In my final post, I looked at how the pharmaceutical as well as biotechnology businesses receive got diverged, peculiarly inward the final decade, as well as the implications for earnings, R&D as well as marketplace pricing of these companies. The pharmaceutical business, inward particular, faces a novel landscape amongst many companies even as well as so stuck amongst a work organisation model that does non piece of work inward delivering value, every bit growth eases as well as margins come upwardly nether pressure. It is no surprise thus that investors are looking for a drug fellowship amongst a novel work organisation model, as well as that may explicate the meteoric ascent of Valeant over the v years, making its recent collapse all the to a greater extent than shocking.
Valeant: The Rise
The best agency to illustrate Valeant's ascent inward the drug work organisation is describe its history inward numbers. The graph below looks at the fourth dimension line of revenues, operating income as well as internet income from 1993 to the the final twelve months ending inward September 2015:
As yous tin see, the inflection holler for is inward 2010, when Valeant went from a fellowship amongst small, slow-growing revenues into hyper speed, increasing revenues almost x plication betwixt 2010 as well as 2015. That increment inward revenues was accompanied past times increases inward operating income as well as internet income, albeit smaller inward proportional terms. The story of how Valeant was able to accelerate its growth has been widely told, but the numbers in ane lawsuit to a greater extent than tell it better.
| Year | R&D | Acquisitions | R&D/Sales | Acquisitions/Sales |
|---|---|---|---|---|
| 2005 | $69.42 | $- | 7.40% | 0.00% |
| 2006 | $77.80 | $- | 7.29% | 0.00% |
| 2007 | $100.61 | $- | 11.94% | 0.00% |
| 2008 | $69.81 | $101.90 | 9.22% | 13.46% |
| 2009 | $47.58 | $- | 5.80% | 0.00% |
| 2010 | $67.91 | $(308.98) | 5.75% | -26.16% |
| 2011 | $65.69 | $2,464.10 | 2.71% | 101.51% |
| 2012 | $79.10 | $3,485.30 | 2.27% | 100.14% |
| 2013 | $156.80 | $5,253.50 | 2.72% | 91.12% |
| 2014 | $246.00 | $1,102.60 | 2.98% | 13.35% |
| LTM | $297.60 | $14,123.20 | 2.98% | 141.46% |
The growth has been driven almost solely past times acquisitions, totaling $26.4 billion since 2010. Looking closer at the 23 acquisitions that Valeant has made since 2013, the fellowship has bought to a greater extent than someone businesses (18 out of the 23) than public, though a really large proportion of the total cost tin live accounted for amongst 2 acquisitions, ane of a populace fellowship (Salix for $12.5 billion) as well as ane of a someone work organisation (Bausch as well as Lomb for $8.7 billion. Valeant seems to receive got also paid for almost all of these acquisitions amongst cash, which raises the interesting follow upwardly inquiry of where they came upwardly amongst the cash. Again, the answer is inward the numbers, amongst the nautical chart below providing a breakdown of funding sources during the menstruation from 2011-2015, the peak menstruation for Valeant's acquisitions:
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| Source: Valeant Statement of Cash Flows |
At to the lowest degree during this period, the marketplace liked the Valeant work organisation model of growth through acquisitions, as well as delivered its verdict past times pushing upwardly Valeant's marketplace capitalization as well as pricing multiples.
Valeant: The Fall
It is perchance because Valeant rose as well as so rapidly from its mid-cap condition to larn a star that its needlelike autumn has been as well as so shocking. The refuse started amongst a report, on Oct 19, on a courtroom filing inward California as well as picked upwardly steam when it was highlighted on Oct 21 past times Citron, an outfit that has long been critical of Valeant's accounting as well as operating practices. That written report claimed that Valeant had hidden a human relationship amongst shadowy chemist's shop entities as well as that it had used that human relationship to create its books. While around were quick to dismiss the written report every bit motivated past times Citron's brusk seat inward Valeant, the written report triggered scrutiny as well as Valeant's initial explanations satisfied no ane as well as the marketplace reacted accordingly:
Recognizing that it faced a major marketplace calamity, Valeant called a by this article inward the New York Times on Oct xiv (a few days earlier the brusk seller stories appeared inward the press). Now that Valeant is inward the populace eye, in that location is no agency that, fifty-fifty if this scandal passes, they tin provide to anonymity. Every drug toll increment for a Valeant drug volition live damage that goodwill does to both accounting statements as well as to expert sense, but the grade to which acquisition accounting has dingy upwardly the numbers at Valeant tin live captured past times looking at how they receive got taken over Valeant's financials inward the final 5 years:
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| Source: Valiant Financial Statements |
As amongst every scandal, I am certain that in that location volition live novel revelations as well as intelligence stories inward the calendar week ahead, around pointing to accounting problems, around to work organisation model failures as well as around to legal jeopardy. Even if Valeant emerges unscathed legally from this mess, I only don’t run into how they tin revert to their onetime work organisation model, as well as it is non clear to me that without it, they are anything to a greater extent than than a middling pharmaceutical company.
The Bottom Line
Does the imminent collapse of Valeant's heart as well as soul work organisation model imply that I grip amongst the brusk sellers who receive got used the Enron analogy to fence that this fellowship is a trounce worth nothing? No, as well as hither is why. Unlike Enron, a fellowship that used special operate entities as well as complex holdings to enshroud it debt as well as had no assets amongst tangible value at the fourth dimension of its troubles, Valeant chemist's shop holdings seem designed to a greater extent than for pricing ability than accounting sleight of manus as well as it owns assets that receive got existent value. Thus, fifty-fifty if Valeant's capacity to grow productively is removed tomorrow, it volition even as well as so receive got value every bit a going concern or every bit a collection of assets.
Going concern value
If Valeant is able to move far through its troubles intact, ane selection that is available to it is to larn a to a greater extent than conventional drug company, resting on R&D for (low) growth as well as making coin of its established products. To value Valeant inward this scenario, hither are the assumptions that I made:
Given my perspective on the company, as well as it is undoubtedly flawed, I don't run into Valeant every bit a significantly nether valued stock, inward spite of the toll drib over the final few weeks. I also don't run into it every bit bubble waiting to burst, a stock heading towards beingness worth nothing. For the moment, I mean value volition sit down on the sidelines as well as watch.
- Base twelvemonth earnings: One of the positive effects of suspending an acquisition-driven strategy is that the expenses associated amongst acquisitions should also dissipate. Consequently, I added dorsum acquisition-related expenses (impairment of goodwill, acquisition charges) to operating income to larn to an adjusted operating income for the final twelve months. (Update: As around of yous receive got pointed out, the most twelve months of financials include only half-dozen months that include Salix as well as thus understate revenues as well as operating income. To remedy this, I require to select inward Salix's revenues as well as operating income from the last quarter of 2014 as well as the outset quarter of 2015 into my trailing numbers. Unfortunately, Salix did non file a first quarter earnings written report for this year, but hither is an approximation. In 2014, Salix generated $1.134 billion inward revenues but reported an operating loss. If yous assume that revenues come upwardly inward evenly over the twelvemonth as well as yous allow for the operating margin of 25.51% that Salix earned inward 2012 & 2013, yous larn revenues of well-nigh $567 1000000 and operating income of $145 1000000 for the missing quarters. Adding these to the trailing 12 calendar month numbers increases the value per portion to $77. H5N1 to a greater extent than optimistic take, where Valeant is able to earn its higher operating margin increases the value per portion to $81. The bottom line is that bringing inward Salix's bump to revenues as well as operating income, which is probable to create growth inward the side past times side twelve months, pushes upwardly value per portion but non past times plenty to alter my basic conclusion, which is that the stock is, at best, fairly valued.)
- Pricing backlash: I assumed that the contention over Valeant's drug pricing strategy volition termination inward curlicue backs of toll increases on around of its drugs, resulting inward a permanent drib of 10% inward earnings. (Update: Though this pose out seems to come upwardly out of left champaign (and it is subjective), it comes from lowering Valeant's pre-tax operating margin (prior to adjustments) of 28.3% towards that of other drug companies which is 25.5%; the drib of 2.8% is roughly the 10% drop. I am also assuming that in ane lawsuit the losses from prior acquisitions curlicue off, the taxation charge per unit of measurement volition motility upwardly to 20%, lower than the tax rate paid past times United States of America pharmaceutical companies, reflecting the company's Canadian base.)
- Low growth: If Valeant follows the measure pharmaceutical fellowship exercise of investing inward R&D as well as hoping for payoffs, its expected growth charge per unit of measurement volition drib to anemic levels (as suggested past times my final ship service on drug companies). I volition assume a 3% growth charge per unit of measurement inward earnings for the side past times side 10 years, good below the 20% posted past times Valeant over the final 5 years, but much of that growth was acquired. (Update: I know that management is forecasting 10% from organic growth. That may really good live truthful for side past times side year, every bit the Salix bump kicks in, but it is tough to sustain thereafter, amongst substantially increasing R&D.)
- R&D spending: I volition assume that Valeant volition receive got to invest inward R&D to hold this growth going, as well as inward my valuation, that investment volition reverberate the provide on working capital alphabetic quality of 15.25% that I receive got estimated for the fellowship (with the adjusted earnings).
- Cost of capital: Factoring inward both the expert side of Valeant's high debt ratio (the taxation effected cost of debt) as well as the bad side (higher cost of debt as well as equity) as well as the revenue exposure for Valeant (75% from developed markets, 25% from emerging markets), I guess a cost of working capital alphabetic quality of 7.52%.
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| Spreadsheet amongst valuation |
Sum of the parts
If this scandal has legs as well as non only lingers, but creates legal problems that taint Valeant every bit a corporation, in that location is a 2nd option. Just every bit Valeant’s ascent inward value was built on additions, yous could create a contrary strategy where value is generated past times subtraction. Thus, Valeant could sell itself slice past times slice (drugs as well as divisions) to the highest bidders, since each slice volition live worth to a greater extent than to an untainted buyer than it would live worth to Valeant. If this is the optimal path, it volition live interesting to run into if this squad that has built the fellowship upwardly over the final v years is willing to prepare aside hubris as well as intermission it downwards over the side past times side few years.
The Bottom Line
The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy tin pay off, if companies maintain discipline, but my sense amongst these companies is that they inevitably hitting a wall, either because they larn likewise large to rest disciplined or because the accounting creates likewise many opportunities to obfuscate as well as enshroud problems. While Valeant's attempt at creating a novel model for a drug work organisation may receive got failed, that does non brand the existing drug fellowship model a success either. The search has to move on!
YouTube Version
Blog posts inward this series
Spreadsheets
The Bottom Line
The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy tin pay off, if companies maintain discipline, but my sense amongst these companies is that they inevitably hitting a wall, either because they larn likewise large to rest disciplined or because the accounting creates likewise many opportunities to obfuscate as well as enshroud problems. While Valeant's attempt at creating a novel model for a drug work organisation may receive got failed, that does non brand the existing drug fellowship model a success either. The search has to move on!
YouTube Version
Blog posts inward this series
Data Attachments
- Valeant 10K as well as 10Q
- Valeant historical financials
Spreadsheets
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