VRX - Valeant Pharmaceuticals International Inc.

[KCLarkin]

If Valeant clinches the deal for Allergan, its shares could rally to $200 based on the potential to cut costs dodge U.S. taxes, Tobin says. If it doesn't go through -- and the odds are rising that it won't -- he sees the stock falling to $70.

 

Maybe I am dense but shouldn't Valeant trade higher if the deal falls apart? There are a number of arbs who are short VRX / long AGN. They will need to unwind their shorts if the deal falls through.

[Guest wellmont]

look at the source before taking action: "hedgeye" risk management....

[Liberty]

If Valeant clinches the deal for Allergan, its shares could rally to $200 based on the potential to cut costs dodge U.S. taxes, Tobin says. If it doesn't go through -- and the odds are rising that it won't -- he sees the stock falling to $70.

 

Maybe I am dense but shouldn't Valeant trade higher if the deal falls apart? There are a number of arbs who are short VRX / long AGN. They will need to unwind their shorts if the deal falls through.

 

And if the deal is off the table, Valeant will start buybacks. They even mentioned it during Q&A of a recent event.

 

I find the idea that without this deal VRX is in bad shape strange. Imagine an alternate timeline where they never went after AGN. They'd just have kept doing what they were doing before, which seemed to be working just fine. Sure, a big merger of equals is a great ways to potentially create a lot of value all at once via operations and tax synergies and to delever, but they don't need it. Look at the rate at which they've been adding bolt-ons this year, add to that more mid-sized deals like B&L, and they can deploy a lot of capital. They've had deals that they walked away from in the past and it wasn't the end of the world... In fact, it's a very good sign showing that they're disciplined and won't overpay.

 

It would just be too bad if Allergan succeeded in killing the deal against the will of their own shareholders, because that kind of crazy corporate bylaw model will spread and be used by other companies to make it impossible for an acquirer to go directly to the company's shareholders.

[KCLarkin]

And if the deal is off the table, Valeant will start buybacks. They even mentioned it during Q&A of a recent event.

 

Even without buybacks, they will pay down debt. I'd rather have them pay down debt so they can do an all cash acquisition next time.

[Liberty]

And if the deal is off the table, Valeant will start buybacks. They even mentioned it during Q&A of a recent event.

 

Even without buybacks, they will pay down debt. I'd rather have them pay down debt so they can do an all cash acquisition next time.

 

If they consider the stock very undervalued, opportunistic buybacks would be better first, IMO. They can pay down debt when the stock is less overvalued.

[KCLarkin]

If they consider the stock very undervalued, opportunistic buybacks would be better first, IMO. They can pay down debt when the stock is less overvalued.

 

True. If it does really fall below $100 buybacks would be much better. I was assuming the price would bounce higher if the deal falls through.

[Liberty]

If they consider the stock very undervalued, opportunistic buybacks would be better first, IMO. They can pay down debt when the stock is less overvalued.

 

True. If it does really fall below $100 buybacks would be much better. I was assuming the price would bounce higher if the deal falls through.

 

Absolutely. It all depends on how Mr. Market reacts. A zillion arbs would cover their shorts, but the media would probably spin this as a big disaster for the company (they care more about the "politics" of these deals than the per share value, and it looks bad when you don't get to do a big deal), so sentiment could be negative for a while. Who knows.

 

 

[Liberty]

ValueAct basically says "VRX doesn't need to do AGN deal, though it would be nice":

 

https://news.yahoo.com/exclusive-valueact-ceo-says-valeant-does-not-buy-163021723--sector.html

[peridotcapital]

Curious how most people are valuing this company when coming to the conclusion that it's a bargain right now. Assuming no Allergan deal it looks like the standalone business generates about $1.5B of FCF annually. Even at $107/share, the market cap is $36B and the enterprise value is $53B. That doesn't look cheap to me. Why are we willing to pay 24x FCF for this? Is it mostly due to the potential for future deal accretion?

[Liberty]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

[Picasso]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

 

When those one-time costs run off, what do you get in free cash flow assuming there are no other acquisitions?

[peridotcapital]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

 

So despite the fact that their business model is to do deals to grow (vs R&D), you are excluding M&A costs from your valuation? Seems to me there will always be M&A costs... they might be one-time in nature for each target, but as long as perpetual M&A is the core strategy, those costs are unlikely to go away. Would it not then make sense to include them in one's valuation model?

 

Put another way, excluding them is like saying, I'm going to exclude R&D costs from my valuation because the R&D is an investment in new, future products that have yet to materialize, and therefore have little to do with the existing standalone business.

[Liberty]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

 

When those one-time costs run off, what do you get in free cash flow assuming there are no other acquisitions?

 

I think they should be able to fairly easily do over 3bn in 2015 without Allergan, but that's with some bolt-ons.

[Liberty]

So despite the fact that their business model is to do deals to grow (vs R&D), you are excluding M&A costs from your valuation? Seems to me there will always be M&A costs... they might be one-time in nature for each target, but as long as perpetual M&A is the core strategy, those costs are unlikely to go away. Would it not then make sense to include them in one's valuation model?

 

Put another way, excluding them is like saying, I'm going to exclude R&D costs from my valuation because the R&D is an investment in new, future products that have yet to materialize, and therefore have little to do with the existing standalone business.

 

This has been discussed before. The business doesn't optimizes for GAAP, it optimizes for cash flows and per share value. The restructuring costs aren't excluded, they are part of acquisition costs and then they look at what return they can get on the whole price. If it's a very high IRR, that's worth doing and creating value, if not, they pass on it.

 

If they stopped doing any acquisitions, GAAP and their adjusted figures would converge, so it would look better, but less value would be created because they have a great track record of M&A. With no M&A, overall growth would be lower, but the debt would melt over time so the multiple the market is willing to pay would probably go up (and they could use the FCF for buybacks). M&A not absolutely necessary.

 

In other words, there's no real economic difference between paying 500m and then expensing 500m for restructuring charges to earn 300m a year than paying 1bn upfront to earn 300m a year, except in the latter case it looks like you're earning 500m less during the restructuring period (which shields taxes).

 

If the restructuring charges were always there for the same businesses, this would be terrible and the adjustments to figure out the earning power would be a sham. But always having restructuring charges for different businesses as they are acquired is fine, as long as once the restructuring ends you really have the synergies you expected. It's just part of the real economic cost of acquisition of those individual businesses.

 

I don't see this as replacing R&D. Other pharmas/healthcare companies do a lot of acquisitions too, and don't have much better organic growth than Valeant, if not inferior (hard to say because they don't break it down) because VRX only focus on above-average markets (though even that depends how you look at it -- Valeant likes to buy end of life drugs cheaply and operate them as high IRR runoffs, so it masks a lot of their growth in the 'durable' part of the portfolio, but it is profitable). VRX has a very nice pipeline of big new products coming. M&A is another engine on top of very cost-effective R&D, IMO.

[loganc]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

 

So despite the fact that their business model is to do deals to grow (vs R&D), you are excluding M&A costs from your valuation? Seems to me there will always be M&A costs... they might be one-time in nature for each target, but as long as perpetual M&A is the core strategy, those costs are unlikely to go away. Would it not then make sense to include them in one's valuation model?

 

Put another way, excluding them is like saying, I'm going to exclude R&D costs from my valuation because the R&D is an investment in new, future products that have yet to materialize, and therefore have little to do with the existing standalone business.

 

I think you have two options to value the business:

 

(1) Look at a "steady state" model of FCF where you assume no additional acquisitions and project conservative organic revenue growth.  In the "steady state" condition, the "one time" acquisition costs can genuinely be modeled as one time items.

 

(2) Assume an ongoing acquisition model of FCF where you include the "one time" items as an ongoing expense but then include higher revenue growth from the acquisitions. 

 

I think either one is fine, but I find model (1) to be easier for me to work with and more conservative.  Also, I believe that the bears generally want to combine models (1) and (2) where they include the "one time" acquisition costs in (2) with the more conservative revenue growth in (1).  I don't think this is a reasonable set of assumptions to use when you model the company.

[peridotcapital]

You need to separate many one-time costs, which are really part of the cost of acquisitions, from the real earning power of the business (that's how they look at acquisition costs to calculate IRRs, upfront cost + cost of all synergies -- if they need to spend 100m once to get 50m in recurring synergies, this masks the earning power but is still totally worth it ROI-wise, and is tax-deductible too).

 

So despite the fact that their business model is to do deals to grow (vs R&D), you are excluding M&A costs from your valuation? Seems to me there will always be M&A costs... they might be one-time in nature for each target, but as long as perpetual M&A is the core strategy, those costs are unlikely to go away. Would it not then make sense to include them in one's valuation model?

 

Put another way, excluding them is like saying, I'm going to exclude R&D costs from my valuation because the R&D is an investment in new, future products that have yet to materialize, and therefore have little to do with the existing standalone business.

 

I think you have two options to value the business:

 

(1) Look at a "steady state" model of FCF where you assume no additional acquisitions and project conservative organic revenue growth.  In the "steady state" condition, the "one time" acquisition costs can genuinely be modeled as one time items.

 

(2) Assume an ongoing acquisition model of FCF where you include the "one time" items as an ongoing expense but then include higher revenue growth from the acquisitions. 

 

I think either one is fine, but I find model (1) to be easier for me to work with and more conservative.  Also, I believe that the bears generally want to combine models (1) and (2) where they include the "one time" acquisition costs in (2) with the more conservative revenue growth in (1).  I don't think this is a reasonable set of assumptions to use when you model the company.

 

That's a good way of thinking about it. I'd probably use model 2 just because that way I don't need to worry about the transparency of what is going into the one-time bucket. Plus I feel better about using actual cash generation, which is what shareholders will be left with assuming the business model doesn't change. Hypothetical free cash flow that won't actually be realized given the M&A strategy seems irrelevant. But in either case, if they don't get Allergan and can still generate $3B of real/actual FCF in 2015 anyway, I can see why the stock here would be interesting.

[KCLarkin]

Curious how most people are valuing this company when coming to the conclusion that it's a bargain right now. Assuming no Allergan deal it looks like the standalone business generates about $1.5B of FCF annually. Even at $107/share, the market cap is $36B and the enterprise value is $53B. That doesn't look cheap to me. Why are we willing to pay 24x FCF for this? Is it mostly due to the potential for future deal accretion?

 

I haven't done all the work yet because it was out of my price range until recently but I could look at this in a few ways:

- 24x FCF = 4% yield growing organically at 10% (optimistic estimate). That's a 14% annual return.

- 24x FCF = 4% yield growing inorganically at 25%. That's a 29% annual return.

- VRX EV/EBITDA = KO EV/EBITDA. Would I rather own VRX or KO?

- Cash PE = 15. Cash ROE = 35%.

 

So your expected annual return is 4% to 29%. In a world of 2.5% yields, that seems attractive.

 

I see a great business selling at a fair price. Seems to me like you are getting the inorganic accretion as a free option. Based on their track record, I think that option has value.

[Guest wellmont]

back of the envelope

 

ebita ~ FCF  = $9

[Liberty]

http://dealbook.nytimes.com/2014/08/12/in-allergan-fight-a-focus-on-clever-strategy-overshadows-the-goal/

[loganc]

http://dealbook.nytimes.com/2014/08/12/in-allergan-fight-a-focus-on-clever-strategy-overshadows-the-goal/

 

I feel like that was a pretty "even handed" article relative to a lot of the other stuff written on dealbook and other outlets. 

 

Also, given the fact that Hempton is doing victory laps on twitter, it is probably a good time to reload.  I believe his criticism was that VRX can't cover the interest payments on a GAAP basis, whatever that means.

 

Edit:  If anyone here can show me that VRX is a credit risk on a "GAAP basis" with math, I am happy to hear it.

[topofeaturellc]

Well if you think GAAP is reflective of the underlying of the business and that D&A approximate Capex + WC over time then its not really stretch to say a company with  less than 1x EBIT cover is "a credit risk on a GAAP basis"

 

 

[rpadebet]

Well if you think GAAP is reflective of the underlying of the business and that D&A approximate Capex + WC over time then its not really stretch to say a company with  less than 1x EBIT cover is "a credit risk on a GAAP basis"

 

Their debt trades at a premium with a yield of about 5.5% and spread of approx 320 bps. This doesn't scream like credit risk to me. Maybe even the credit markets are missing the GAAP credit risk.

[Guest wellmont]

Well if you think GAAP is reflective of the underlying of the business and that D&A approximate Capex + WC over time then its not really stretch to say a company with  less than 1x EBIT cover is "a credit risk on a GAAP basis"

 

that's just it. if there is any business out there where GAAP is not reflective of the underlying business it's $vrx. It seems to me that the bears are resting their entire case on the reporting not being GAAP and being "funny". but there are a lot of very very smart number crunchers who own a ton of this that believe otherwise. The bears are fortunate actually that there are many business journalists who don't really understand the nuances of GAAP vs Non Gaap, and are skeptical of stuff like cash earnings. They see GAAP losses and wonder how this business is staying solvent. This is a reason why stocks stay undervalued and misunderstood for very long times, and thus create opportunity for enterprising investors.  The false cost of amortization has made think-for-themselves investors a ton of money over the years.

[topofeaturellc]

I can actually think that Hempton's bear case as stated in his posts is idiotic (and I actually think his real bear case is different, but he needs people to disbelieve mgmt to get the short to work), and also think VRX is a terrible idea. And you guys can disagree with either or both of those things.  I'm just saying the statement that on a GAAP basis you could argue there is credit risk is not some insane idea.  There is no embedded statement from me on the value of GAAP accounting wrt to VRX.

 

That said - I think you guys are crazy to be so confident in this idea. Its just an industrial roll-up ported over to Pharma that you paying a very rich multiple of CF for right now.  There's no magic here.  If the roll-up works you'll get paid until it stops working, and once it stops working. Look out below.

[topofeaturellc]

Well if you think GAAP is reflective of the underlying of the business and that D&A approximate Capex + WC over time then its not really stretch to say a company with  less than 1x EBIT cover is "a credit risk on a GAAP basis"

 

that's just it. if there is any business out there where GAAP is not reflective of the underlying business it's $vrx. It seems to me that the bears are resting their entire case on the reporting not being GAAP and being "funny". but there are a lot of very very smart number crunchers who own a ton of this that believe otherwise. The bears are fortunate actually that there are many business journalists who don't really understand the nuances of GAAP vs Non Gaap, and are skeptical of stuff like cash earnings. They see GAAP losses and wonder how this business is staying solvent. This is a reason why stocks stay undervalued and misunderstood for very long times, and thus create opportunity for enterprising investors.  The false cost of amortization has made think-for-themselves investors a ton of money over the years.

 

I don't think most people take issue with the amortization, so much as the restructuring charges. Although one could argue that in context of the P&L the amortization is economic if you believe the reduction in R&D implies gradually declining products.

 

The issue of GAAP vs Non-GAAP is nowhere near as black and white as either the bulls or bears would like to portray it.