VRX - Valeant Pharmaceuticals International Inc.

[Liberty]

Here's the audio file for anyone who wants it:

 

https://www.dropbox.com/s/gtio6sf5b18oci2/2015-jan-VRX-guidance.m4a?dl=0

[jay21]

Quick question on Ackman if anyone has followed him closely: Has he ever praised any CEOs the way he has Pearson (maybe the 3G team)? He is usually the activist trying to replace underperforming mgmt like at CP and PG.

 

Not that I am substituting his judgement for my own but he seems to have a good eye. Although, I do think that big investors definitely have an edge over smaller ones in this area. The amount of access they get to management is very surprising.

 

I am just trying to see what his track record is for assessing mgmt quality. Thanks

[Liberty]

Just reading the slide deck, I love this management team. They are basically focusing on re-deploying their earnings mainly into small/medium acquisitions. Without issuance of more debt for a large acquisition, this will bring down their EBIT/E ratio over the next 18 months. This will eventually lead to a large acquisition.

 

And in the meantime, earnings grow 10% organically, and the earnings redeployed into small/medium acquisitions have an IRR of 20%. So 30% growth while the business model gets "confirmed" by the market and EBIT/E gets reduced. Then of course they go in for the kill on a large acquisition.

 

Life could be worse.

 

As Pearson said, the vast majority of all their acquisitions so far have been small and medium private businesses. That's not changing. They've tried to do a few public companies in the past, and will no doubt try a few more in the future, but I think it's erroneous for people to suddenly expect them to go after a lot more Allergan-type deals all of a sudden and change their strategy.

 

They have a 300m FX headwind, so the guidance is pretty strong if you adjust for that. They have more international than many others. Sometimes that helps, sometimes it hurts, but the underlying businesses, regardless of FX, seem to grow really fast.

 

And of course, the guidance assumes no new M&A and no pricing gains, which we know is not realistic. They'll beat it, probably by a mile.

[Liberty]

Quick question on Ackman if anyone has followed him closely: Has he ever praised any CEOs the way he has Pearson (maybe the 3G team)? He is usually the activist trying to replace underperforming mgmt like at CP and PG.

 

Not that I am substituting his judgement for my own but he seems to have a good eye. Although, I do think that big investors definitely have an edge over smaller ones in this area. The amount of access they get to management is very surprising.

 

I am just trying to see what his track record is for assessing mgmt quality. Thanks

 

Off the top of my head, he did praise Hunter Harrison to a similar level.

[moody202]

And in the meantime, earnings grow 10% organically, and the earnings redeployed into small/medium acquisitions have an IRR of 20%. So 30% growth while the business model gets "confirmed" by the market and EBIT/E gets reduced. Then of course they go in for the kill on a large acquisition.

 

I am not following how you add the 10% to 20% to come up with 30% growth. The 20% IRR is on much smaller capital that is deployed for acquisition!

 

Quick question on Ackman if anyone has followed him closely: Has he ever praised any CEOs the way he has Pearson (maybe the 3G team)? He is usually the activist trying to replace underperforming mgmt like at CP and PG.

 

My sense is that Ackman has been much more reserved about praising Pearson since the deal fell apart. On CNBC yesterday he did't go as far in praise of Pearson as he did previously. Anyone else notice that?

[Liberty]

My sense is that Ackman has been much more reserved about praising Pearson since the deal fell apart. On CNBC yesterday he did't go as far in praise of Pearson as he did previously. Anyone else notice that?

 

He could be looking for a way to get back in, so it's not to his advantage to praise the company too much and increase the price.

 

He did say last year that his ultimate goal was to be a long-term Valeant shareholder, and he tried to make it one of his biggest positions (if not his biggest) and elected to take all-stock on the AGN deal. I doubt he's changed his mind since.

[giofranchi]

I have been thinking about how to value Valeant, and have concluded that if the stock moves around +/- 30% it doesn't make a huge difference. The key with Valeant is the strength of the business model - if you believe in that, that is a huge margin of safety. Just let that work for 7 or so years and the stock should quadruple or so.

 

I agree.

Though waiting could be costly with such an high quality business like VRX, I still want to see how they manage to increase EPS organically and to reduce debt during the next 12 to 18 months.

Then, I would be much more confident about their business model, and I will surely pull the trigger again.

The same is true for Endo.

 

Gio

 

[original mungerville]

I have been thinking about how to value Valeant, and have concluded that if the stock moves around +/- 30% it doesn't make a huge difference. The key with Valeant is the strength of the business model - if you believe in that, that is a huge margin of safety. Just let that work for 7 or so years and the stock should quadruple or so.

 

I agree.

Though waiting could be costly with such an high quality business like VRX, I still want to see how they manage to increase EPS organically and to reduce debt during the next 12 to 18 months.

Then, I would be much more confident about their business model, and I will surely pull the trigger again.

The same is true for Endo.

 

Gio

 

Yes, I think waiting will be very costly.

[original mungerville]

Just reading the slide deck, I love this management team. They are basically focusing on re-deploying their earnings mainly into small/medium acquisitions. Without issuance of more debt for a large acquisition, this will bring down their EBIT/E ratio over the next 18 months. This will eventually lead to a large acquisition.

 

And in the meantime, earnings grow 10% organically, and the earnings redeployed into small/medium acquisitions have an IRR of 20%. So 30% growth while the business model gets "confirmed" by the market and EBIT/E gets reduced. Then of course they go in for the kill on a large acquisition.

 

Life could be worse.

 

As Pearson said, the vast majority of all their acquisitions so far have been small and medium private businesses. That's not changing. They've tried to do a few public companies in the past, and will no doubt try a few more in the future, but I think it's erroneous for people to suddenly expect them to go after a lot more Allergan-type deals all of a sudden and change their strategy.

 

 

I am not sure I agree with your characterisation Liberty. Would it not be fair to say the vast majority of acquisitions (in terms of numbers) so far have been small/medium, but in terms of capital deployed - at the time it was acquired - Bausch would have been pretty big for Valeant relative to all the small ones up to that point.

 

Similarly, going forward they are going to do a bunch of small/medium ones mainly using earnings power as capital while keeping the leverage ratio stable at these levels (so some debt may be used which will permit a few significant mediums). But at some point, once their stock is high enough, and their leverage is on the low end, I think they will do a large one.

 

I get the feeling it is Pearson's aspiration at some point to do a large one (given last year he mentioned being a top pharma company in short order - although he took that back; also on the conference call today he was asked if he would Valeantacize a big pharma at some point, and he declined to comment instead of simply saying "no"). 

 

Having said that, they don't need a large one to be successful and a large one could be riskier than a bunch of mediums. In any case he is very disciplined and rational, as is their major shareholder, and parts of their board. So we are in good hands I believe.

[original mungerville]

And in the meantime, earnings grow 10% organically, and the earnings redeployed into small/medium acquisitions have an IRR of 20%. So 30% growth while the business model gets "confirmed" by the market and EBIT/E gets reduced. Then of course they go in for the kill on a large acquisition.

 

I am not following how you add the 10% to 20% to come up with 30% growth. The 20% IRR is on much smaller capital that is deployed for acquisition!

 

 

Well $100 in earnings power used to make an acquisition at an IRR of 20% means next year and every year after that you will have the original $100 in earnings plus $20 per year. On top of that, you have the original $100 which was going to grow 10% annually. So you end up with 130 in earnings one year out, 169 in earnings two years out, etc. ie 30% growth.

 

Now, I actually think that organic growth might come in lower than 10% but that acquisition growth will come in higher than 20% - as Pearson's 20% IRR target for acquisitions uses the statutory rate of the domicile of the acquiree. That is to say maybe something like 20-35% tax is the going in assumption on an acquisition whereas Valeant's tax rate is 5% right now, and will not likely ever get higher than 10%. So that's another 10-30% you have to add on to the IRR. Pick a number, but that number is north of 20%. So even if organic growth comes in at 5%, I think earnings can still grow 30% as long as they keep deploying their full earnings into acquisitions every year.

 

Now, what happens if they don't? Well growth slows like it did over the past 12 months. That just doesn't matter because in this scenario, they just pay down debt which just gets the dry powder ready for a larger acquisition the following year (say deploying 2 years of earnings power at once).

 

So any way I look at it, I see 30% growth annually on average.

[original mungerville]

By the way, this is also why Valeant will not use earnings to pay down debt in order to get the leverage down (other than very opportunistically).

 

The reason for this is that for shareholders, the better way to get the leverage down is by increasing the earnings power by taking the full earnings power every year and acquiring at an IRR of 25-30% (this includes the tax benefits). They have leverage of 3.5x as of Q4. If you do the foregoing for three years, all of a sudden you have grown earnings 30% annualized without additional debt issuance or assuming any maturities. So earnings grow to over twice what they were. As such, the leverage drops below 1.6x or something (ie it drops by a little more than 50%). 

 

The leverage is high for me, however, I get comfortable with the leverage purely due to the strength of the business model and the discipline in terms of price paid for acquisitions.

 

Its pretty rare that you get this type of rationality applied to an industry that has so much cost to cut. It seems worth investing in for the long-haul in a material way.

[giofranchi]

Yes, I think waiting will be very costly.

 

Most probably it will!

 

But this goes well beyond VRX… Let me explain:

 

Imo we all invest in a wide range of industries and enterprises… without having a true knowledge about those industries and enterprises… by “true knowledge” I mean that very seldom we are insiders, very seldom we manage a business in the same industry we have invested lots of capital, very seldom our own business (or the business we work for) has anything to do with those enterprises we are interested in.

 

I always keep in mind Keynes words:

One’s knowledge and experience is definitely limited and there are seldom more than two or three enterprises at any given time which I personally feel myself entitled to put full confidence.

 

Hey! Let’s be honest: I know very little about insurance (FFH), and I know very little about the money management business (OAK)… just as I know very little about the pharmaceutical industry (VRX)… I am an engineer, my field of expertise is civil and infrastructural engineering, and I run a for profit master school… what do those things have in common with insurance, the money management business, or the pharmaceutical industry?… Truth be told, very little… probably, nothing!

 

This is why, when I try to evaluate a business and its management, I always look for a very long and “perfect” track record: if I cannot ever be 100% positive about its future, at least I require that its past be crystal clear! Then what I am usually satisfied with is to make sure those conditions and the environment which led to such outstanding results in the past have not changed today, and don’t show any signs of changing for the foreseeable future.

 

Now, coming to VRX, if there is one argument the bears have pointed out, and which I might at least in part agree with, is that VRX’s organic growth track record is not so clear yet… But, for the reasons I have tried to explain, it is very important to me: VRX’s business model is basically based on the premise that a lot of waste is still present in the pharmaceutical industry, therefore they can find bargains to acquire, because later they cut unnecessary costs aggressively… Very fine! I like it a lot!… Except that, as I have said, I don’t really know the pharmaceutical industry… And therefore what could be for me the only real proof those unnecessary costs truly are nothing but a waste of resources? Well… an healthy track record in organic growth, of course! ;)

 

This is how I’ll proceed: I will keep watching VRX closely, if its business model truly is successful, and organic growth shows its success once and for all, I am sure it will be copied! Everything that’s successful gets copied, right? ENDP is already doing something similar, and it is still much smaller than VRX! If I miss the boat with VRX, I’ll have learnt my lesson well, and will be able to invest in ENDP (or in any another company that will follow in VRX’s footsteps).

 

Cheers,

 

Gio

 

[Liberty]

Just reading the slide deck, I love this management team. They are basically focusing on re-deploying their earnings mainly into small/medium acquisitions. Without issuance of more debt for a large acquisition, this will bring down their EBIT/E ratio over the next 18 months. This will eventually lead to a large acquisition.

 

And in the meantime, earnings grow 10% organically, and the earnings redeployed into small/medium acquisitions have an IRR of 20%. So 30% growth while the business model gets "confirmed" by the market and EBIT/E gets reduced. Then of course they go in for the kill on a large acquisition.

 

Life could be worse.

 

As Pearson said, the vast majority of all their acquisitions so far have been small and medium private businesses. That's not changing. They've tried to do a few public companies in the past, and will no doubt try a few more in the future, but I think it's erroneous for people to suddenly expect them to go after a lot more Allergan-type deals all of a sudden and change their strategy.

 

 

I am not sure I agree with your characterisation Liberty. Would it not be fair to say the vast majority of acquisitions (in terms of numbers) so far have been small/medium, but in terms of capital deployed - at the time it was acquired - Bausch would have been pretty big for Valeant relative to all the small ones up to that point.

 

Similarly, going forward they are going to do a bunch of small/medium ones mainly using earnings power as capital while keeping the leverage ratio stable at these levels (so some debt may be used which will permit a few significant mediums). But at some point, once their stock is high enough, and their leverage is on the low end, I think they will do a large one.

 

I get the feeling it is Pearson's aspiration at some point to do a large one (given last year he mentioned being a top pharma company in short order - although he took that back; also on the conference call today he was asked if he would Valeantacize a big pharma at some point, and he declined to comment instead of simply saying "no"). 

 

Having said that, they don't need a large one to be successful and a large one could be riskier than a bunch of mediums. In any case he is very disciplined and rational, as is their major shareholder, and parts of their board. So we are in good hands I believe.

 

I think we're saying the same thing, just differently.

[Liberty]

This is how I’ll proceed: I will keep watching VRX closely, if its business model truly is successful, and organic growth shows its success once and for all, I am sure it will be copied! Everything that’s successful gets copied, right? ENDP is already doing something similar, and it is still much smaller than VRX! If I miss the boat with VRX, I’ll have learnt my lesson well, and will be able to invest in ENDP (or in any another company that will follow in VRX’s footsteps).

 

That follows logically, but I'm not sure things will work like that.

 

As Pearson himself said in answer to a question, there's no secret to the model. Its very simple. Just like Warren Buffett, Tom Murphy, or Henry Singleton's models have been out for a long time. The reason why people don't do it is not because the models are a secret or don't have a track record, it's because it's hard to execute day-after-day, most executives don't want to do those things because they don't find them fun/they aren't in their nature, they don't have the right mindset/skills/incentives, it's hard to get the company culture right, a supportive board, etc. Models can be copied, but talented individuals cannot (yet) be cloned. Otherwise, every company would just copy the Berkshire model or whatever. But in fact, we only have a handful of successful Berkshire clones despite the fact that few companies are as admired by smart business people.

 

So I'm sure Valeant's success will have an influence on the industry (some cost cutting, more inversions, maybe some decentralization (but most managements really don't like giving up control)), but it won't spawn a bunch of Mike Pearsons. Endo is the closest thing because management comes from the Valeant team and they copied the model exactly, but even with that I don't find them as impressive as Valeant.

 

Not to say that there can't be talented followers, but I don't think it's as simple as saying "oh well, I'll just catch the next one". Who's the next Prem Watsa?

[Liberty]

Doesn't sound like Ackman will be part of the next attempt at a merger-of-equals...

 

http://business.financialpost.com/2015/01/08/valeant-pharmaceuticals-inc-moves-on-after-allergan-bill-ackman-speedbump/

 

“[Allergan] would have been a nice acquisition for us, [but] I think we marched on quite well without it,” Mr. Pearson said in an interview after the analyst call. “I view it as more of a speedbump than anything else.” [...] Valeant still enjoys a “good relationship” Mr. Ackman, but Mr. Pearson said it’s not likely Valeant will try to do another deal with him in the future.

 

“At this point, he is still an active Allergan shareholder and is focused on that,” Mr. Pearson said. “We have nothing in the works. You can never say never, but if I was ever going to say never, it would probably be on something like this.”

 

[giofranchi]

Not to say that there can't be talented followers, but I don't think it's as simple as saying "oh well, I'll just catch the next one". Who's the next Prem Watsa?

 

Maybe… But don’t exaggerate on the opposite side either… When Nole Djokovic ceases to be the n.1 tennis player in the world, my best guess is we will have another n.1 tennis player! ;D Would you call him just “a talented follower”?!... Hmmm… Anyway, I think he will be one hell of a tennis player! ;)

 

The reason why people don't do it is not because the models are a secret or don't have a track record

 

Well, the overall track record is obviously there for anyone to see! But my issue is with how much clear VRX’s track record in organic growth is until now…

 

Gio

[Liberty]

Maybe… But don’t exaggerate on the opposite side either… When Nole Djokovic ceases to be the n.1 tennis player in the world, my best guess is we will have another n.1 tennis player! ;D Would you call him just “a talented follower”?!... Hmmm… Anyway, I think he will be one hell of a tennis player! ;)

 

I'm not exaggerating, I'm basically just giving a milder form of what you usually say about the importance of good capital allocators and owner operators ;)

 

When Nole Djokovic ceases to be the n.1 tennis player in the world, my best guess is we will have another n.1 tennis player!

 

So now we care more about relative performance than absolute performance, eh?

 

If the top 25 chess players in the world all die in a plane crash, the #26 will all of a sudden become #1, but does that make him/her as good as the former #1? ;)

[giofranchi]

I'm not exaggerating, I'm basically just giving a milder form of what you usually say about the importance of good capital allocators and owner operators ;)

 

Well, I don’t think I have ever said something like: if Watsa is gone, I will cease investing… Instead, what I have often repeated is: if Watsa is gone, I will look somewhere else… The world is a very large place, full of talented people! ;)

 

Cheers,

 

Gio

 

[Liberty]

I'm not exaggerating, I'm basically just giving a milder form of what you usually say about the importance of good capital allocators and owner operators ;)

 

Well, I don’t think I have ever said something like: if Watsa is gone, I will cease investing… Instead, what I have often repeated is: if Watsa is gone, I will look somewhere else… The world is a very large place, full of talented people! ;)

 

Ok, now I think we're misunderstanding each other, because that's certainly not what I meant.

 

All I was saying is that Valeant is what it is in good part because of who Mike Pearson is, not just because of the model that Mike Pearson uses, so I don't think that others can easily copy what Valeant does and that there just will be a bunch of "next Valeants" to invest in the industry because of model-copying once they further prove out their approach.

 

I never said that he was the last good capital allocator on Earth and that if you pass on him you should stop investing altogether (not sure why you'd think I believe that).

 

What I'm saying is a lot closer to your reasons for selling Lancashire after Brindle left. It's not just the model, it's the people, and really top people are rare.

[giofranchi]

not sure why you'd think I believe that

 

I was just emphasizing the concept…

 

Overall I agree with you! ;)

 

Cheers,

 

Gio

[original mungerville]

Gio, your reasoning on VRX is not as sound as it normally is! Let's say organic growth is 0% real or 2% (ie on par with inflation). If they can acquire at IRRs of 30% and maintain 2% organic growth, that's not good enough? Why is there a need for organic growth before you invest?

 

Pearson is saying he'll do 10.50 a share or something in earnings. Well, we know he is going to beat that organically (unless the US dollar goes through the roof) because that is what he does, he beats expectation constantly. So, taking the US dollar out of the equation, earning power will probably be 11 per share or something in 2015. Of course, that doesn't include acquisitions made late last year or in the first part of 2015 which will begin helping the bottom line - so lets call it 12 per share for 2015. Stock is at 150 or something, so about 13 times earnings power. And they can do 30% IRR deals for the next 5 years - you do the math and then tell me if real organic growth of zero percent is a deal stopper.

 

Pearson makes me giddy every time I listen to him because there is no way he is going to piss away capital.

 

 

[giofranchi]

Gio, your reasoning on VRX is not as sound as it normally is! Let's say organic growth is 0% real or 2% (ie on par with inflation). If they can acquire at IRRs of 30% and maintain 2% organic growth, that's not good enough? Why is there a need for organic growth before you invest?

 

Hi original mungerville,

 

I have never said organic growth is necessary to get outstanding results… Probably, I have not expressed my thought clearly enough!

 

Organic growth imo is necessary only to give me confidence in VRX’s business model. It has nothing to do with outstanding results, but it is nonetheless of great importance to me. Because without that confidence I cannot but wait and see…

 

A good and clear track record in organic growth is what I need to be convinced those costs which are so vigorously attacked and cut by Pearson & Co. are truly nothing but a waste of resources… In other words, I want to see the evidence those businesses acquired by VRX, and which are subsequently subjected to their costs cutting treatment, keep performing very well.

 

This is because I don’t feel able to judge myself VRX’s costs cutting strategies. If you feel you are able to do that instead, good for you! But I think my knowledge about the pharmaceutical industry is definitely not deep enough…

 

If you know other ways to achieve confidence that something truly works, without “insider” knowledge, please let me know!… Until now, the only thing that has convinced me is a long and great track record. ;)

 

Gio

 

[Liberty]

I agree with Gio on organic growth. Only caveats are that periods of lower organic growth can be expected and it doesn't mean the model doesn't work, especially if there's some external factor at play (ie. Industry-wide slowdown), and you have to separate organic growth on durable assets and tail products that were never expected to grow anyway (and were bought at an appropriately discounted price to produce high IRRs despite this). This should be easier now that they have beefed up disclosure.

 

Those tail assets seem to have really confused the market so far. If that changes, I expect multiples to change too.

[original mungerville]

Gio,

 

Again, I am not sure this is totally logical:

 

"Organic growth imo is necessary only to give me confidence in VRX’s business model. It has nothing to do with outstanding results..."

 

Let me explain.

 

1. Would you rather buy a stock at a 10x p/e growing at 10% for 20 years; or

2. A stock at a 3x p/e growing at 0% (where capital is then well allocated, eg reinvested or paid out).

 

Valeant is, at a minimum, transforming acquisitions from 1s into 2s. So they, at a minimum, are swapping organic growth for a higher initial earnings yield (by cutting costs immediately). If you like 2 better, you should agree that organic growth is not necessary to provide confidence in Valeant's business model. And it has everything to do with outstanding results - this is how one judges the value of a business model. Transforming 1s to 2s is outstanding and demonstrates the power of the business model without organic growth.

 

This is EXACTLY like FFH. They used to buy at below book value, restructure for a few years, and return the company to underwriting profitability. Many, including people on this board, did not understand that their high combined ratios were in large part due to the fact that these restructuring costs were incurred almost every year (as acquisitions were sequenced every couple years) as well as the extra few years to get the combined ratio under control. So the overall combined ratio looked worse than it otherwise would have.

 

ie They were buying at say 0.80 of book, say spending 0.4 of book or whatever over 4 years to get underwriting under control. This made the overall combined look poor. However, it is no different than buying at 1.2x book and having a combined ratio already in order at the acquiree. Their initial model was rational, however the rating agencies and investor community did not understand this simple math - putting pressure on them. Furthermore, restructuring is a pain in the ass and consumes headquarter time, causes unnecessary worries, etc. So I think in recent years they said screw it, we will just buy good companies at above book where we don't have to restructure too much. Its interesting and less painless, but its probably just not as optimal: that 0.4 of book is tax deductible whereas the 1.2x paid was after-tax.

 

In any case, to me Pearson just said screw it, nobody understands our model, they think we don't have organic growth. I'm going to show them here. So he is going to reconcile Valeant's value creation with external investors and rating agencies. I just think its a big red herring though, much like Fairfax 5 years ago. So I was surprised by the surprise on this board that Fairfax's underwriting has now improved. And similarly, I am likely to be surprised by the surprise in the market that Valeant does actually have some organic growth. What level? I don't know but I would guess it is at least 5%. Pearson is saying its around 10%. Let us just pretend its half or 5%. So they are transforming

 

1. Acquirees at a 10x p/e with growth of 10% into

2. Acquirees at 3x p/e with growth of 5%

 

It is a very powerful model irrespective of whether organic growth is 5 or 10%. Of course if its 10%, it is even more powerful. But the value created by the model is clear. Its just different from the rest of the industry just like Fairfax was different years ago. It does not mean its not a great investment. Great investments are borne out of this type of murkiness. When things become obvious and in line with industry, like Fairfax recently, the prices soar because all the unintelligent investors can plainly see the value. 

 

 

 

 

 

 

 

 

 

[Liberty]

To me, the importance of showing organic growth on the 'durable' part of the business (and not on things that have been explicitely bought as run offs) is to show that they are indeed durable under the Valeant model (even with lower R&D than is typical), and that putting back in the amortization is warranted.

 

If things stop growing after the cuts and restructuration, it probably means that their model is damaging the assets, and that totally changes the long-term value of the business, regardless of the IRR of new acquisitions (since, except in a merger-of-equals situation, the total value of existing assets will always be much bigger than the value of acquired assets, so more of the value is found there, and they need those existing assets to perform well to finance those attractive acquisitions).