VRX - Valeant Pharmaceuticals International Inc.

[ERICOPOLY]

Position size is about 25%.  I don't do really crazy sizing anymore.

 

Does anyone agree that you can assess Munger's character without meeting him?  How about Buffett?  Most of us haven't met either one.

 

You could meet a guy alone on the street, and you might walk away with a favorable view of him if he said the right things.  But I think you'd learn more about him by looking at the company that he keeps.

[ourkid8]

You have become soft huh...

 

Position size is about 25%.  I don't do really crazy sizing anymore.

[ERICOPOLY]

I think Pearson's character is immaterial for this business. If you want to judge character check out valueact guys. If not Pearson, they will get someone else. The board will set the milestones and the CEO's job is to execute against it.

 

If Pearson can't execute, they will find someone else who can - it is that simple.

 

I dont understand how anyone on this board is in a position to favorably judge Pearson's character based on the history of his actions without having any personal connections to him. FWIW I completely agree with Munger's comments about VRX. The only second level analysis that makes sense here is to go long HLF when Ackman needs to close out his position to cover redemptions at the end of the year.

 

You've hit the nail on the head. Has anyone spoken to current/former VRX staff about Pearson? Has anyone spoken to Pearson's ex co-workers at McKinsey?

If not, then saying "Pearson's a man of integrity" is just a whole lot of uninformed hand-waving.

Show me the data.

 

McKinsey guy on Twitter just tweeted out a bunch of good things about him in the past few days.

 

Don't know how anecdotes are data though.

 

Yes it isn't a bet on Pearson's character alone.  It's the whole network of people involved.  A guy in the CEO's seat needs a lot of help from his lieutenants to orchestrate a fraud.

[ZenaidaMacroura]

 

I dont understand how anyone on this board is in a position to favorably judge Pearson's character based on the history of his actions without having any personal connections to him. FWIW I completely agree with Munger's comments about VRX. The only second level analysis that makes sense here is to go long HLF when Ackman needs to close out his position to cover redemptions at the end of the year.

 

Obviously this is just twitter/any ole kook can be posting but I thought this was interesting:

 

http://imgur.com/lekUrQy

[returnonmycapital]

Shorts aside, how does an investor, with margin of safety in mind, not conclude that the success of this investment depends almost entirely on the sustainable value of the firm’s intangibles and the ability of the firm to grow them with leverage?

 

First, is the firm overpaying for intangibles?

 

Assets per share are $140 (intangibles of $116) of which the firm generates approximate annual sales of a little over $30. Using owner earnings (GAAP earnings + dep/amort – additions to ppe) and a liberal net margin of 25% of sales, the return on assets comes to about 5%. Valeant is paying more than 20 times earnings for assets (the vast majority of which are intangible). 

 

Next, is the firm using too much debt to pay for intangibles?

 

The share count hasn’t changed dramatically since 2010 despite the per-share addition of more than $100 of assets. Debt has risen from $12 per share to now $90 per share (equity, from $16.25 to $18.50 and no dividends).

 

Finally, is the stock cheap?

 

For a firm with assets to equity of 9 times (similar to a bank) and a return on assets of 5% (and 83% of assets intangible) why is a stock that is currently priced at about 6 times book considered cheap?

 

I suppose the answer is future growth. But then Valeant would need to be able to leverage itself even more on terms similar (but not worse) to its past acquisitions and at an interest cost of less than 5%. It has happened so perhaps it will continue, but at some point acquisitions get tough (Allergan?) and/or the debt costs associated with them become more expensive. Or worse, equity is used.

 

Speaking of equity, what is the risk that some goodwill, which now measures almost 3 times equity, gets written off? It’s not zero. Any writedown would materially affect book value which might cause pressure on debt, the alleviation of which would require new share issuance and subsequent dilution to equity holders.

 

The recent talk of a move toward internal product development would likely result in net margin contraction. J&J spends more than 11% of sales on R&D, Merck spends 17%; Valeant spend 3% of sales on R&D.

 

I just don’t get what others find so obviously good about Valiant as an investment.

 

[ATLValue]

I think Pearson's character is immaterial for this business. If you want to judge character check out valueact guys. If not Pearson, they will get someone else. The board will set the milestones and the CEO's job is to execute against it.

 

If Pearson can't execute, they will find someone else who can - it is that simple.

 

I dont understand how anyone on this board is in a position to favorably judge Pearson's character based on the history of his actions without having any personal connections to him. FWIW I completely agree with Munger's comments about VRX. The only second level analysis that makes sense here is to go long HLF when Ackman needs to close out his position to cover redemptions at the end of the year.

 

You've hit the nail on the head. Has anyone spoken to current/former VRX staff about Pearson? Has anyone spoken to Pearson's ex co-workers at McKinsey?

If not, then saying "Pearson's a man of integrity" is just a whole lot of uninformed hand-waving.

Show me the data.

 

McKinsey guy on Twitter just tweeted out a bunch of good things about him in the past few days.

 

Don't know how anecdotes are data though.

 

Yes it isn't a bet on Pearson's character alone.  It's the whole network of people involved.  A guy in the CEO's seat needs a lot of help from his lieutenants to orchestrate a fraud.

 

Check out page 10

 

http://www.allergan.com/miscellaneous-pages/allergan-pdf-files/investor-presentation-may-27-2014

 

[ERICOPOLY]

 

For a firm with assets to equity of 9 times (similar to a bank) and a return on assets of 5% (and 83% of assets intangible) why is a stock that is currently priced at about 6 times book considered cheap?

 

 

ROA at KO is fucking terrible if you measure it the way you do.

 

 

[ERICOPOLY]

In other words, if Berkshire were to wholly acquire KO for the present market cap of $186B, the entire $186B would be an asset on Berkshire's books.

 

Most of that asset would be intangible.

 

You would be arguing that the return on assets is aweful because you are counting the intangibles in those assets.

[ERICOPOLY]

For a firm with assets to equity of 9 times (similar to a bank)

 

Well, if you set about the approach of calling 100% of market cap an "asset", then the S&P500 trades at 1x book value.

 

It also inflates the asset to equity ratio of the S&P500, and then you find yourself getting relatively closer to the entire market being compared to a "bank".

 

So there might be something there to think about further before you apply it to VRX.

[returnonmycapital]

Alright, why is a 6% earnings yield ($6.75/sh owner eps / $115/sh current market value) considered cheap?

[ERICOPOLY]

Alright, why is a 6% earnings yield ($6.75/sh owner eps / $115/sh current market value) considered cheap?

 

I am expecting a high growth rate in the earnings, but I'm not paying a premium for that.  Normally, I stay away from high growth in earnings stocks because the growth is priced into the stock.  Prior to the recent selloff, there was more of that growth priced into the stock and today there isn't.

 

[Liberty]

Alright, why is a 6% earnings yield ($6.75/sh owner eps / $115/sh current market value) considered cheap?

 

Because the real earning power isn't $6.75.

[Picasso]

Because there's a lot more than 6% of earnings yield.  Restructuring costs are rolling off, there's organic growth, inventory issues being worked off from Salix, etc.  The earnings yield is greater than 10%.  The question becomes how much future capital VRX has to deploy to incrementally grow that earnings yield.  That's debatable since they're locked out of the capital markets until perception changes.

[returnonmycapital]

I've read the posts, but then I went and looked at their financial statements over the last few years and did not come to the same conclusions as you fellows; as highlighted below:

 

"I suppose the answer is future growth. But then Valeant would need to be able to leverage itself even more on terms similar (but not worse) to its past acquisitions and at an interest cost of less than 5%. It has happened so perhaps it will continue, but at some point acquisitions get tough (Allergan?) and/or the debt costs associated with them become more expensive. Or worse, equity is used.

 

Speaking of equity, what is the risk that some goodwill, which now measures almost 3 times equity, gets written off? It’s not zero. Any writedown would materially affect book value which might cause pressure on debt, the alleviation of which would require new share issuance and subsequent dilution to equity holders.

 

The recent talk of a move toward internal product development would likely result in net margin contraction. J&J spends more than 11% of sales on R&D, Merck spends 17%; Valeant spend 3% of sales on R&D."

 

I actually find it surprising that the market allowed the balance sheet to get where it is. I'll keep reading your posts and try to open my mind, but the only thing obvious to me at present is that things will have to change, and maybe even soon.

[ERICOPOLY]

Speaking of equity, what is the risk that some goodwill, which now measures almost 3 times equity, gets written off?

 

Show me a company that doesn't have any economic goodwill, and we'll agree it's a turd.  So let's own it!  No risk of goodwill declining.

 

[Picasso]

I think there's a bit of confusion around the debt levels.  AT 4-5x EBITDA, it sounds high especially when you think about how large $30 billion is.

 

But when you compare EBITDA on VRX versus another levered entity, say KMI, taxes on VRX are very, very low as long as they can strip out geographic earnings.  So if they have the debt, taxes are low and if debt is low then tax rates will be higher.  Also KMI has much higher levels of capex and depreciation.  So a comparable 4-5x on VRX is probably closer to 3-3.75x on another entity.

[Liberty]

To paraphrase Malone, it's better to pay interest and restructuring charges than tax.

[ERICOPOLY]

I was able to add even more VRX throughout the day because BAC rallied hard -- BAC's puts are cheap at $16 strike, so I bought those instead of buying any VRX puts.

 

I know, it goes down too.  Just exciting day regardless. 

 

It can be difficult to sex a chick when they hatch -- but once it's crowing it's gets a bit obvious.

 

[Picasso]

I'm amazed by how the market shifts the narrative or how it views the capital structure.

 

You have a stock like Transdigm levered 7x and the market doesn't bat an eye.  Debt yields 5% on CCC, stock trades at a "full" multiple.  Or the Berkshire holding CHTR, or Buffett's new baby KHC, or 3G's QSR.  Those are all very levered stocks with huge intangibles and yet the market is okay focusing on the returns of the levered equity.

 

Then you have Valeant which is levered a lot less at say 4x in 2016 but the market is tunnel visioned over the intangibles and $30 billion of debt.  It wasn't that long ago that the market was more focused on the levered equity returns.  What, maybe four months ago everything was business as usual?

 

It seems like Kinder Morgan is making that transition as well.  Not long ago it was a great business with 90% fee based contracts and the 6x leverage was no big deal.  Now investors are focusing more on the $45 billion of debt versus the dividend yield on the stock. 

 

That's probably the biggest problem with these public market versions of private equity.  A stubbed toe shifts the narrative and the business suddenly has to operate defensively.  You just never know what might cause that to happen.  That said, out of all the "private equity" stocks out there, Valeant is now the cheapest even on an EV/EBITDA basis.

[Liberty]

I'm amazed by how the market shifts the narrative or how it views the capital structure.

 

You have a stock like Transdigm levered 7x and the market doesn't bat an eye.  Debt yields 5% on CCC, stock trades at a "full" multiple.  Or the Berkshire holding CHTR, or Buffett's new baby KHC, or 3G's QSR.  Those are all very levered stocks with huge intangibles and yet the market is okay focusing on the returns of the levered equity.

 

Then you have Valeant which is levered a lot less at say 4x in 2016 but the market is tunnel visioned over the intangibles and $30 billion of debt.  It wasn't that long ago that the market was more focused on the levered equity returns.  What, maybe four months ago everything was business as usual?

 

It seems like Kinder Morgan is making that transition as well.  Not long ago it was a great business with 90% fee based contracts and the 6x leverage was no big deal.  Now investors are focusing more on the $45 billion of debt versus the dividend yield on the stock. 

 

That's probably the biggest problem with these public market versions of private equity.  A stubbed toe shifts the narrative and the business suddenly has to operate defensively.  You just never know what might cause that to happen.  That said, out of all the "private equity" stocks out there, Valeant is now the cheapest even on an EV/EBITDA basis.

 

CHTR is a great example of a company that if someone just quickly looks at it, the leverage may seem high, the GAAP numbers are crap, the FCF is low, capex elevated, etc.. But you have to look at where they are going, understand what's actually going on underneath the numbers, go to the real economics, and what the normalized earning power of the business could be. Then you have the M&A picture making things even less clear... Not for everyone either.

[Picasso]

Right, and someone could point to Charter going through bankruptcy in the past or Rich Kinder's link to Enron etc etc.  You have to understand the business strategy and economics, what fat can be cut and what can't. You can't lever equity returns in every industry and a lot of investors seem to have issue with the fact this is being done in the pharma industry.

 

I found it interesting that the ex-medtronic CEO who was bashing Valeant and Pearson on CNBC has a son who works at Alcon. In the same interview they stated how LLY spent $40 billion on R&D and had nothing to show for it, yet the blasted Valeant for spending 3-4% without looking at the differences in the business/product mix. I suppose we'll see if this is a viable thing in the pharma industry but so far people seem to hate the idea.

[Liberty]

I found it interesting that the ex-medtronic CEO who was bashing Valeant and Pearson on CNBC has a son who works at Alcon. In the same interview they stated how LLY spent $40 billion on R&D and had nothing to show for it, yet the blasted Valeant for spending 3-4% without looking at the differences in the business/product mix. I suppose we'll see if this is a viable thing in the pharma industry but so far people seem to hate the idea.

 

I saw the Alcon link on Twitter. Huge conflict of interest that wasn't disclosed. Alcon has been losing share to the newly invogorated Bausch & Lomb..

 

See here: https://twitter.com/CaraOriel/status/657544115257778176

 

And he's not just a 2-bit player at Alcon either:

 

http://www.alcon.com/docs/BioJeffGeorge.pdf

 

I think Valeant really is bad at PR. If I was them, from day 1 I'd have repeated again and again that when you make an acquisition, the vast majority of the price isn't going to employees and real estate and computers and desks, it's a way to pay for assets that are basically embedded R&D. So whether you spend money on internal or external R&D, the money is still making its way to people in labs creating new assets. Like how larger miners will buy juniors when they find something; the money is still going into exploration, even if indirectly.

 

To be fair, VRX has been saying that, but not in a way that people understood. Certainly not in a way that is as catchy as the "they just slash R&D" headlines. They phrase it as "we are agnostic about where we source innovation, it doesn't have to be internal", but that doesn't make the idea clear to most observers.

[KCLarkin]

I think Valeant really is bad at PR.

 

Pearson is an engineer. Engineers generally think PR and marketing are evil. Just ask thomas peterffy.

 

The fun thing is that everyone is attacking Valeant's business model. But of course, all the major pharma companies acquire or in-license drugs. All pharma companies raise prices.  Gilead bought Sovaldi and promptly doubled the price. The only real difference is that Valeant is a value investor.

 

http://www.nature.com/nrd/journal/v9/n3/full/nrd3078.html

 

Indeed, for every dollar lost in declining product revenues due to patent expirations by 2012, it has been estimated that large-cap pharmaceutical companies will only be able to replace on average 26 cents with new product revenues. Simply stated, without a dramatic increase in R&D productivity, today's pharmaceutical industry cannot sustain sufficient innovation to replace the loss of revenues due to patent expirations for successful products.

 

http://www.valeant.com/Portals/25/PDF/Valeant's-Perspectives-on-RandD.pdf

 

Only 4 of today's top 50 products were discovered, developed, and commercialized internally by "Big Pharma"

[APG12]

They should try to explain, in non-economic terms, what it means to get a low return on R&D investment. It means that the valuable time of extremely smart people is being directed towards the development of something which people do not value very much. It means that some of the most precious human effort is being wasted.

[Jurgis]

They should try to explain, in non-economic terms, what it means to get a low return on R&D investment. It means that the valuable time of extremely smart people is being directed towards the development of something which people do not value very much. It means that some of the most precious human effort is being wasted.

 

This is completely incorrect explanation. R&D yields low return not because "valuable time of extremely smart people is being directed towards the development of something which people do not value very much" but because finding drugs that work and are safe is extremely difficult. It is possible to spend hundreds of millions of $ and tens/hundreds of person years on a promising direction that could yield a highly needed drug and yet have negative results.