VRX - Valeant Pharmaceuticals International Inc.

[Picasso]

Ericopoly, since you're going to have to read through hundreds of pages to see what Schwab means I'll get you up to speed.

 

If you look at Valeant's "deal model" or various presentation slides, they consider "cash generation" on a deal to be EBITA.  They aim for a 20% unlevered IRR on a deal and a 5-6 year cash payback.  They use EBITA because it is unlevered.  The levered cash generation (free cash flow) is compounding much higher due to the debt involved at lower costs than returns on capital deployed.  You'll see the difference by looking at EBITA and cash flow from operations over the past six years.

 

So there is controversy on whether you want to consider cash generation EBITA or EBTA.  For valuation purposes it depends whether you want to value this levered (using cash EPS as a proxy for free cash flow) or unlevered (using EBITA as a measure of cash generation including all debt).

 

There's some back and forth thought on this topic.

[gary17]

If I buy a share of XYZ company at 5x book directly on the stock exchange, I don't have any amortization. If I own Valeant instead, and they buy XYZ for 5x book, suddenly my share of XYZ has amortization. My cash flow is exactly the same, but suddenly my share of XYZ is worth less just because I own it via Valeant?

 

My mind just can't understand how that reflects economic reality.

 

I'm assuming you don't have an income statement

whereas Valeant does ?

 

the economic reality the accounting is trying to capture is that you amortize the cost of an acquisition against future earnings to provide a more "realistic" view of the business operation.

 

you as an individual is not required to do this.

[Picasso]

Well these are Buffett's thoughts on this topic from his 1983 letter.  Pretty much what KC has pointed to.

 

If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder.

 

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%.

 

With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business.

 

Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true" earnings of $3 per share cause him to rethink his purchase price?

 

[ERICOPOLY]

Ericopoly, since you're going to have to read through hundreds of pages to see what Schwab means I'll get you up to speed.

 

If you look at Valeant's "deal model" or various presentation slides, they consider "cash generation" on a deal to be EBITA.  They aim for a 20% unlevered IRR on a deal and a 5-6 year cash payback.  They use EBITA because it is unlevered.  The levered cash generation (free cash flow) is compounding much higher due to the debt involved at lower costs than returns on capital deployed.  You'll see the difference by looking at EBITA and cash flow from operations over the past six years.

 

So there is controversy on whether you want to consider cash generation EBITA or EBTA.  For valuation purposes it depends whether you want to value this levered (using cash EPS as a proxy for free cash flow) or unlevered (using EBITA as a measure of cash generation including all debt).

 

There's some back and forth thought on this topic.

 

Okay, here is my take on it based on what I saw in another company I commented on in the past -- SSW (Seaspan).

 

People were putting a P/E on it without mention of leverage but I commented on that company to look at the value of the unlevered business as well.  Of course, you can jack up the stock price value if you use a constant P/E while the company adds cheap leverage. 

 

So I'm a fan of taking the risk (from debt) into account by assigning a lower P/E to a highly levered company, and a higher P/E to the exact same company if it were not levered. 

 

So I'm on page 16 so far of this thread and original_mungerville has already covered this by saying he'd rather put a lower multiple on it due to the debt.  I agree.

[original mungerville]

The issue is if they admit the call options were to protect themselves from legal liability than they admit there was an identified legal liability risk.

 

Yes, but all businesses have legal liability risk so that does not prove that they knew of a real, ongoing legal risk - although I would not be surprised if internal emails revealed that.

 

Agree - but how many businesses are bought with options with the intent of avoiding legal liability? There's a definite implication that they thought there was a material enough liability to warrant using options to buy the business (assuming they structured the deal to avoid legal liability).

 

It does not prove anything. I think the implication is strong (again making that same assumption, which could be wrong).

 

Agree. If it was for competitive (secrecy) purposes only, you would think they would have clearly disclosed that on the call on Monday, but maybe not. Maybe they want Philidor to continue to sell competitors' drugs. I don't know. I am guessing the reason is some sort of regulatory arbitrage (but I can't figure out what) or they effectively wanted the aggression of Philidor without theassociated legal liabilities (in which case, they may end up getting dragged through the mud and pay a fine at the end).

 

But why would Philidor want to give Valeant "the aggression of Philidor"? What would Philidor gain from being aggressive and taking on the very legal liabilities that your explanation assumes Valeant wanted to avoid?  Valeant already paid the shareholders of Philidor $100 million for the option, and was indemnified in the amount of that $100 million for any future liability.  So why would the owners of Philidor be aggressive to the point of illegality and risk losing that $100 million? If I was the guy who pocketed $100 million I'd be playing by the rules to make damn sure I keep that $100 million. Any appreciation in the value of Philidor goes to Valeant when they exercise their option for $0.  That explanation doesn't make sense to me for that reason.

 

There was also a good chunk of performance payments ($100 plus million) of which $33 million was dispensed after the $100 million option purchase.

[original mungerville]

J&J only gets fined $2 billion for that? And the guy moves up to CEO?

 

At that rate, California should be paying Valeant for any wrongdoing of theirs in terms of selling toe nail polish in the state.

 

 

[blainehodder]

So the conversation seems to have shifted to:

-Is Valeant shielded from legal liability through purchase option of Philidor and/or external legal counsel saying it is okay?

-Is Philidor shielded from legal liability with purchase option of Isolani?

-Is there anything to be shielded of with regards to R&O and the state board of California, and potential misuse of R&O license or non licensed sales?

-If so how much if this chain causes max pain?

 

Can worst case really be an impairment of 20B+ (implied discount to a pretty reasonable valuation?)

 

I don't see that being remotely possible. Any opinions on that?

[ZenaidaMacroura]

But why would Philidor want to give Valeant "the aggression of Philidor"? What would Philidor gain from being aggressive and taking on the very legal liabilities that your explanation assumes Valeant wanted to avoid?  Valeant already paid the shareholders of Philidor $100 million for the option, and was indemnified in the amount of that $100 million for any future liability.  So why would the owners of Philidor be aggressive to the point of illegality and risk losing that $100 million? If I was the guy who pocketed $100 million I'd be playing by the rules to make damn sure I keep that $100 million. Any appreciation in the value of Philidor goes to Valeant when they exercise their option for $0.  That explanation doesn't make sense to me for that reason.

 

I mostly agree with you, like it's easy to see why someone should be happy with $100mm, but they can still earnthe milestone payments right? 

 

Look at how Pearson's compensation is structured -it's easy to say "hey he's a billionaire!"  But the way it's setup could encourage someone who cares about that kind of thing to really push the results.  Maybe?

[ZenaidaMacroura]

So the conversation seems to have shifted to:

-Is Valeant shielded from legal liability through purchase option of Philidor and/or external legal counsel saying it is okay?

-Is Philidor shielded from legal liability with purchase option of Isolani?

-Is there anything to be shielded of with regards to R&O and the state board of California, and potential misuse of R&O license or non licensed sales?

-If so how much if this chain causes max pain?

 

Can worst case really be an impairment of 20B+ (implied discount to a pretty reasonable valuation?)

 

I don't see that being remotely possible. Any opinions on that?

I think there's also some regulatory overhang (and the fact that this whole fiasco might paint a big target on Valeant).  And given how critical parties have tried to drag them through the mud it may be more difficult finding acquisitions going forward unless the target is in some trouble (salix/biovail?).  There may be more resistance from the target/require a higher price. 

 

They may try to mount the AGN defense etc.

[giofranchi]

Okay, here is my take on it based on what I saw in another company I commented on in the past -- SSW (Seaspan).

 

People were putting a P/E on it without mention of leverage but I commented on that company to look at the value of the unlevered business as well.  Of course, you can jack up the stock price value if you use a constant P/E while the company adds cheap leverage. 

 

So I'm a fan of taking the risk (from debt) into account by assigning a lower P/E to a highly levered company, and a higher P/E to the exact same company if it were not levered. 

 

So I'm on page 16 so far of this thread and original_mungerville has already covered this by saying he'd rather put a lower multiple on it due to the debt.  I agree.

 

+1

 

Cheers,

 

Gio

[original mungerville]

Probably at most 50/50 chance they are legally responsible, then any fine far less than $1B. Impact on growth for one year only.

 

I don't see this as a big issue at all now. In terms of painting targets, acquisitions not wanting to sell, etc.They can do tuck-ins with cash (and/or debt). But at this stock price, and bond prices, they can retire bonds below par by buying on the open market (which is great) and also retire common shares. I can see 20% compounded returns while reducing debt - just from buying back shares.

 

The other legal issues re raising prices on those two drugs. I think its going to be hard to prove that that was illegal, but they may have to settle something there. In any case, the sum total of fines can't be more than $1 Billion in my view. Not much dd on that, just staring at the recent settlements in the news (ie J&J and that other one) and ball parking. I'd be surprised if the California thing exceeds a $300 million and if their total bill exceeds $500 million. But no more than $1Billion for me.

[Liberty]

The company bought back 200,000 shares at $111.50 USD:

 

https://www.canadianinsider.com/company?ticker=VRX

 

 

[ERICOPOLY]

I had a theory last night that the same retards (as with FFH) are shorting this stock again because they just don't know how to assess good character from bad in people.  There is evidence in this if you look at who they associate with (each other).  The Fairfax investment was a no-brainer because of the exceptionally high character of Prem and the men he associates with.

 

So these guys are not always wrong, but their weakness is that they can't tell the difference when they've come across men where massive fraud is not in their DNA.

 

I'm trying to be charitable here -- there might be an explanation for why these shorts are so crazy other than conspiracy.  They might just be exceptionally poor judges of character and operate mainly on patterns they see in a balance sheet and disclosures that fit patterns they've seen elsewhere in frauds.  But without an ability to assess character, they lack the higher-level filter that's necessary to avoid getting burned by FFH.

 

These guys surround themselves with other shorts and journalists of low character -- evidence they cannot really assess character.

[giofranchi]

I had a theory last night that the same retards (as with FFH) are shorting this stock again because they just don't know how to assess good character from bad in people.  There is evidence in this if you look at who they associate with (each other).  The Fairfax investment was a no-brainer because of the exceptionally high character of Prem and the men he associates with.

 

So these guys are not always wrong, but their weakness is that they can't tell the difference when they've come across men where massive fraud is not in their DNA.

 

I'm trying to be charitable here -- there might be an explanation for why these shorts are so crazy other than conspiracy.  They might just be exceptionally poor judges of character and operate mainly on patterns they see in a balance sheet and disclosures that fit patterns they've seen elsewhere in frauds.  But without an ability to assess character, they lack the higher-level filter that's necessary to avoid getting burned by FFH.

 

These guys surround themselves with other shorts and journalists of low character -- evidence they cannot really assess character.

 

+1

 

And this is essentially why you must be very careful about reputation in business! I know it sounds strange said by me… I have invested a long time with Biglari… Saying over and over again that all I cared about were business results! But I make mistakes, lots of them… I want to recognize them, and hopefully correct them: I now believe reputation is paramount, because our economic system is basically based on trust.

 

Cheers,

 

Gio

[Guest Grey512]

I don't think there needs to be accounting fraud for the shorts to profit. Shorts could "win" a bunch of ways:

 

1. Prices or volumes on VRX come in below sell-side expectations because the broader ecosystem (regulators, insurers; especially insurers) take a harder line against VRX. FCFs comes in below expectations. Stock plunges

 

2. Even if independent reviews conclusively confirm that VRX accounting is legit (good for VRX stock), Hempton was sufficiently vocal in raising concerns about VRX's network of subs/VIEs and their aggressive (and potentially illegal) behaviour, e.g. shipping meds to states where they were not licensed. At a minimum, this introduces further business/regulatory/legal uncertainty for VRX

 

3. VRX's ability to make acquisitions likely to be impeded by magnified regulatory attention as well as heightened risk level on VRX's credit and stock. Unlikely that capital markets will be as welcoming to VRX as they were before, should VRX wish to tap them again in any meaningful way in the next 2-3 years

 

4. Overall de-leveraging of the financial system (which will come; the question is when) would likely have a stronger effect on VRX than simply the effect of increasing interest rates on global P/E multiples; VRX was a big beneficiary of the zero-rate, QE environment. The whole investing world moved further & further out on the risk curve

 

5. As a highly levered stock, if there is deflation (in any meaningful way) in VRX's top-line (which again is possible due to all the drug pricing hoopla and increased attention from Hillary, Shkreli, McCaskill, etc), then that is very dangerous for VRX equity holders. Equity value can become impaired fast, and stay down for a long time.

 

 

+

 

6. (and you may laugh at this) Charlie Munger compared VRX to ITT & Geneen. To Munger, VRX is dumb. Who was proven to be wiser, in the long run, Munger or any one of us dilettantes here on COBF? Touche.

 

+

 

7. For a business such as VRX to earn abnormal returns on capital and create value, it has to at least in some way "game the system" (the byzantine network of laws & regulations & players in US pharma reimbursement). Raising prices & slashing R&D also does not feel like a force benefiting humanity. VRX was tremendously successful in this. It engaged in excellent, skilful rent-seeking behaviour. Either it continues being tremendously successful at extracting that economic rent and takes off like a rocket and becomes a megacap rivaling AAPL in size, or the forces of gravity & reversion to the mean assert themselves (via regulation or competition). We are already seeing those forces at work!

 

It just sounds like a good set-up for a larger portion of economic value to flow back from VRX and towards other players in the system, including equity holders (being paid a greater earnings yield), consumers (exposed to lower price hikes than before thanks to Shkreli, Hillary & McCaskill), and insurers (greater awareness of how VRX was effectively raping, duping & exploiting them, and an associated stronger response)

 

I was not long VRX in the past and I am not long now; I am also not a big user of the healthcare system. I am approaching this whole thing dispassionately. If you were long in the run-up to this whole debacle and are sitting on a hefty paper loss (a la Sequoia & Pershing Square), I question whether you are sufficiently emotionally detached to think straight about what is happening.

[shalab]

If one reads the proxy - the incentives to management becomes clearer - from the latest one, it had incentives such as:

- reduce leverage less than 4x

- do one major deal in a year

 

Management team hit everyone of the incentive metrics out of the ball park by a wide margin in 2014.

 

As someone pointed out, the pharma business as a whole is not a great business - it relies on price raises and new drugs for the most part.

 

In Valeant's case - it relies on its "business model" to be different. While this "business model" has been hugely successful in the past several years, it is not clear if it will continue to be successful for another five-ten years.

 

 

[giofranchi]

As someone pointed out, the pharma business as a whole is not a great business - it relies on price raises and new drugs for the most part.

 

I believe the exact opposite instead: imo this century will be remembered as the century of biotechnology.

 

Cheers,

 

Gio

 

[KCLarkin]

I believe the exact opposite instead: imo this century will be remembered as the century of biotechnology.

 

Gio, there is an important difference between Pharma and Biotech. At least in theory, it is much harder to make generic copies of biotech drugs.

[valueyoda]

Michael Pearson has to retain his shares for at least a year after he retires or loses his job, so he is most definitely incentivized to create long term shareholder value that is durable than to cut corners in the short run to inflate the share price, as it would serve him no purpose.  Valeant's commission will probably conclude that Philidor's actions were too aggressive and opt not to exercise its option to buy it and switch to 2-3 alternative specialty pharmas with some potential legal liability (even though I think that a fine would be fairly minimal). It is fun to investigate and uncover shady details on a public company, but the question in the end always remains whether it is material to the long term free cash flow generation of the business. And I am more assured now that the impact is relatively mild.

 

Valeant is battling perception right now. So Valeant's access to capital markets is non-existent right now. Therefore, it will shift its focus on improving current operations, internal R&D projects with a high likelihood of success, debt repayment and share buybacks. In the end that may prove to be a very successfull outcome, since pharma valuations are not too attractive anymore. In 2017, Valeant's net debt will already be reduced to $22bn, reducing investors' concerns with regard to financial leverage. It is better to do good rollups with cheap debt than to increase the share count too excessively. Maybe, Valeant will act like Teledyne in the 1970s, reducing leverage and repurchasing shares aggressively after a multi year streak of acquisitions.

 

I am purchasing more shares around these valuations.

[giofranchi]

Gio, there is an important difference between Pharma and Biotech. At least in theory, it is much harder to make generic copies of biotech drugs.

 

I agree.

 

But in what I think will follow focusing on these differences will be later regarded as focusing on the tree instead of the forest… We will see! ;)

 

Cheers,

 

Gio

 

[cmlber]

As someone pointed out, the pharma business as a whole is not a great business - it relies on price raises and new drugs for the most part.

 

I believe the exact opposite instead: imo this century will be remembered as the century of biotechnology.

 

Cheers,

 

Gio

 

The pharma business as a whole has historically been one of the best industries as measured by return on equity. So your gut opinion that it is not a good industry is disproven by facts.

 

[original mungerville]

I had a theory last night that the same retards (as with FFH) are shorting this stock again because they just don't know how to assess good character from bad in people.  There is evidence in this if you look at who they associate with (each other).  The Fairfax investment was a no-brainer because of the exceptionally high character of Prem and the men he associates with.

 

So these guys are not always wrong, but their weakness is that they can't tell the difference when they've come across men where massive fraud is not in their DNA.

 

I'm trying to be charitable here -- there might be an explanation for why these shorts are so crazy other than conspiracy.  They might just be exceptionally poor judges of character and operate mainly on patterns they see in a balance sheet and disclosures that fit patterns they've seen elsewhere in frauds.  But without an ability to assess character, they lack the higher-level filter that's necessary to avoid getting burned by FFH.

 

These guys surround themselves with other shorts and journalists of low character -- evidence they cannot really assess character.

 

Exactly. I posted this same point the day Valeant was crashing and I was buying based on character of Pearson and the board of Valeant vs the character of this group of jokers. Prem surrounded himself with guys like Chou (ie one of the only mutual fund managers I know of who gave back MER in a bad year and whose trailer fees go to remaining unit holders rather than himself), etc. Anyhoo.

 

The other thing I think they have a problem with is understanding acquisition accounting. In the FFH case, the didn't get the concept of buying below book (where book is after-tax) and then incurring restructuring costs for the next three years (in the form of pre-tax combined ratios above 100%) is, in my book, all part of the acquisition costs (I mentally was booking that upfront as a capital cost that is actually tax efficient). Rating agencies could not get their heads around that either.

 

Same shit here, Valeant is incurring deal and integration costs upfront in their capital expense for acquisitions, then adjusting cash EPS going forward. The shorts either don't "get it" or are just using that as part of the same dumb ass argument this time.

 

Also (maybe a year ahead of your FFH time), FFH had one financial reinsurance cover for $1B which only gave them real protection of around $100M. I did not know/understand that until the shit hit the fan (and in my view FFH mischaracterised that). Similar thing here with Valeant and Philidor.

 

Philidor = FFH's financial reinsurance cover (both went / are going to go away to a degree after this)

 

Not good, I don't like it, but even people of the highest standards push things too far sometimes potentially. Buffett included.

 

 

 

[original mungerville]

Picasso thought I had big balls buying that day. Well, it was a simple bet on character. Now we will see if the bet was right or wrong, and whether this is more or less isolated in terms of an event in Valeant

 

They absolutely misjudge character whereas that is what I search for before taking a big position. Hell, I just have to look at their pictures and I know they look crooked. That's BEFORE they open their mouths, then it gets worse.

[scorpioncapital]

As someone pointed out, the pharma business as a whole is not a great business - it relies on price raises and new drugs for the most part.

 

I believe the exact opposite instead: imo this century will be remembered as the century of biotechnology.

 

Cheers,

 

Gio

 

The pharma business as a whole has historically been one of the best industries as measured by return on equity. So your gut opinion that it is not a good industry is disproven by facts.

 

I think that history includes companies with patents and R&D that have been given the franchise to earn such high returns. The high returns of the generic roll-up pharmas like Valeant have come from balancing the forces of run-off with the forces of price increases fueled by high debt due to low interest rates. If that party begins to slow or falter, I'm not sure what will happen. Perhaps they will have to change their model very quickly and then it becomes a turn-around story with some time and headwinds and more uncertainties. Much will depend on selecting the best companies, the most prudent, the best managements - but that's always the case.

[KCLarkin]

The pharma business as a whole has historically been one of the best industries as measured by return on equity. So your gut opinion that it is not a good industry is disproven by facts.

 

A business with historically high but rapidly falling ROE. Limited organic reinvestment opportunities. Massive legal and regulatory risks. Patent cliffs. An industry rife with corruption and conflicts. What's not to love?

 

I'm taking this directly from Valueline, so I make no representations about validity:

 

Merck:

ROE 2005: 31%

ROE 2015: 21.5%

 

Pfizer:

ROE 2005: 22.9%

ROE 2015: 13%

 

In the future, these might be wonderful businesses but I don't think I would rely on historical ROE as the core to my investment thesis.