VRX - Valeant Pharmaceuticals International Inc.

[giofranchi]

That's what I meant by "lite version". They pay more, don't cut as much, their tax rate isn't as low, etc. I guess that's less controversial. But still, are people not having trouble figuring out the performance of each of their acquisitions, figuring out the organic growth rate of everything (which they don't even break out most of the time), and untangling the accounting? Or are they not even trying because it's so much more fun to pile on Valeant?

 

Cannot tell…

As far as I am concerned, AGN reports results on a pro-forma basis (meaning the same assets compared to how they performed the year before), though maybe not every quarter… And that’s enough information.

AGN and PRGO are my way to concentrate on the pharma and biotech industry, while diversifying away from VRX a little… They are smaller positions.

 

Cheers,

 

Gio

 

[giofranchi]

(1) there are no ardent supporters of AGN to battle on this site

 

You keep insulting me!! ;D ;D ;D

 

Cheers,

 

Gio

[Liberty]

I suspect that it's because:

 

(1) there are no ardent supporters of AGN to battle on this site

 

(2) the people who aren't investing in VRX probably also are not invested in AGN

 

I'd be interested if someone who was invested in AGN but very much against VRX would self identify. That would be an interesting conversation.

 

You're probably right. That's a good way to segment it too...

[merkhet]

(1) there are no ardent supporters of AGN to battle on this site

 

You keep insulting me!! ;D ;D ;D

 

Cheers,

 

Gio

 

Yes, but they're already battling with you on one front. No need to open up another. :)

[rpadebet]

Now that the thread seems to have cooled down for the past 12-24 hours, I would like to ask the longs a question and risk reigniting the fire. This is a simple one, maybe it's already answered in one of these pages, but it's too painful to go through the posts again and separate emotion from fact.

 

So when VRX refers to 20% IRRs on acquisitions, do you think they refer to levered IRRs or unlevered IRRs?

 

I think this is important because, even I can probably do 20% levered irr (at least in my deal model!) on even 10y treasuries with 0% organic growth in coupons, if I can borrow enough and borrow @ cheaper than the yield.

 

[giofranchi]

So when VRX refers to 20% IRRs on acquisitions, do you think they refer to levered IRRs or unlevered IRRs?

 

This is what I think they mean:

 

Through:

1) Not overpaying

2) Cutting unnecessary costs

3) Synergies

4) A more efficient sales force

5) Fiscal advantages

6) Satisfactory future developments

They aim at buying businesses the results of which could be compared to bonds that yield 20% annually on the purchase price + all restructuring charges, before any interest payment.

This way they are going to receive cash that after 5/6 years will have covered the purchase price + all restructuring charges.

 

Then with that cash they must of course pay interests on their debt.

 

By the way, as I think I have shown, the cash their businesses have produced since 2008 almost exactly matches my interpretation. ;)

 

How long is the duration of those bond-like 20% yields?... Of course it depends on both a) the durability of the products sold (how many of them are subject to patent expiration and when, how much competition there is in the market for those products that are not subject to patent expiration), and b) how satisfactory future developments can be.

a) That’s why VRX looks for products that generally are not subject to patent expiration (or if so, that might expire as far in the future as possible… basically buying products that have just been approved, or are about to be approved), and VRX concentrates on very specific areas (like dermatology or eye care) in which it becomes the n.1 player very soon, this way having a strong hand to keep competition at bay. b) That's also why VRX actually invests in R&D and keeps improving its products.

 

Cheers,

 

Gio

 

[giofranchi]

By the way, I am not saying they will succeed in getting that kind of returns… Until now I don’t think there is evidence enough either they will be successful or they will fail.

 

All we know until now is the following:

 

CFFO 2009-2015: $6 billion

CFFI (sale of a business) 2009-2015: $1.4 billion

Interests paid 2010-2015: $3.4 billion

Total cash generated since 2008: $6 + $1.4 + $3.4 = $11 billion, which is roughly the cash they claim they have generated

 

Purchase price 2008-2015 (cumulative): $35.7 billion

Restructuring charges 2010-2015 (cumulative): $1.8 billion

Total capital deployed since 2008: $35.7 + $1.8 = $37.5 billion, which is roughly the capital they claim they have deployed

 

Can we infer from this either they will be successful or they won’t in achieving their goal of 20% IRRs? I don’t see how.

 

One thing I agree with AZ_Value is a 20% IRR is a very ambitious goal and one that usually is out of reach. To achieve that goal imo there must be something extremely inefficient in an industry. Remember: they are not playing the inefficiencies of the stock market… When you buy a whole business, I agree with AZ_Value that those inefficiencies tend to disappear… Instead, they are playing the inefficiencies of the pharma industry. When you take away a poor management from a wonderful business, you could achieve great results. How much inefficient is the pharma industry today?... I suspect a lot! But I truly cannot tell... therefore, I cannot say if VRX will be successful in achieving their goal.

 

Cheers,

 

Gio

 

[rpadebet]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

[jay21]

AZ - based on your modelling what type of IRRs are the public markets expecting from VRX's acquisition targets as standalone public companies? If they are publicly traded then you know the price. If you use your model, what type of IRRs or cash flow streams are to be expected?

 

Hopefully, that was clear. Thanks.

 

Anyone have any thoughts?

[giofranchi]

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

Well, 1), 2), and 3) are ways they have perfected to take advantage of what I have called the inefficiencies of the pharma industry.

They could be viewed imo as a one-time gain. Think of it as a stock that trades for half its IV and reaches IV in a relatively short period of time.

But then you shouldn’t forget:

a) The pharma and biotech business is among the best out there, and imo it will only grow and get better over time.

b) What Ackman refers to as “platform value”, which is nothing but their ability to go on making new deals, taking advantages of the inefficiencies of the pharma industry, and growing the newly acquired businesses.

Think of a) and b) this way: after reaching IV, the business goes on growing and creating value.

Now compute the present value of $45 billion in equity that grow at a CAGR of 15% (except, of course, that no one knows how long this could go on…).

 

Cheers,

 

Gio

 

[Bagehot]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

[rpadebet]

That is right Gio. Essentially what you are saying is inefficiency reduction doubles the value of the investment once VRX is the operator. Beyond that the value increase comes from revenue growth which translates to earnings growth.

 

In high margin businesses, like pharma, it is difficult and sometimes mathematically impossible to grow earnings sustainably  by "cutting fat" or margin expansion. think MSFT with their 80% margins. We know there is fat, but you can't grow earnings beyond a cumulative 25% even if you basically shutdown the campus. So saying VRX can instantly do 2x earnings from cost cutting is very very optimistic.

 

In low margin businesses, like retail, you can grow earnings through margin expansion. BABA/AMZN etc if they improve their margin by 1-2% can basically double their earnings.

 

In high margin businesses the sustainable earnings growth driver is almost always Revenue growth. It is better for MSFT to focus on revenue growth (while maintaining the margins) than focus on margin improvement. Similarly, for VRX too revenue growth is critical.

 

In your analysis you have said 15% earnings growth going forward should be assumed to justify the price today after the fat has been cut. Keeping constant margins (the margins after cost cutting), this translates to 15% revenue growth as well at the enterprise level. That is why organic growth is important. Do you think they can get or are getting 15% organic growth at the asset/enterprise level? From their slides if I revenue weight their growth, it doesn't seem to be the case. They seem to be doing the more normal 5%-10% revenue growth.

 

Please keep going through with this analysis. I think you and I are getting somewhere here  ;)

[Bagehot]

AZ - based on your modelling what type of IRRs are the public markets expecting from VRX's acquisition targets as standalone public companies? If they are publicly traded then you know the price. If you use your model, what type of IRRs or cash flow streams are to be expected?

 

Hopefully, that was clear. Thanks.

 

Anyone have any thoughts?

 

Works well for the mortgage servicers!

[rpadebet]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Bagehot,

I think I answered your question when I answered Gio above. You can double triple or quadruple earnings at low margin businesses like retail if you can find a way to expand margins. Take MSFT pre-Nokia and try this out and see how much earnings growth you get.

 

It is very important to understand earnings growth drivers in high margin vs low margin businesses. Cost cutting is very popular in Retail land and revenue growth is very popular in software and pharma for a reason.

[rpadebet]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Bagehot,

I think I answered your question when I answered Gio above. You can double triple or quadruple earnings at low margin businesses like retail if you can find a way to expand margins. Take MSFT pre-Nokia and try this out and see how much earnings growth you get.

 

It is very important to understand earnings growth drivers in high margin vs low margin businesses. Cost cutting is very popular in Retail land and revenue growth is very popular in software and pharma for a reason.

 

Btw on an unrelated note, MSFT's acquisition of Nokia was such a bad deal because, even though Ballmer got his revenue growth by doing it, he sacrificed margin to get there. If he had got that revenue growth at legacy MSFT margins, then he would have been termed "God" as it is incredibly difficult! This is also why they say when companies add value only when they grow within their moat where they usually have a margin or revenue growth advantage. Once they venture outside, they give up those advantages.

[jay21]

You are missing his point bout earnings growth from taxes. They are doubling the EBIT of the company through synergies and then getting a better tax rate.

 

Unlevered Company pre VRX:

 

Revenue: 100

EBIT: 25

Taxes at 40%:10

Earnings: 15

 

Unlevered Company post VRX:

 

Revenue: 100

EBIT: 50

Taxes at 10%:5

Earnings: 45

 

A triple in earnings on a double in EBIT. unlevered.

 

[Ross812]

Gio and rpadebet,

 

I took these numbers from AZ's spreadsheet:

 

http://3.bp.blogspot.com/-8FPz1xTTuVA/Vd0CIM1PqHI/AAAAAAAAAPA/aRqd3ZaPqa8/s640/2014%2BCash%2BPayback%2BTable%2B2.JPG

 

Here is what I came up with by subtracting yearly restructuring costs out of cash generated and instead adding it to the purchase price. I was conservative when calculating IRR since the deal close and assumed all deals closed in Q4 of the year they reported on the spreadsheet:

 

 

 

[Bagehot]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Bagehot,

I think I answered your question when I answered Gio above. You can double triple or quadruple earnings at low margin businesses like retail if you can find a way to expand margins. Take MSFT pre-Nokia and try this out and see how much earnings growth you get.

 

It is very important to understand earnings growth drivers in high margin vs low margin businesses. Cost cutting is very popular in Retail land and revenue growth is very popular in software and pharma for a reason.

 

Actually I kinda cheated and picked a real VRX acquisition (Bausch & Lomb) as my example, they had <20% EBIT margins when they were acquired (~$600M on ~$3.3B of sales). VRX took out $900M of costs bringing the margins to ~45%, and are in the process of launching the new Ultra contact lens, for which they have ordered 6 lines at an estimated $150M of sales per line. Layering that incremental revenue in, not to mention the revenue growth since Bausch has been acquired, I think comfortably brings you to somewhere in the 50s from an operating margin perspective.

[Bagehot]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Bagehot,

I think I answered your question when I answered Gio above. You can double triple or quadruple earnings at low margin businesses like retail if you can find a way to expand margins. Take MSFT pre-Nokia and try this out and see how much earnings growth you get.

 

It is very important to understand earnings growth drivers in high margin vs low margin businesses. Cost cutting is very popular in Retail land and revenue growth is very popular in software and pharma for a reason.

 

Btw on an unrelated note, MSFT's acquisition of Nokia was such a bad deal because, even though Ballmer got his revenue growth by doing it, he sacrificed margin to get there. If he had got that revenue growth at legacy MSFT margins, then he would have been termed "God" as it is incredibly difficult! This is also why they say when companies add value only when they grow within their moat where they usually have a margin or revenue growth advantage. Once they venture outside, they give up those advantages.

 

Margin dilution from an acquired business does not matter at all. What matters is what you pay to acquire the business and the free cash flow the business generates under your ownership from now til kingdom come. If Mastercard acquired some industrial conglomerate that cut their reported operating margin in half, but they paid 5x EBIT for the business, were fully paid back in 3 years, and the conglomerate's earnings power was 2x and growing in year 3, MA's intrinsic value will be higher, not lower, even though their reported operating margin would be half of what it had been.

[Guest Schwab711]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Why did VRX book $3.75b in DTLs from the Salix txn if there is tax synergies? I also don't like that they write-up intangibles/IPR&D just to amortize it so they can claim their tax rate is lower when in reality they are paying higher cash taxes and will be for decades.

[giofranchi]

In high margin businesses, like pharma, it is difficult and sometimes mathematically impossible to grow earnings sustainably  by "cutting fat" or margin expansion. think MSFT with their 80% margins. We know there is fat, but you can't grow earnings beyond a cumulative 25% even if you basically shutdown the campus. So saying VRX can instantly do 2x earnings from cost cutting is very very optimistic.

 

Well, not so in pharma! All this (or a lot!) is based on wasteful R&D… Which is a huge cost that could be better managed!

Furthermore, they don’t only cut costs, but also improve sales, and exploit synergies, and lower their fiscal burden.

I repeat: I don’t know how much inefficient the pharma industry actually is… Therefore, it is very difficult for me to quantify that “one-time gain”, but I wouldn’t be surprised if lots a businesses in the pharma industry could do much better with the right management!

 

Revenue growth: I don’t think they will have to grow organically at 15% to compound value at 15%, because they will go on making deals and taking advantage of inefficiencies. Therefore, what I have called a “one-time gain” will be possibly repeated many times in the future adding to their organic growth.

 

Cheers,

 

Gio 

 

[giofranchi]

Gio and rpadebet,

 

I took these numbers from AZ's spreadsheet:

 

http://3.bp.blogspot.com/-8FPz1xTTuVA/Vd0CIM1PqHI/AAAAAAAAAPA/aRqd3ZaPqa8/s640/2014%2BCash%2BPayback%2BTable%2B2.JPG

 

Here is what I came up with by subtracting yearly restructuring costs out of cash generated and instead adding it to the purchase price. I was conservative when calculating IRR since the deal close and assumed all deals closed in Q4 of the year they reported on the spreadsheet:

 

 

Ross,

Sorry I don’t understand: have you added interest payments back? Have you considered the cash from the sale of the portfolio of aesthetic drugs in 2014?

 

Thank you,

 

Gio

 

[Guest Schwab711]

1) VRX has a net debt/EBITDA ratio of 7x while their peers are between -1 and 1.

 

2) They have refinancing risk annually between 2018 through 2023

 

3) They clearly spent >$5b on R&D this year. I get the whole idea of cutting R&D, but they still spend billions annually (on average) on R&D and Salix should increase future R&D somewhat substantially considering they still have 9/22 drugs unapproved.

[Bagehot]

Gio,

Let us ignore the 20% IRR for the moment as it is difficult to prove one way or another.Your cash generated numbers also indicate that they have earned back roughly only 30% of the capital in 6 years. This to me appears low if they are getting 20% IRR unlevered. But then most of the big capital was deployed recently so it could still work out.

 

I have a far simpler follow up question:

So if VRX has deployed 37.5b capital in total the last 6-7 years, why should their total assets be worth much more than that? Do you agree that most of the capital deployed is deployed recently?

 

VRX does 3 things once they acquire

1) Reduce R&D,duplicate corporate overhead and other expenses

2) Reduce tax expense because of their lower tax rate

3) Hope to gain revenue synergies by deploying the products through their global distribution platform

 

You can yourself compute how much each of these add to pre-acquisition earnings. But assuming they double the pre-acquisition earnings and assuming the pre-acquisition multiple and post-acquisition multiple of earnings is same, the businesses are at best worth 2x the purchase price in VRX hands than in legacy management hands.

 

So, the Total Asset Value cannot be far greater than 2*37.5 = 75b. (This is optimistic because majority of this capital has been deployed recently and as we know it takes time to create value. I have assumed an instant double)

 

Taking out the 30b debt from that capital gives an equity value of 45b. Which translates to 130$ share price.

 

If current price of 230$ is fair, then you are actually saying that the assets in VRX hands are worth 3X what they paid just a few years ago. Can you reconcile that huge jump in Asset Value just because of change in operators?

 

As you know even BRK trades between 1.2x and 1.5x book value and their assets have been on the books for longer. If you take asset value then multiple is far lower for BRK.

 

Your assumption of doubling earnings power isn't right. Here's a toy example to show why. Target has $100 of revenue, $20 of EBIT, no debt, and a 40% tax rate. VRX buys them with internally generated FCF (ie not levered), gets no revenue synergies, cuts costs in-line with base VRX EBITA margins (so ~55%) and Target now pays a 5% tax rate. What is the increase in earnings power? Well, it goes from $12.00 to $52.25, or 4.4x before considering any use of leverage to further juice equity returns. The tax synergies are the real "force multiplier," especially for US domiciled acqs like Salix.

 

Why did VRX book $3.75b in DTLs from the Salix txn if there is tax synergies? I also don't like that they write-up intangibles/IPR&D just to amortize it so they can claim their tax rate is lower when in reality they are paying higher cash taxes and will be for decades.

 

Not sure I follow? GAAP requires them to write up the intangibles and IPR&D, it isn't like management has any choice in the matter, and GAAP accounting has zero impact on tax accounting. A deferred tax liability means your current GAAP income is higher than your tax income, so VRX booking a $3.75B DTL would actually be the opposite of what you are arguing, it means that they are actually paying lower cash taxes than book taxes today.

[giofranchi]

Actually I kinda cheated and picked a real VRX acquisition (Bausch & Lomb) as my example, they had <20% EBIT margins when they were acquired (~$600M on ~$3.3B of sales). VRX took out $900M of costs bringing the margins to ~45%, and are in the process of launching the new Ultra contact lens, for which they have ordered 6 lines at an estimated $150M of sales per line. Layering that incremental revenue in, not to mention the revenue growth since Bausch has been acquired, I think comfortably brings you to somewhere in the 50s from an operating margin perspective.

 

Yeah! That is a very useful example! Thanks!

 

Cheers,

 

Gio