A Valeant Update: Damaged Goods Or Deeply Discounted Drug Company?

Rats larn a bad rap for fleeing sinking ships. After all, given that survival is the strongest evolutionary impulse together with that rats are non high upwardly inwards the nutrient chain, why would they not? That idiom, unfortunately, is what came to quest heed equally I took some other human face at Valeant, the vessel inwards my investment portfolio that most closely resembles a sinking ship. This is a stock that I had trivial involvement in, during its glory days equally the ultimate value investing play, but that I took start a human face at, afterwards its acute autumn from grace inwards Nov 2015. While I stayed away from it then, I bought it inwards May 2016 afterwards it had dropped some other 60% together with I institute it inexpensive plenty to add together to my portfolio. I thence compounded my losses when I doubled my asset inwards Oct 2016, arguing that land it was, at best, an indifferently managed companionship inwards a pitiful business, it was nether priced at $14 . With the stock trading at less than $12 (and downwards to $10.50, equally I write this post) together with its biggest investor/promoter abandoning it, in that place is no means that I tin avert my eyes whatever longer from this develop wreck. So, hither I go!

Valeant: H5N1 Short (and Personal) History

I won't bore you lot past times repeating (for a 3rd time) the story of Valeant's autumn from investment grace, which happened amongst stunning speed inwards 2015, equally it went from value investing favorite to untouchable, inwards the affair of months. My start post, from Nov 2015, examined the companionship inwards the aftermath of the fall, equally it was touted equally a contrarian bet, trading at unopen to $90, downwards to a greater extent than than 50% inwards a few months. My belief thence was that the company's line of piece of job organisation model, built on acquisitions, debt together with drug repricing was broken together with that the company, if it became a to a greater extent than conventional drug line of piece of job organisation company, amongst depression growth driven past times R&D, was worth $73 per share. I revisited Valeant inwards Apr 2016, afterwards the companionship had gone through a serial of additional setbacks, amongst many of its wounds self inflicted together with reflecting either accounting or administration misplays. At the time, amongst the updated data I had together with staying amongst my story of Valeant transitioning to a tedious drug company, amongst less attractive margins, I estimated a value per portion of $44, to a higher house the stock toll of $33 at the time. I bought my start batch of shares. In the months that followed, Valeant's woes continued, both inwards terms of operations together with stock price. After it announced a revenue driblet together with a reject inwards income inwards an lucre written report inwards Nov 2016, the stock hitting $14 together with I had no pick but to revisit it, amongst a fresh valuation. Adjusting the valuation for the novel numbers (and a to a greater extent than pessimistic receive got on how long it would receive got for the companionship to brand its means dorsum to beingness a conventional, R&D-driven pharmaceutical company, I valued the shares at $32.50. That may receive got been hopeful thinking but I added to my holdings at around $14/share.

Valeant: Updating the Numbers

Since that valuation, non much has gone good for the companionship together with its most recent lucre written report suggests that its transition dorsum to wellness is yet hitting roadblocks. While verbalize of imminent default seems to receive got subsided, in that place seems to live overwhelming pessimism on the company's operating  prospects, at to the lowest degree inwards the close term. In its most recent lucre report, Valeant reported farther deterioration inwards cardinal numbers:

	2016 10K	2015 10K	% Change
Revenues	$9,674.00	$10,442.00	-7.35%
Operating income or EBIT	$3,105.46	$4,550.38	-31.75%
Interest expense	$1,836.00	$1,563.00	17.47%
Book value of equity	$3,258.00	$6,029.00	-45.96%
Book value of debt	$29,852.00	$31,104.00	-4.03%

Much equally I would similar to believe that this reject is curt term together with that the stock volition come upwardly back, in that place is at nowadays a existent jeopardy that my story for Valeant, non an optimistic together with uplifting story to laid about with, is at nowadays broken. The company's growth strategy of acquiring other companies, using huge amounts of debt, raising prices on "under priced" drugs together with paying equally trivial inwards taxes equally possible were perchance legally defensible but they were ethically questionable together with may receive got damaged its reputation together with credibility thence thoroughly that it is at nowadays unable to larn dorsum to normalcy. This tin explicate why the companionship has had thence much problem non entirely inwards getting its operations dorsum on rails but also why it has been unable to pin to beingness a to a greater extent than traditional drug company. If researchers are leery almost working inwards your R&D department, if every toll increase you lot attempt to brand faces scrutiny together with force dorsum together with your credibility amongst markets is stone bottom, making the transition volition live tough to do. It tin also indirectly explicate why Valeant may live having problem selling some of its most lucrative assets, equally potential buyers appear wary of the corporate taint together with perchance receive got lingering doubts almost whether they tin trust Valeant's numbers.

In fact, the i argent lining that may emerge from this sense is that I at nowadays receive got the perfect representative to illustrate why beingness a line of piece of job organisation entity that violates the norms of practiced corporate demeanour (even if their actions legal) tin destroy value. At to the lowest degree inwards sectors similar wellness care, where the regime is a leading client together with predatory pricing tin Pb to to a greater extent than than merely populace shaming, the Valeant story should live a cautionary annotation for others inwards the sector who may live embarking on similar paths.

The Ackman Effect

You may uncovering it foreign that I would pass this much fourth dimension talking almost Valeant without mentioning what may appear to live the large story almost the stock, which is that Bill Ackman, long the company's biggest investor together with cheerleader together with for much of the in conclusion 2 years, a powerful board member, has admitted defeat, selling the shares that Pershing Square (his investment vehicle) has held inwards Valeant for almost $11 per share, representing a staggering loss of almost 90% on his investment. The reasons for my lack of response are similar to the ones that I voiced inwards this post, when I remained an Apple stockholders equally Carl Icahn sold Apple together with Warren Buffett bought the stock inwards Apr 2016. As an investor, I receive got to brand my ain judgments on whether a stock fits inwards my portfolio together with next others (no affair how much regard I receive got for them) is me-too-ism, destined for failure.  

Don't larn me wrong! I recall Bill Ackman, notwithstanding his Valeant setbacks, is an accomplished investor whose wins outnumber his losses together with when he takes a topographic point (long or short) inwards a stock, I volition banking company check it out. That said, I did non purchase Valeant because Ackman owned the stock together with I am non selling, merely because he sold. In fact, together with this may appear similar a stretch, it is possible that Ackman's presence inwards the companionship together with the potential veto ability that he mightiness receive got been exercising over large decisions may receive got conk to a greater extent than of an impediment than a assist equally the companionship tries to untangle itself from its past. I am non for certain how well-sourced these stories are, but in that place are some that suggest that it was Ackman who was the obstruction to a Salix sale in conclusion year.

Valeant: Three Outcomes

As I meet it, in that place are iii paths that Valeant tin take, going forward.

1. Going Concern: To value Valeant equally a going concern, I revisited my valuation from Nov 2016 together with made its pathway to stable drug companionship to a greater extent than rocky past times assuming that revenues would conk along to driblet 2% a twelvemonth together with margins volition rest depressed at 2016 levels for the side past times side five years together with that revenue growth volition rest anemic (3% a year) afterwards that, amongst a moderate improvement inwards margins. With those changes set inwards together with leaving the likelihood that the companionship volition non brand it at 10% (since the companionship has made some headway inwards reducing debt), the value per portion that I larn is $13.68. 

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To illustrate the uncertainty associated amongst this value estimate, I ran a simulation amongst my estimated distributions for revenue growth, margins together with cost of working capital missive of the alphabet together with arrived at the next distribution of values.

The simulation confirms the base of operations instance intrinsic valuation, insofar equally the median value of $13.31 is unopen to the toll at the fourth dimension of the valuation ($12) but it provides to a greater extent than data that may or may non contention the investment decision. There is a clear jeopardy that the equity could conk to zilch (about 12%), if the value dips below the outstanding debt ($29 billion). At the same time, in that place is pregnant upside, if the companionship tin uncovering a means to alter its trajectory together with conk a boring, depression growth drug company.

2. Acquisition Target: It is a sign of desperation when equally an investor, your best promise is that someone else volition larn your companionship together with pay a premium for it. I am afraid that the Valeant taint thence strong together with its construction thence opaque together with complex that real few acquirers volition desire to purchase the entire company. I meet trivial jeopardy of this bailing me out.

3. Sum of its parts, liquidated: It is truthful that Valeant has some valuable pieces inwards it, amongst Bausch & Lomb together with Salix beingness the biggest prices. While neither line of piece of job organisation has attracted equally much attending equally Valeant had hoped, in that place are 2 reasons why. The start is that Ackman, amongst pregnant losses on the stock together with a topographic point on the board, may receive got exercised some veto ability over whatever potential sales. The minute is that potential buyers may live scared away past times Valeant's history. One solution, at nowadays that Ackman is no longer at the company, is for Valeant to opened upwardly its books to potential acquirers together with sell its assets individually to the best possible buyers. Note that this liquidation value volition receive got to transcend $29 billion, the outstanding debt, for equity investors to generate whatever remaining cash.

There is i other macro concern that may brand Valeant's hereafter to a greater extent than thorny. As a companionship that pays a depression effective taxation charge per unit of measurement together with borrows lots of money, the proposed changes to the taxation police line (where the marginal taxation charge per unit of measurement is probable to live reduced together with the taxation savings from involvement expenses curbed), Valeant volition in all probability receive got to pay a much higher effective taxation charge per unit of measurement going forward, i argue why I receive got shifted to a 30% taxation charge per unit of measurement for the future.

The Bottom Line

Let's start amongst the tardily judgment. This was non an investment that I should receive got made together with much equally I would similar to blame macro forces, the company's administration together with Bill Ackman for my losses, this was my mistake. I was correct inwards my initial post inwards in conclusion that the company's one-time line of piece of job organisation model (of acquiring growth amongst borrowed coin together with repricing drugs) was broken but I clearly underestimated how much impairment that model has done to the company's reputation together with how much move it volition receive got for it to conk a boring, drug company. In fact, it is possible that the impairment is thence severe, the companionship volition non live able to brand the adjustments necessary to endure equally a going concern. 

So, at nowadays what? I cannot opposite the consequences of my master copy sin (of buying Valeant at $32) inwards Apr 2017 together with the secondary sin (of doubling down, when Valeant was trading at $14) past times selling now. The interrogation thence becomes a elementary one. Would I purchase Valeant at today's price? If the answer is yes, I should concord together with if the answer is no, I should fold. My intrinsic value per portion has dropped to merely to a higher house where the stock is trading at now, together with at this stage, my judgment is that, valued equally a going concern, it would live trading slightly nether value. In a foreign way, Bill Ackman's move out is what tipped the scales for me, since it volition plough over Valeant's management, if they are thence inclined, the capacity to brand the decisions that they may receive got been constrained from making before. In particular, if they recognize that this may live a clear instance where the companionship is worth to a greater extent than equally the amount of its liquidated parts than equally a going concern, in that place is yet a jeopardy that I could cut my losses on this investment. Note, though, that based on my numbers, I don't human face to brand my master copy investment (which averages out to $21/share) back. I am non happy almost that but sunk costs are sunk!

As I conk along to concord Valeant, I am also aware that I mightiness live committing i of investing's biggest sins, which is an aversion to admitting mistakes past times selling losers. My discounted cash menses valuations may live an after-the-fact rationalizing of something that I don't desire to do, i.e., sell a large loser. To counter this, I briefly considering selling the shares together with rebuying them dorsum immediately; that makes me acknowledge my error together with receive got my losses land restarting the investment procedure amongst a novel buy, but the "wash sales" dominion is an impediment to this cleansing exercise. The bottom line is that if I am asset on to Valeant, non for intrinsic value reasons (as I am trying to convince myself) but because I receive got an investing blind spot, I volition live in conclusion i to know!

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Previous Posts on Valeant

1. Checkmate or Stalemate: Valeant's Fall from Investing Grace (November 2015)
2. Valeant: Information Vacuums, Management Credibility together with Investment Value (April 2016)
3. Faith, Feedback together with Fear: The Valeant Test (November 2016)

Spreadsheets

1. Valeant Valuation: March 2017

Valeant: Data Vacuums, Management Credibility In Addition To Investment Value

As an investor, would y'all purchase shares inwards a fellowship that is at the pump of a political too legal firestorm? What if this fellowship has a CEO who has lost the religious belief of his board too an ex-CFO who is existence defendant of shady fiscal practices? And would y'all draw  the purchase trigger if the fellowship has delayed its scheduled annual filing past times to a greater extent than than 2 months, too past times doing thence is running the adventure of violating debt covenants too existence pushed into default? And to top it all off, would y'all live a petty worried  if the largest investor inwards the stock, a good known activist amongst his reputation too wealth on the line, is forthwith calling the shots? No way, y'all say! At the correct price, I would, too that is the ground that I decided to revisit my Valeant valuation final week, half dozen months after I valued it for the get-go time, inwards the aftermath of a crisis born of hubris too happenstance. In structuring this post, I volition depict on an old-time consulting matrix, where companies were classified into stars, cash cows, dogs too enquiry marks, to illustrate the transience of these classifications, since Valeant has cycled through the entire matrix inwards a year.

Valeant, the Star

Valeant's ascension from an obscure Canadian drug fellowship to pharmaceutical star has been good chronicled too rather than drown y'all inwards prose, I intend it is best captured inwards this picture, which shows the increment inwards marketplace position value (market cap too firm value) too operating numbers (revenues too operating income), particularly betwixt 2009 too 2015:

Source: S&P Capital IQ

During a stream when other pharmaceutical companies were struggling amongst revenue growth too turn a profit margins, Valeant outstripped them on both counts, growing revenues at almost 43% a yr piece posting higher operating turn a profit margins than the balance of the sector. At to the lowest degree on the surface, the fellowship seemed to live delivering the best of all combinations: high growth amongst high profitability.

So, how did Valeant draw of this feat? In an before post on the company, inwards Nov 2015, I argued that the Valeant line of piece of work concern model was a stool amongst 3 legs: growth from acquisitions, amongst the acquisitions funded primarily amongst debt, followed past times a strategy of increasing prices on "under priced" drugs.

The unique combination of growth too profitability made the fellowship a target for value investors, making it a favored halt for investors equally various equally Bill Ackman, the activist investor, too the Sequoia Fund, a storied usual fund, too a dominant piece of work of their portfolios. In their defense, non exclusively were these investors transparent nearly their large bets on Valeant, but at to the lowest degree until September 2015, their concentration was viewed equally a forcefulness rather than a weakness. In fact, when I posted on why diversification is a necessary constituent of fifty-fifty a value investing strategy, it was these 2 investors that were held upwards equally a counters to my argument.

To encounter the allure of Valeant to value investors, allow me cash inwards one's chips dorsum to mid-year final year, when the company's line of piece of work concern model was going strong, its stock cost was higher than $200/share too its firm value exceeded $100 billion. If the intrinsic value of a fellowship is driven past times cash flows from existing assets, value-creating growth too depression risk, Valeant looked attractive on almost every dimension:

Valeant was non exclusively delivering the value trifecta, high revenue growth inwards conjunction amongst high operating turn a profit margins too generous excess returns, but was doing thence on steroids (taking the shape of depression taxes too high debt). One annotation of caution fifty-fifty then, though, was that the line of piece of work concern model was built on an architecture of acquisitions, amongst acquisition accounting playing a large piece of work inwards pushing upwards operating profitability too lowering taxes.  If y'all were unfazed past times the acquisition accounting outcome too assumed that the fellowship could cash inwards one's chips along to deliver this combination going forward, the value per portion that y'all would accept obtained for the fellowship would accept been to a greater extent than than $200/share. 

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In estimating the value, I did lower the compounded revenue growth for Valeant to 12% for the adjacent 10 years, but that translates into revenues to a greater extent than than tripling over the decade. 

From Star to Cash Cow

While many line Valeant's autumn to September too Oct of 2015, when partly because the Salix drugs that Valeant acquired (and repriced) affected to a greater extent than people (and drew to a greater extent than complaints). The Philidor revelations pushed these concerns into hyperdrive too the stock lost almost 55% of its value inwards September too October, dropping from $180/share to $80/share.

In my Nov post, I rehashed much of this story too argued that fifty-fifty if Valeant were able to endure legal too regulatory scrutiny, the fellowship would never live able to provide to its onetime line of piece of work concern model. In effect, fifty-fifty inwards the absence of to a greater extent than bad news, Valeant would accept to live run similar other pharmaceutical companies, reliant on R&D, rather than acquisitions, for (more anemic) growth. Removing the debt-funded acquisitions too the drug repricing  from the line of piece of work concern model yielded a fellowship amongst lower revenue growth (3% a year, rather than 12%), lower margins (a pre-tax operating margin of 43.66%, instead of 49.82%) too higher taxes (with an effective taxation charge per unit of measurement of 20% replacing 16.51%).

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Note that these numbers were reflective of to a greater extent than conventional drug companies too reverberate a profitable, albeit slow-growth business. With these numbers, though, the value per portion that I obtained for Valeant was nearly $77, downwards substantially from its star status, but the marketplace position price, at $82, was higher. 

From Cash Cow to Dog?

If in that location were night clouds on the horizon for Valeant inwards Nov 2015, the months since accept exclusively made them darker for iv reasons:

1. Information blackout: In Nov 2015, when I valued Valeant, I used the most recent fiscal filings of the company, from Oct 2015,  to update my numbers. Almost half dozen months later, in that location accept been no fiscal filings since, too the 10K that was expected to live filing inwards Feb 2016 was delayed, ostensibly because the fellowship was withal gathering information, too that delay has extended into April. 
2. Managerial Double talk: In the intervening months, Valeant’s managers accept been inwards the news, almost equally frequently giving testimony to Congress, equally belongings press conferences. Arguing, as they did, that they grew through R&D similar whatever other pharmaceutical fellowship too that their revenue increases came generally from book growth (rather than cost increases) was thence much at odds amongst the facts that they became less credible amongst each iteration. Michael Pearson’s hospitalization for an undisclosed illness, but before Christmas, was something that was out of the company’s command but its treatment added to the air of opacity but about the company. 
3. Legal Jeopardy: The Philidor entanglement, the master source of the crisis, did non cash inwards one's chips away. In fact, the company, after claiming that separation from Philidor would live low-cost too piece of cake backtracked inwards Jan too Feb amongst Bill Ackman increased his interest of the company inwards a bid to save what was left of his investment inwards the fellowship too to a greater extent than importantly, his reputation equally a savvy activist investor.

With the stock trading at $32, the enquiry of whether the stock is a proficient purchase forthwith looms large. Compared to my Nov 2015 estimate, the respond is an emphatic yes, but the caveat is that a neat bargain has happened to the company’s fundamentals during the final half dozen months that could accept shifted the value downwards significantly. The job that I face, similar whatever other investor inwards Valeant, is that inwards the absence of fiscal filings, in that location are no numbers to update. The solution seems simple. Wait for the delayed filing to come upwards out inwards belatedly April, early on May or later, too work that updated data inwards my valuation. That is the low-risk option, but I intend that it is also a depression provide option, since if the filing contains proficient intelligence (that revenues accept held upwards too turn a profit margins stay healthy), the stock cost volition adapt before my valuation does. The alternative is scary, but it has a bigger payoff. I could endeavour to brand a judgment on Valeant’s value now, before the data comes out, too follow through past times buying or selling the stock. In arriving at this value, hither are some of the adjustments that I chose to make:

1. The Dark Side of Debt: The debt at Valeant has cash inwards one's chips to a greater extent than burden than a help, equally it has non exclusively triggered worries nearly covenants existence violated but has opened upwards the possibility that that the fellowship volition accept problem making its payments. In fact, Value of Valeant equally Cash Cow (November 2015)
2. Value of Valeant equally Dog (April 2016)