VRX - Valeant Pharmaceuticals International Inc.

[original mungerville]

My point is that you are fixated on GAAP profits.  I think that is a very weak short thesis.  Good luck.

 

GAAP profits are comparable. I find Pearson's metrics to be disingenuous, and i do not believe they accurately reflect the firm's economics (at least more than GAAP figures do). Moreover, it doesn't make sense to me as to why GAAP net income, or even GAAP operating income (that is, before interest) is so low, given the fact that Pearson is playing accounting games by essentially capitalizing R&D. Firms that capitalize R&D usually do so in order to inflate GAAP EPS; Valeant cannot even claim to be able to do that.

 

But hey, you are free to prove me wrong. Show me why that is a weak argument.

 

I am not short by the way, and that is not a short thesis. I have not done enough work on the company to be able to take a position either way; however the risk-reward just doesn't seem to be there for me.

 

Berkshire is another, Fairfax is a third, most successful platform companies would be other examples. It is probably fair to say dozens were frauds for every one that was not. Just like it is fair to say that dozens of investments earn average or near-average returns for every one that earns a tremendous amount.

 

I don't know anything about Fairfax, but a focus on adjusted EBITDA is a bit of a red flag for me. This is something that Buffett espouses as well.

 

I would not say Buffett focuses entirely on non-GAAP figures... he puts a lot of stock on GAAP figures as well. One has to judge which one is more suitable depending on the situation.

 

Now please can we get away from Berkshire/Liberty/Fairfax and get back to Valeant. Tell me why cash earnings/Pearson's adjusted EBITDA tracks the true economics of the business better than GAAP earnings/GAAP operating income. Do you even know why? Or are you just following Ackman / Pearson?

 

Why? When you fully acquire and capitalize the restructuring costs in your return analysis and then track net income going-forward excluding any of these acquisition/restructuring costs, its a legitimate way to look at the business decisions.

 

Fairfax effectively did this with large acquisitions of insurance companies below book value years ago. They bought these things at below book, then in the next 3 years had to restructure, etc and incur cost to get the operating costs down (this ensured GAAP profits were negative on those acquisitions in the first 3 years, rating agencies hated it and downgraded them, etc etc). Another way to look at the same situation was to say, hey, what if I just add all those restructuring costs to the purchase price and take them out of the income statement for those first 3 years? Well all of a sudden, they paid 0.8 plus restructuring charges (which BTW are tax deductible) - say 1.1 times book (of which a portion was tax-deductible) if we assume they lost 0.1 times book every year during the 3-year restructuring phase. So in this other way of looking at it, they paid only 1.1x book for a fully restructured, underwriting profit producing insurance company (in a tax-advantaged way I would add) - which is a pretty good deal at the end of the day.

 

But that shit doesn't show up in GAAP profits does it? Rating agencies don't look at it that way either. And great investment opportunities don't fall on our laps all the time either. This is just the way it is supposed to be.

 

 

 

[ccplz]

I've been short for the last month, so I'm happy  ;)

 

I thought you were short?  At any rate its good that you listed out your negative views so that we can see whether it makes sense or not.

 

Yes. I bought back last week.

 

My views are not very well researched so it was only a low conviction idea and a small position. Like i said i haven't had the time to do a lot of reading on Valeant, and it seems that to have a position one way or another in this company requires one to do a lot of reading, given their relative lack of transparency and multitude of moving parts.

 

When you fully acquire and capitalize the restructuring costs in your return analysis and then track net income going-forward excluding any of these acquisition/restructuring costs, its a legitimate way to look at the business decisions.

 

Sure. Restructuring costs can be non-recurring but is that the case with Valeant? A company that depends on making acquisitions for growth and then 'cutting the fat' in the newly acquired business. Does this sound like it is a non-recurring expense? It also makes up a relatively small proportion of Valeant's cost structure (200m out of 4 bn in total expenses). Even if we add 200m back to operating income, operating income would still only be around 1 bn... a multiple of 50-60 seems relatively high for a company like Valeant.

 

You still haven't answered my question yet. What exactly does Pearson's metric include/exclude and why is it accurate in tracking the true economics of the business?

 

Let's focus on the key issue here, and not get side tracked.

[Picasso]

ccplz, EBITA usage is more to figure out the debt carrying capacity.  If Valeant has $7.5 billion of EBITA in 2016, you're looking at pre-tax interest of $1.5 billion against that on their $30 billion of debt.  By looking at EBITA you can guide for some leverage ratio and figure out how much they can acquire per year, repurchase shares, etc.  Or we can compare that EBITA to an unlevered purchase price on VRX but it seems like investors don't really value it that way.

 

Now the bigger issue is why they seem to call EBITA cash generation in their presentation.  The actual cash is more EBTA (no I) but they're looking at unlevered returns (so total cash generated to support the full acquisition price).  So I can see why they say this, because they're taking the Malone approach to maximizing long-term cash flow compounding in a tax deferred manner.  Like Malone says, it's better to pay interest than taxes.

 

As for the GAAP profits or operating income... Well you have a lot of restructuring costs and amortization that isn't telling you a ton about the true economic value.  And there are plenty of other companies which do this like different Malone type entities.

[ccplz]

ccplz, EBITA usage is more to figure out the debt carrying capacity.  If Valeant has $7.5 billion of EBITA in 2016, you're looking at pre-tax interest of $1.5 billion against that on their $30 billion of debt.  By looking at EBITA you can guide for some leverage ratio and figure out how much they can acquire per year, repurchase shares, etc.  Or we can compare that EBITA to an unlevered purchase price on VRX but it seems like investors don't really value it that way.

 

Now the bigger issue is why they seem to call EBITA cash generation in their presentation.  The actual cash is more EBTA (no I) but they're looking at unlevered returns (so total cash generated to support the full acquisition price).  So I can see why they say this, because they're taking the Malone approach to maximizing long-term cash flow compounding in a tax deferred manner.  Like Malone says, it's better to pay interest than taxes.

 

As for the GAAP profits or operating income... Well you have a lot of restructuring costs and amortization that isn't telling you a ton about the true economic value.  And there are plenty of other companies which do this like different Malone type entities.

 

Sure. Restructuring costs can be non-recurring but is this the case with Valeant? A company that depends on making acquisitions for growth and then 'cutting the fat' in the newly acquired business - Does this sound like a non-recurring expense to you?

 

Anyways, i would love to hear your thoughts on the rest of the issues i raised (primarily leverage used, possible liquidity risks, possible risks of roll-up / acquisition strategy and whether or not you think this is a good strategy, evidence of Pearson's competence).

[original mungerville]

Well, so far I have said his key metric includes the I and the T. I have also said that when they look at acquisitions, they capitalize restructuring costs and effectively add those back to get to "cash net income" which I believe is legitimate.

 

All the other details can be found in every one of their quarterly results press releases. Further Ackman assesses these in one of his presentations found here: http://www.scribd.com/doc/219842453/Bill-Ackman-s-VRX-AGN-Presentation

 

See slides 61 to 63.

 

 

[Picasso]

If they stop making acquistions, they'll just start having a ton of taxable income.  I'm sure that needs to happen eventually, but its all a focus on creating the best long-term growth in cash flow per share.  Look at my post a couple pages back where I compared the increase in cash from ops against the share issuance.  If we saw share issuance in line with that growth in ops, then yes I would agree it is a recurring expense.  But based on what we've seen, it doesn't appear that way.  Growth in operating cash is outstripping the costs of issuing shares and debt by a mile.  Even if interest rates doubled, they'd have around $3 billion of interest expense against at least $7.5 billion of EBITA.  Keep in mind that they've financed out their debt over many years, so you aren't going to see a massive spike in interest expense from refi risk, not immediately.  That might change if they do another big debt deal for another cash acquisition.

 

In terms of leverage versus the asset base, well they aren't buy a ton of tangible assets.  ESRX has a ton of intangible assets but they're generating a ton of cash from it.  Not sure the asset base/leverage worries me because this is about the cash flow generation.

 

As for the acquisition strategy, what big mistakes have the made so far? B+L? Big success.  Salix? So far looking great.  The thing that seems to have caused the latest stir was Marathon, but it only cost them a few hundred million and they've already earn most of that back, if not all.  That point is something that always needs to be monitored.  It's not past Pearson to make a bad deal, but I think its unlikely.  Have you noticed that almost everything they couldn't buy has done really well?  Actavis more than doubled after they lost the bid.  Allergan ended up in Actavis.  Endo decided they wanted Salix after their bid.  Even the acquisitions they couldn't get done ended up being great investments.

 

Based on the operating results, I'd say Pearson is pretty competent at what he's doing.  It's really just a John Malone styled roll up of Berkshire styled cigar butts and quality assets by looking at cash flows versus revenue/GAAP profits.  He's definitely not around long enough to directly compare to those two, but he's taking the same approach.  And if you watch a couple interviews of Pearson he isn't exactly a slick sales guy.

[original mungerville]

ccplz, EBITA usage is more to figure out the debt carrying capacity.  If Valeant has $7.5 billion of EBITA in 2016, you're looking at pre-tax interest of $1.5 billion against that on their $30 billion of debt.  By looking at EBITA you can guide for some leverage ratio and figure out how much they can acquire per year, repurchase shares, etc.  Or we can compare that EBITA to an unlevered purchase price on VRX but it seems like investors don't really value it that way.

 

Now the bigger issue is why they seem to call EBITA cash generation in their presentation.  The actual cash is more EBTA (no I) but they're looking at unlevered returns (so total cash generated to support the full acquisition price).  So I can see why they say this, because they're taking the Malone approach to maximizing long-term cash flow compounding in a tax deferred manner.  Like Malone says, it's better to pay interest than taxes.

 

As for the GAAP profits or operating income... Well you have a lot of restructuring costs and amortization that isn't telling you a ton about the true economic value.  And there are plenty of other companies which do this like different Malone type entities.

 

Sure. Restructuring costs can be non-recurring but is this the case with Valeant? A company that depends on making acquisitions for growth and then 'cutting the fat' in the newly acquired business - Does this sound like a non-recurring expense to you?

 

Anyways, i would love to hear your thoughts on the rest of the issues i raised (primarily leverage used, possible liquidity risks, possible risks of roll-up / acquisition strategy and whether or not you think this is a good strategy, evidence of Pearson's competence).

 

Yes, restructuring costs should be thought of as a non-recurring event for a company which depends on making acquisitions for growth and cutting fat. Your point is that it is a recurring non-recurring expense - and so it should be expensed. But that is the wrong way to look at it. The right way to look at it is if they did just one acquisition and had to incur one-time expense to restructure it, would it be fair to capitalise that and take those costs out of future income? (assuming they did just one acquisition in their entire history).

 

If you answer "Well, yes, I think so" which is what I answer. And if the return so calculated is attractive and looks like it can be repeated, then why the hell would you stop at one. And so you get this series of recurring non-recurring costs with Valeant's business model which at first blush seems like it should be expensed. But hey, that is just the way life is isn't it? Its not supposed to be easy, not everybody is supposed to be able to make outsized returns. The contradiction of a recurring non-recurring charge is just one example of the many contradictions and riddles which need to be reasoned and solved with respect to this investment.

 

[original mungerville]

If they stop making acquistions, they'll just start having a ton of taxable income. 

 

Why? 

[Picasso]

If they stop making acquistions, they'll just start having a ton of taxable income. 

 

Why?

 

They lose the "recurring" restructuring charges and amortization begins to roll off from previous acquisitions.  They start having pre-tax operating income that needs to get taxed at some point.

[giofranchi]

I don't agree with every point AZ Value is making, but I applaud his writing and research in the sense that AZ is very clearly a passionate and thoughtful value investor and good researcher and anyone who publishes a work that serious and detailed makes us all better.

 

He should be much much much more careful… Someone who accuses publicly anyone else to have told a lie… Because that’s the exact word he used!... And then is proven blatantly wrong… Should at least keep quiet for, let’s say,… a decade?! ;)

When you clearly don’t know how to behave, you simply lose credibility on all fronts.

 

Cheers,

 

Gio

 

[giofranchi]

Third, it is surprising that Valeant responded to just those four points on AZ Value' blog.  Does that mean that it is conceding that all the rest of them are true?  Of course not, but why even open the door to that kind of argument by responding in this specific tit-for-tat way.  Additionally, in my mind at least, they responded to some of AZ Value's points that weren't nearly the most salient.  What about the more central points about the evolving changes in reporting numbers/lack of certain meaningful figures in their Annual Reports/clearly misleading slides in some cases (using unweighted averages/etc.)?

 

I don’t agree. Period.

They have addressed EXACTLY all those points that have bothered me the most. And for that I am very grateful!

Of course, most of them I had already answered myself, but to receive a positive confirmation is always useful.

 

Cheers,

 

Gio

 

[giofranchi]

Anyways I'm sure these are all issues you have considered...so I am very curious as to what you bulls see in this company.

 

Sincerely, you are right: every single thing you have written has already been discussed many times on this thread… And repeating them over and over again would add nothing to the discussion.

If you are interested, I would suggest you to read with much carefulness Liberty’s posts on this thread: they have addressed all your doubts innumerable times!

 

Cheers,

 

Gio

 

[ccplz]

Is there really a need to post multiple times one after another? Couldn't you just consolidate everything into one post without having to clutter the thread with your drivel?

 

 

 

 

 

 

[ccplz]

Also I don't think you should be the one talking about credibility mate ;) that'd be like the pot calling the kettle black, wouldn't you say?

 

[ccplz]

 

He should be much much much more careful… Someone who accuses publicly anyone else to have told a lie… Because that’s the exact word he used!... And then is proven blatantly wrong… Should at least keep quiet for, let’s say,… a decade?! ;)

 

 

It's far from clear to me that Valeant has disproven anything that AZ has said, but even if we assume that they have:

 

Someone who is ultimately wrong, despite having reasonably good reasons for their beliefs, should just keep quiet for a decade? What sort of logic is that?

 

How disturbing.

[ccplz]

Thanks OM and Picasso for your replies. I will try to respond to them in the morning.

 

 

[tombgrt]

Is there really a need to post multiple separate posts one after another? Couldn't you just consolidate everything into one post without having to clutter the thread with your drivel?

 

 

He hasn't got time for that, he has to run two businesses you know!! And do you think that Twitter spam-feed is going to fill itself?!

 

I don't agree with every point AZ Value is making, but I applaud his writing and research in the sense that AZ is very clearly a passionate and thoughtful value investor and good researcher and anyone who publishes a work that serious and detailed makes us all better.

 

He should be much much much more careful… Someone who accuses publicly anyone else to have told a lie… Because that’s the exact word he used!... And then is proven blatantly wrong… Should at least keep quiet for, let’s say,… a decade?! ;)

When you clearly don’t know how to behave, you simply lose credibility on all fronts.

 

Cheers,

 

Gio

 

 

Someone is finally putting forth some decent analysis and you want to silence them... Brilliant. Just stfu.

[giofranchi]

 

He should be much much much more careful… Someone who accuses publicly anyone else to have told a lie… Because that’s the exact word he used!... And then is proven blatantly wrong… Should at least keep quiet for, let’s say,… a decade?! ;)

 

 

It's far from clear to me that Valeant has disproven anything that AZ has said, but even if we assume that they have:

 

Someone who is ultimately wrong, despite having reasonably good reasons for their beliefs, should just keep quiet for a decade? What sort of logic is that?

 

How disturbing.

 

That’s not what I have said. Read more carefully. You get disturbed because you don’t pay attention.

 

Gio

 

[ccplz]

I'm sorry I must have misunderstood what you were saying. It's hard to tell over the internet sometimes, especially with people whos first language isn't English.

 

I would appreciate it if you could clarify your thoughts without resorting to sarcasm. Your regular English is hard enough to understand.

[giofranchi]

Is there really a need to post multiple separate posts one after another? Couldn't you just consolidate everything into one post without having to clutter the thread with your drivel?

 

 

He hasn't got time for that, he has to run two businesses you know!! And do you think that Twitter spam-feed is going to fill itself?!

 

I don't agree with every point AZ Value is making, but I applaud his writing and research in the sense that AZ is very clearly a passionate and thoughtful value investor and good researcher and anyone who publishes a work that serious and detailed makes us all better.

 

He should be much much much more careful… Someone who accuses publicly anyone else to have told a lie… Because that’s the exact word he used!... And then is proven blatantly wrong… Should at least keep quiet for, let’s say,… a decade?! ;)

When you clearly don’t know how to behave, you simply lose credibility on all fronts.

 

Cheers,

 

Gio

 

 

Someone is finally putting forth some decent analysis and you want to silence them... Brilliant. Just stfu.

 

Come on! You had promised! Don’t you remember? It was just a few days ago… ;)

 

By the way, why do you keep repeating that I run two businesses? Actually, they are three!

You don’t believe that?!... Why would I say so, if it weren’t the truth? I really don’t understand you…

 

Cheers,

 

Gio

 

[giofranchi]

I'm sorry I must have misunderstood what you were saying. It's hard to tell over the internet sometimes, especially with people whos first language isn't English.

 

I would appreciate it if you could clarify your thoughts without resorting to sarcasm. Your regular English is hard enough to understand.

 

Ok, no problem: I meant he should be careful to accuse publicly someone else of lying. Because, if you are later proven wrong, you simply lose all credibility. Period.

 

AZ_Value wrote: “let me say right away as categorically as I possibly can that the $99M [in Sanitas cash generated] claimed by Valeant is a lie”.

VRX instead has explained why it is the accurate number. And filed its replied with the SEC.

 

Now, as I have said, you should be more careful with public accusations of that sort, which later turn out to be unfounded.

 

I hope my poor English has not prevented me from explaining my thought clearly enough this time! ;)

 

Cheers,

 

Gio

 

[NBL0303]

 

Gio - did you sell your Valeant stake last week?  I thought I remembered reading that you were selling your stake but I can't remember if it was you or someone else.

[giofranchi]

 

Gio - did you sell your Valeant stake last week?  I thought I remembered reading that you were selling your stake but I can't remember if it was you or someone else.

 

I sold half my investment, spent a few days trying to gather as many information as I could about the history of government intervention in the pharma industry (which I still think is the biggest unknown here), then I bought back some yesterday.

 

Cheers,

 

Gio

 

[merkhet]

Just to be clear, most of the time I am calm and try to be logical and rational (to the best of my abilities). However, in rare cases I get hyper/pissed, and I have done so on this thread in the past month or so - not because of an opposing opinion backed by an earnest effort at analysis, I welcome that as it does make us all better.

 

No I get unhappy in the following situations:

 

1. When I believe its not a mistake in the analysis, instead that the analysis was purposely put together to knowingly mislead. Usually this obfuscation is delivered by an intelligent individual leading the charge. Also less intelligent individuals can be used to mindlessly post rambling replies which make no sense.

 

2. When we can't agree on simple stuff like 1+1 = 2 or that a truncated IRR on a business usually has a terminal value in the last year. Because if we can't agree on basic/fundamental principles, how are we supposed advance and have a broader conversation on more important high level stuff like the business model? 

 

And #1 gets me a lot more pissed off than #2 (#2 is just an annoyance).

 

Okay, this was a good post to explain things from your perspective, and I want to also try to explain a few things from my perspective without you feeling like I am somehow attacking you. If you think that's possible, read on. If not, then don't. No big deal.

 

(1)

 

While I'm sympathetic to the situation you described concerning Fairfax's past as a target of the short & distort crowd of short sellers, and I agree that a healthy amount of cynicism is sometimes a good thing, I think there is a danger of getting very biased when you come at something with the idea that "this individual is trying to trick me." That's why I initially brought up the research from Dan Kahan below.

 

(1) Dan Kahan of Yale Law had a fantastically good piece of research on how ideology motivates people's mathematical abilities (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2319992) indicating that two people might see the exact same information and yet interpret things completely differently.

 

I suspect that you pattern matched what's happening now with Valeant with what happened in the past with Fairfax, but the problem is that not everyone who was commenting negatively on this stock is a part of the short & distort crowd. However, because you started with the presupposition that some individuals speaking negatively had sinister motives, in my opinion, it colored your thinking and caused you to lash out at random folks on this thread who, honestly, probably didn't deserve it.

 

(2)

 

As for the main point of contention between you and I on IRRs, it's because you and I are talking about different things. I've tried to point this out before. If you'll remember, you originally disliked the way that AZ's blog post dealt with IRRs because you said that IRRs need terminal values and then berated some folk for not including a terminal value.

 

I have modified my comments to be more in line with this board's culture:

 

No AZ, its not "fine", your IRRs are not "fine". Nobody, I MEAN NOBODY, does an IRR calculation for a business and in year 10 essentially assumes it goes bankrupt. What the!?!? Just how stupid do you think we are?

 

The problem is that AZ was trying to validate Valeant's deal model of getting 20% IRRs on every acquisition rather than figure out the total worth of an acquisition.

 

Did anyone actually think that AZ meant to say that these cash flows would actually drop to $0 in Year 11? Or did they, like me, think of the ten year IRR calculation as a rough model and/or a way to verify how Valeant was measuring IRRs?

 

That's why I keep correcting you every time that you go back to this particular concept. An IRR calculation, by definition, does not have a terminal value appended to it, because it's just the calculation of the return necessary to bring an NPV to zero for a defined amount of time between zero and n years. (That's the equation I put up about a month ago.) The reason AZ did an IRR that ended in year 10 is because Valeant's own deck says that they are targeting a 20% IRR at statutory tax rates. It makes no sense to include a terminal value in this particular case because neither of them is making a statement about the acquisition's total cash flows past time n.

 

In order to see what I mean, it's easy to just invert the situation. Let's say AZ included a terminal value after Year 10 of his IRRs for B+L of $40 billion. That's a good and healthy number, right? So now he has an IRR of X% for n years + $40 billion for the value of the cash flows past time n, and he compares that to the part of Valeant's deck that says their deal model requires an IRR of 20%. What extra information does the $40 billion terminal value add to the validation of the Valeant deal model which only concerns itself with the cash flows from time 0 to n?

 

Just to belabor the point here, you keep pointing out that the correct way to value a business is to count the cash flows from now until judgment day (e.g. including a terminal value), but no one is actually disagreeing with you on that. (Not even me. Really.) The only disagreement is that when comparing one IRR to another IRR, neither of them needs a terminal value.

[NBL0303]

 

 

I sold half my investment, spent a few days trying to gather as many information as I could about the history of government intervention in the pharma industry (which I still think is the biggest unknown here), then I bought back some yesterday.

 

Cheers,

 

Gio

 

Interesting.