also bought Dow, this is where Jublia and retinae micro came from. Dow we've paid back 6x cash on cash.

 

I think cash on cash over long term is how you should measure results, not earnings accretion next year.

 

Ex-acquisitions since 2008 we've averaged 8% organic growth.

 

We had two acquisitions fail. Thankfully they were small. One in Canada, paid 6m, did nothing for us, sold for 3m.

 

We insist that every business makes money. Every quarter. Businesses are supposed to make money, that's what we expect. Also expect them to grow. If it doesn't make money, we either exit that business, or fire the person running that business.

 

Quite honestly, in pharma, it's hard to lose money, considering the margins we have on these products.

 

We've divested 8-9 things since I joined. We stated publicly, everything is for sale. If people make us an offer that is higher than what we think it's worth, we'll take it.

There are countries in central europe where we won't exit, but we're not putting more capital in right now because they're not growing.

 

Outside the US, very little pricing that we're getting. About negative 1%. Only place you can rise prices is OTC, but that's tough too. Inside the US, we have 4-5 key business segments. Lots of contracts with managed care. In derm for example, contractually we get about 5%/year. Contact lenses, it's market based, but we're trying to gain market share right now so not much price. It's like an OTC.

 

When we buy new products, if we find they've been mispriced, we'll sometimes do a one-time price increase. For example with Marathon, they had a product that was way lower than competition. Didn't make sense. We raised priced, sales didn't go down. This creates shareholder value because if we paid 2x sale, in reality price was lower because they were leaving money on the table. Sometimes this happens because a product is too small for a big company, and they lose track of pricing.

We've been accused of raising price, but our organic growth is more volume-based than price-based, and will continue to be.

 

How can we make acquisitions and then increase the growth trajectory of products? One thing, we never reduce number of sales reps. Often we add. We think they're very important, especially in categories where relationship with patient-doctor is important.

 

B&L, honestly, was not a great team. We got rid of all the top management. They had about 90 reps running around the country. We now have 180. We got rid of about 1/3 of the original reps and hired better people. They didn't have any metrics, now they know exactly which rep has seen which doctor and when. Change the incentive compensation, used to be highly fixed, now based on results.

For derm, it's about scale. We have almost 500 reps in US, we know all the dermatologists. Next biggest salesforce has about 100.

 

Salix had 167 primary care salesforce for Xifaxan IBS-D. But to do primary care in US you need at least 600, so either you have zero, or you have at least 600. Our approach is we'll go after specialists, and then do DTC. We think this will be patient driven, because when you have IBS-D you know it.

 

How sustainable is the tax rate? We spend a lot of time to make sure we do this right, we're just following the law, not doing anything or risky. Recently we had a board of meeting, we invited external law firms to asses what we're doing. They all came back and said we're doing everything right, middle of the road. So why is our tax rate so much lower if we're middle of road? Because other companies don't work at it. We have people who work US-hours in Ireland, the IP is there and the supply chain is managed from there. You just have to work at it, most other companies don't do it for every product. Also we have a lot of debt, that debt is in the US, that shield income. We don't have inter-company debt, real debt, which is less iffy.

 

US and Japan are the outliers with tax codes, they don't have territorial tax. What will happen in my mind is eventually the US will go territorial. Either every country goes like US, or US changes. That would reduce our advantage by helping other companies, but it wouldn't raise our tax rate.

If we didn't have debt we couldn't shield interest, but even if every M&A in the world dried up, I would still have debt and buy back shares.

 

For finding new CFO we don't hire search firms. They cost a lot of money. Higher success rate hiring people ourselves. Through personal connections, someone you can really trust. We're not looking for the world's best accountant, tax person, or balance sheet treasurer. Howard was not the best of any of those. We're looking for a thought partner, we debated together, he often took opposite position. Looking for a good thinking, problem solver, intellectually get to the right answer.

 

With Medicis, only time we fired sales rep, the approach we took was to get the best reps, we didn't care from where they came, because both reps were overlapping. But this was mistake. Undervalued value of relationships with doctors (dermatologists are particularly loyal). Now keep sales reps.

We like the aesthetics market, but it all depends on price and availability. We won't overpay. If we never get back into it, we're fine too.

 

How will I cash out of my shares? Even when I leave I can't cash out, so I will spend time thinking about after I leave, succession. A few years ago, I'd probably have argued I didn't have any successor within the company. It's the board's decision. I'd argue now that I have at least two successors. One is Howard, who will be on the board, and Ari Kellen, who is a physician by training, but worked with me for 23 years at McKinsey. Really really smart. Better than me in a lot of ways. 2 internal candidates at this point. But this journey has a long way to go. I just signed a 5-year contract, so you're quite stuck with me.

 

What did we learn from Pershing partnership last year? I would never have thought that making false accusations like Allergan did would take hold. Learned that Wall Street, the way it's organized, makes a hostile deal hard to execute and leads you to overpay. They'll extract everything they can from you. It was so obvious to me last year that at $105 we were so undervalued, why didn't everyone rush in? Market not very efficient when you're in one of these types of things. Also learned that investors really don't like the perception that one investor (Ackman) had an advantage, even if it was legal, and it was legal. Final thing I learned, honestly, is that people will pay anything for what they believe is a strategic asset. For us nothing is strategic. Highly unlikely we'll do it again. I never say never, I do what's right for shareholders. Highly highly highly unlikely we'd ever do that again.

 

What we look for in M&A is things that fit our financial profile. Most other company find a strategic and

then try to make the numbers fit. That's how it worked when I worked at McKinsey. We look for 20% IRR cash on cash, 6-year payback at statutory tax-rate, durable assets, etc. First lens is always financial.

 

Hope you enjoyed, took me a while to type it all.

 

Thanks Liberty! I'm sure this was a pain to write up, it was definitely worth the effort.

[Green King]

does anyone know that price of credit default swap for its Valeant debt ?

 

TIA

[original mungerville]

does anyone know that price of credit default swap for its Valeant debt ?

 

TIA

 

No, but bonds are not investment grade. Although there seems to be good demand for them - in recent past I believe they traded at better yields than their ratings would have indicated.