Wherefore are thou positive catalyst?

There’s a general sentiment among Valeant bulls that the company needs to do something.  That leads to two questions. The first is obvious, the second important although largely implied.

First, what exactly should the company do?

Second, what exactly is the problem?

I think right now Valeant faces three main public problems – none of which they’ve even admitted fully.

-Valeant’s relationship with Philidor and implications for its business

-Valeant’s potential liquidity/debt issues

-Valeant’s cockroach problem.

The company has tried and failed to solve these problems by saying variations of: there is no problem, it’s a small problem, we’re actively addressing the problems but we can’t exactly tell you how big the problems are but things will be fine we promise.

This approach has repeatedly failed.  I do not think the company can fire any more “we are confident” bullets that are not backed by substantive points. Its last attempt failed to soothe the market, and without additional information, it will only further the impression of the lady doth protest too much.

(Ackman’s approach has been to make very hopeful assertions, such as “Valeant will immediately announce a specialty pharmacy relationship” that would be helpful…if they happened to be true.  That is also not a sustainable strategy.)

So let’s look at some potential substantive solutions to each issue and then discuss the firing Mike Pearson option that even some devout stockholders have been floating.

(Philidor)

-Valeant could release the results of its independent investigation

This one is very, very tricky. As Arthur Anderson and Richard Nixon can tell you, if you are sufficiently high ranking/possessing of plausible deniability then it is not the initial crime but the cover up that destroys you. I think Valeant’s board of directors knows that very ambitious government attorneys will be checking their work very carefully with their subpoena powers. The Board of Directors needs to get a passing grade.  Relatedly, I do agree(!) with Ackman that Mark Filip is an excellent and completely legitimate attorney. I see no reason why he would risk that reputation on a white wash.

I think Valeant’s late October conference call was, errm, in some creative tension with various subsequent reports from very respected media outlets about the operations of Philidor. (For example – compare slide 43 with this Bloomberg report).

If the media outlets are right, and I have to think that they would only print stories that they were very confident in, then Valeant’s investigative report would have to confirm the general picture that has developed that Valeant was heavily involved in the formation and operation of Philidor. (Who’s going to break it to Sequoia?)

If Valeant released such a report, would it help the stock price?  I don’t see why it would. It may not further hurt the stock price because the news is priced in.  But, in order to get a passing grade, the report may need to contain yet more damaging information that is not yet public.

(This being said, I am surprised that Valeant first said it was immediately severing ties with Philidor at the end of October, and now says that Philidor (whose plans it appears to know through the principle of spooky entanglement even though it severed ties at the end of October) is now continuing operations through the end of January…).

-Valeant could announce a relationship with another specialty pharmacy.

Valeant could do this, but they would have to find a specialty pharmacy that was willing to take the intense scrutiny that they would be subjected to by PBM’s and other actors in the space.  The terms of Valeant’s relationship with the specialty pharmacy are also….unlikely….to allow it to realize the unique advantages that Philidor possessed.

(Liquidity)

This is a more difficult question to solve because Valeant itself has not acknowledged any kind of liquidity crisis – after all, until very recently, they were going to make $7.5 billion ebitda next year.  There are, however, a few options.

-Valeant sells a part of itself to raise cash

The primary problem here is that Valeant’s equity currently rests on the premise that Valeant has significantly increased the value of the assets that it has acquired.  The basic math is that Valeant, starting from near nothing, has made about $40 billion in acquisitions and now has an enterprise value of $55 billion.  If Valeant sold its acquisitions for what it paid, then Valeant would have a total enterprise value of 40 billion. Because it has $31 billion in debt, the equity would be worth $9 billion.  That would put the stock price at around $27.  And, part of the reason Valeant bid the way it did was because of its tax advantages, which many other potential buyers would not possess. Also simply in order to get to $27, Pearson & Co. would have had to defy the general trend that mergers are value destroying.

A secondary problem is that Valeant’s stock price may get a short term bump if they announced they were exploring a potential sale of a division but if a buyer did not quickly emerge, then the stock price would be punished severely because the hope of a sale is helping to keep the stock price elevated.  The eventual punishment may be even more severe if a buyer dropped out after doing due diligence, and, I have to imagine, any buyer would do very, very careful due diligence.

Ackman clearly is fond of some sort of merger because he has been floating the idea of an Allergan purchase. I am curious how Ackman interprets the Allergan CEO’s recent statement on the matter. He does not sound like a particularly interested buyer but….perhaps he is playing it cool.

-Valeant issues equity

I think this would be the equivalent of initiating a bank run because it would directly acknowledge that Valeant needs to raise cash, and thus their revenue/profits for 2016 are in far more doubt than Valeant has been willing to acknowledge.  And, I am curious what buyers would want additional equity when there don’t seem to be many new buyers at the current price…

-Valeant issues debt

This is impossible. And they only have $800 million left on their revolver.

-Valeant issues reassuring 2016 guidance

This may help although I remain curious about the level of faith that Valeant bulls will have in guidance rather than 10-k audited financials. If Valeant issues rose-colored guidance, and then fails to meet it, the punishment will be severe. I lean toward the idea that Valeant will announce an absolutely horrible Q4 2015 take the hit and then ride it out toward 2016. Perhaps this Q4 is already priced in, but I am not sure. I still hear people trying to work down from 7.5 billion EBITDA.

Valeant’s Cockroach Problem

This issue, unfortunately for Valeant, seems very difficult to address because what faith can anyone put in a general statement that they do not have cockroaches. Even Pearson didn’t seem entirely willing to make such a statement on the most recent conference call.  Instead, he spoke broad generalities about how, from his lofty vantage as CEO, he thinks the business is clean but obviously can’t know everything.

Valeant could, of course, attempt to answer in detail many of the questions that have been asked by John Hempton and others about currently unexplored issues, such as their use of charitable foundations to funnel copayments for government health insurance patients, but, for whatever reason, they have not done this yet.

(I am enamored of this exchange from the Q3 call on the issue)

“Doug Miehm – RBC Capital Markets
Thank you. Couple questions as well. Number one, with respect to patient access and foundations, maybe you could walk us through how many foundations you fund. And of those foundations what proportion of their annual operating budget would you provide to them? The second one just has to do with, if you were to split out the US neuro business, can you give us a sense of what EPS contribution or EBITDA contribution that business would have? And I’ll leave it there.

Laurie Little – Head of IR
Hey guys, why don’t you just concentrate just a couple right now. We are trying to get through everybody so why don’t we answer the –

Mike Pearson – Chairman and CEO
Yes, pick your two favorite.

Douglas Miehm

Just the foundations, just elaborate on that.

Mike Pearson – Chairman and CEO
Okay. So it is — I don’t have the price number but it’s like four or five and so its small number. We make sure as we mentioned that they have other companies are also contributing or other organizations, so these are also contributing, we do not want to be the only one to contribute. Again, we just given the money and they do what they want to with that money. And I don’t have — I don’t want to give you a price figure in terms of what percent of our funding, I don’t have that and I don’t want to guess. Next question?”

Their limited responses to various specific accusations in the 8-k SEC filing has also been………..somewhat halting and opaque. 

Firing Pearson

This solution, proposed even by very, very dedicated shareholders, has been increasing in popularity.  It’s a bit unclear what Pearson has done wrong – besides a general live by the stock price, die by the stock price ethos.

The central problem with this approach is that Mike Pearson’s brilliance as the CEO has been the primary bull argument for why Valeant should receive a special valuation.

Valueact specifically installed Pearson as CEO.

Sequoia’s discussions frequently emphasize what a wonderful and innovative manager Pearson is.  Tell em David:

“Mike Pearson believed that he could build a large and successful pharmaceutical company without taking the risk of expensive R&D that most large, successful pharma and biotech companies had taken. He would instead do it by focusing on specialties that did not require these risks through lean R&D, zero-based budgeting, minimal taxation, and high returns from the get-go on numerous acquisitions. He would target companies of all sizes in product and geographic areas in which big companies did not compete and in which there was minimal reimbursement risk. By avoiding all of those other risks, he would be able to take some risk by leveraging his balance sheet to generate very rapid growth and high returns on total capital and spectacularly high returns on shareholders’ equity.”

Ackman’s initial presentation about the Valeant-Allergan merger is called the “Outsider.” (Spoiler Alert: Mike Pearson is an Outsider CEO.)

Each of these major shareholders has taken the position that Pearson is a once in a generation CEO.

To support or even suggest the firing of Pearson, while still remaining a shareholder of Valeant, seems to be the most blatant case of thesis creep that I have ever seen.

I’ll let Julian Robertson explain (courtesy of my absolute favorite financial blogger)

“Robertson’s mantra was, as long as the story around the investment remained the same, the position should get bigger. As soon as the story changed, it was time to get out…

To understand the concept of story, consider this example. Say you are interested in a solid oak wooden table. [An] analyst could tell you that he had checked out the market for tables, evaluated the information, and come to the conclusion that the table was a good buy at $100 because it was well made, solidly built, and would not fall apart. This is the story. So you go to the shop, prepared to buy the table. And then, just as you are running your hand over the table, a corner falls off. Well, now the seller is desperate to get rid of the broken table and is willing to sell it for $20. To the analyst, this seems like a steal. He sees an incredible opportunity to buy something for $20 that is really worth $100 and needs just a bit of fixing to get it there. But in Robertson’s eyes, the story is now flawed, and now he would say that you should want no part of the deal. How could something so well built, made of the finest oak, break?”

Pearson was the story of Valeant: this CEO is great and he has built an amazing company. If the story has changed, do you still want to buy the table?

Now call me old-fashioned, but I would think that a CEO like Pearson would only get fired if he was bad at a significant aspect of his job. Here are the main choices.

1 – Deal making. If Pearson was a bad dealmaker –i.e. overpaid for his acquisitions, then I think it’s very hard to find a reason that Valeant stock has any value – for the reasons discussed above.

2 – Operations/synergy creation. This would raise lots of questions about Valeant’s ability to actually generate sufficient cash to satisfy its debt, as well as its prior classification of integration costs. You can’t answer this by looking at the SEC filings because Valeant provides no breakdown of its various segments besides the revenues from “developed” and “emerging.”

3 – Creation and implementation of a viable durable business model.  This would imply that tax inversions, price increases, and various mechanisms to avoid the natural implications of price increases on market demand is not viable….

4 – Implementation of sufficient internal controls – this would imply that there are lots of additional cockroaches.

Each of these choices is very, very bad for Valeant. Ackman’s made some vague comments about how Pearson is not the best public face for the oncoming government onslaught, but I’m not even sure Jennifer Lawrence could put a good face on Valeant’s business model. If Pearson remains the brilliant dealmaker and operational man that Valeant’s major shareholders have repeatedly suggested, then it seems they must retain him because the company needs those skills now more than ever to deal with the unique challenges that it faces.

But let’s pretend that removing Pearson doesn’t raise at least one of those significant questions about the viability of Valeant.

If Pearson is gone, then don’t you have to evaluate Valeant as a traditional company on normal metrics? Pearson was the premium and now Pearson’s gone.

So what are Valeant’s comparables? We’ll use the following, each of which roughly represent an area of Valeant’s business. JNJ (durable branded pharmaceutical generics), Cooper & Co (B&L), Gilead (Salix), Teva (generics). (We can’t attempt to compare like to like because Valeant doesn’t break down its financials into operational segments.)

None of these companies, as far as I know, have the legal/regulatory risks of Valeant nor the same questions about the legitimate market demand for their products so the comparison should be flattering to Valeant.

We’ll use ev/ebitda (a metric that I think excessively favors Valeant because it depends on a certain level of good-faith in a corporation’s debt load in order to be accurate), price/earnings (just for fun-sies, I know that’s an outdated metric according to the bulls), ev/revenue, and ev/ttm GAAP cash flows. I refuse to use any metric (cough cash eps cough) that does not directly incorporate Valeant’s debt load (either through ev on the front end or amortization on the back end) into the evaluation. Forgive me if that shows a rudimentary grasp of capital structures but, at the very least, any white knight purchaser of Valeant will have to assume its debt.   (GAAP  TTM and EBITDA Valeant metrics do not include the $400 million from Allergan)

(a few of these calculations will be a little rough but are hopefully generally right. I do not include Valeant’s integration costs, which would make things marginally better)

 

  Valeant Ratio Gilead Ratio Valeant Share Price @ Gilead Ratio
Ev/Ebitda 12.1 6.88 11.2
P/E 40.39 9.6 17.5
Ev/Revenue 5.54 4.96 62
Ev/GAAP Cash 27.1 8.32 0 (got to get above 30 bil EV!)

(Brief editorial as a Gilead long, I continue to be astounded that major investors look at the real challenges facing both Gilead and Valeant and bet on Valeant….do you think Xifaxan is clearly a better drug than Harvoni?)

 

  Valeant Ratio JNJ Ratio Valeant Share @ JNJ Ratio
Ev/Ebitda 12.1 11.48 65.52
P/E 40.39 19.48 35
Ev/Revenue 5.54 3.67 19
Ev/GAAP Cash 27.1 15.08 3

 

  Valeant Ratio Teva Ratio Valeant Share Price @ Teva Ratio
Ev/Ebitda 12.1 9.1 34
P/E 40.39 29 52.5
Ev/Revenue 5.54 3 0
Ev/GAAP Cash 27.1 10.5 0

 

  Valeant Ratio Cooper & Co. Ratio Valeant Share Price @ Cooper Ratio
Ev/Ebitda 12.1 15.7 90.8!!!!
P/E 40.39 36 62.3
Ev/Revenue 5.54 4.75 51.04
Ev/GAAP Cash 27.1 19.61 26.8

So, do Valeant bulls really want Valeant to be valued like a normal company?

(One final note, the fact that Valeant’s stock price was $260 in August is an artifact, not a metric.  What would you think if a proud Pets.com owner in late 2000 told you that the stock must be a deal because it used to be $200 and is now $40?)

Disclosures

I am short Valeant through put options.

I am obviously biased but it is in my own financial interests to avoid epistemic closure and motivated reasoning. I will try to be reasonable when the errors that I undoubtedly make are pointed out to me.

I do not place any weight on the statements of Valeant management. Instead, I look at Valeant’s SEC filings and external measurements. If you do trust Valeant management, you should buy stock. They say it’s a great deal.

 

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Wherefore are thou positive catalyst?

Can Valeant find the $3 billion in cash it may need in 2016 to avoid breaching its debt covenants?

We’ve all heard the news. Valeant is going to devote its 2016 cash flows to paying down its debt. Urged on by its most prominent shareholders, Valeant has promised that 2016 will be all about showing its ability to reduce its debt.

But, perhaps Valeant’s newfound interest in paying down its debt is motivated even more by satisfying its creditors.

Bloomberg recently had an interesting article about how Valeant’s creditors were spooked by the possibility of a revenue squeeze.

One key premise of the article is that Valeant “risks violating its credit agreements and triggering a technical default on its senior debt next year if its Ebitda — earnings before interest, taxes, depreciation and amortization — over a 12-month period aren’t enough to cover its interest expense at least three times.”

Now, not to alarm Valeant’s creditors, but in Q3 2015 (per Guru Focus), Valeant’s ebitda was $1.14 billion and its interest expense was $420 million. (Yahoo Finance has a trailing twelve months ebitda of 4.97 billion, which includes $400 million from Pershing Square’s Allergan investment. Take that out and divide by 4, and we have an almost exactly identical amount of $1.15 billion).

That’s a coverage ratio of 2.71. If we simply pro-rate that over the next 12 months, then Valeant is already in breach of its senior debt covenants. Speaking roughly, if Valeant does not increase its ebitda (and for the purposes of this analysis, I will make that assumption because of the headwinds that Valeant is facing), then it will really, really, really need to repay some debt to avoid breaching its covenants.

Valeant has roughly $30 billion of debt. Each billion of debt is roughly responsible for $14 million in interest payments per quarter. ($420 million in interest/30 = 14). If EBIDTA is flat, then Valeant needs to gets its quarterly interest payments below $380 million. (1.14 billion / 3 is $380 million). That means Valeant needs to repay roughly $3 billion in debt over the next 12 months to avoid triggering a breach of its covenants if it’s quarterly ebitda remains flat. That’s putting aside the fact that Valeant drew down $845 million of its revolver in October in order to pay for its acquisitions and, according to Pearson, that’s Valeant’s first priority – let’s say that balances out the fact that Valeant will presumably pay off higher interest rate debt first.

(My guess is that Valeant may have worked out a deal with its creditors that allows it to use some special form of ebitda, like the deal that allowed it to add back synergies when calculating ebidta for debt borrowing purposes. But, on the other hand, it would be like Wall Street to give Valeant the rope with which to hang itself. For the purpose of this analysis, we’ll assume it’s regular old Ebitda.)

So, Valeant appears to need around $3 billion in cash to pay off debt over the next twelve months to avoid defaulting on its covenants. And Valeant says its going to use all of its cash for that purpose. Can Valeant generate that much cash?

I think the first place to look is at Valeant’s historical record of cash generation.

The Record Reflects…

Interestingly, Valeant has said similar things before about using capital to pay down debt.

In December 2014, after its bruising battle with Allergan, Valeant leaked to Reuters its new strategy.

Valeant was going to show the world just how good its business was. It was “abandoning its growth-by-acquisitions strategy for the time being to try to reduce debt, boost its stock price and one day return to its traditional deal-making in a stronger position, people familiar with the matter told Reuters.” It would “focu[s] on its ability to pay down debt or buy back shares.”

Valeant wanted its balance sheet to stop being cluttered by all these darn acquisitions so that investors could see just how great Valeant was: “”The silver lining that has come out of the Allergan situation is that we have already reported one relatively clean quarter…By delivering several more clean quarters over the next several months, we will clearly show the strength of our base business.”

That sounds like a great idea. It would have been interesting if Valeant had actually done it. But instead, within two months of announcing its plans, Valeant spent 15.8 billion dollars to buy Salix.In order to finance the acquisition, Valeant borrowed 10.1 billion in junk bonds, issued 1.45 $billion worth of shares, and assumed about$4 billion in debt from Salix.

And, unfortunately, that pesky balance sheet became messy again. Valeant, to its great regret, will have to incur $300 million in integration costs over the next two years. (pg. 17)

I suppose the opportunity to buy a company in the midst of an enormous inventory scandal was just too good to pass up.

Interestingly, Allergan passed up the exact same deal even though completing it would have ensured Allergan could have fought off Valeant’s hostile takeover bid.

Valeant has talked a good game about capital allocation. Indeed, in order to appear like an Outsider CEO, you are expected to say that you’re going to be flexible with your cash flows – buying back stock, paying down debt, or acquiring companies – depending on the business environment.

But, in order to be flexible with your cash flows, you must actually have cash flows. Since 2012, Valeant’s actions, rather than its talk, fail to indicate the presence of substantial cash flows. They certainly do not indicate that Valeant will be able to generate the $5 billion in cash it needs over the next year to avoid triggering its debt covenants.

Stock Buybacks

Valeant shareholders in recent weeks have hopefully talked about how Valeant will use their cash flows to buy back shares – at least before Mike Pearson shot that down on the most recent conference call.

But Valeant’s most recent annual report provides a wonderful summary of their general approach to using cash flows for stock repurchases: talk a lot, do a little.

Every November, as the leaves turn, Valeant announces a stock buyback program of between 1.5 to 2 billion dollars.

“On November 3, 2011, the Company announced that its Board of Directors had approved a new securities repurchase program (the “2011 Securities Repurchase Program”). Under the 2011 Securities Repurchase Program, which commenced on November 8, 2011, the Company could make purchases of up to $1.5 billion of its convertible notes, senior notes, common shares and/or other future debt or shares. The 2011 Securities Repurchase Program terminated on November 7, 2012.

On November 19, 2012, the Company announced that its Board of Directors had approved a new securities repurchase program (the “2012 Securities Repurchase Program”). Under the 2012 Securities Repurchase Program, which commenced on November 15, 2012, the Company could make purchases of up to $1.5 billion of senior notes, common shares and/or other future debt or shares. The 2012 Securities Repurchase Program terminated on November 14, 2013.

On November 21, 2013, the Company’s Board of Directors approved a new securities repurchase program (the “2013 Securities Repurchase Program”). Under the 2013 Securities Repurchase Program, which commenced on November 22, 2013, the Company could make purchases of up to $1.5 billion of its convertible notes, senior notes, common shares and/or other future debt or shares. The 2013 Securities Repurchase Program terminated on November 21, 2014.

November 21, 2014, the Company may make purchases of up to $2.0 billion of its senior notes, common shares and/or other securities prior to the completion of the program, subject to any restrictions in the Company’s financing agreements and applicable law. The 2014 Securities Repurchase Program will terminate on November 20, 2015 or at such time as the Company completes its purchases.”

Wow, that’s a total of $6.5 billion in announced buybacks. So, how much did Valeant actually purchase with these announced purchased programs.

Let’s start with 2011.

Under the 2011 Securities Repurchase Program, the Company repurchased 5,257,454 of its common shares for an aggregate purchase price of $280.7 million.”

Okay, not bad, $280 million dollars worth.

2012

“Under the 2012 Securities Repurchase Program, the Company repurchased 507,957 of its common shares for an aggregate purchase price of $35.7 million.”

Okay, a lot less, but still something .

2013.

No common shares were repurchased under the 2013 Securities Repurchase Program”

Not great, but they were busy buying Bausch & Lomb.

And 2014

No common shares were repurchased under the … 2014 Securities Repurchase Program.”

Okay, couple of down years.

BUT, in 2015, shareholders will be pleased to learn that ” the Company repurchased 224,215 of its common shares for an aggregate price of $50 million .”

So, in total, Valeant has announced $6.5 billion in buyback programs, and actually purchased…$365 million in stock since 2012.Perhaps this is simply a prudent capital allocation because Valeant’s stock was overpriced the whole time, but that would raise other questions.

And, what happened to Valeant’s share count? It’s gone up about 10% despite that $365 million of repurchases because Valeant has issued about $3 billion of equity.

At the end of 2011, Valeant’s share count was 306 million. In 2013, Valeant issued about $1.5 billion in equity to help it close the Bausch and Lomb transition. The share count went up to 333 million. In 2015, Valeant issued another $1.5 billion in equity to close the Salix transaction after it got into a bidding war. The share count now stands at 343 million. (Valeant’s use of equity issues for its major acquisitions shows that it’s not using whatever cash it’s generating from its business for its big purchases – presumably they’re going to bolt-ons, because Valeant only had 1.5 billion in the bank at the end of last quarter .)

(Small tangent, the pride of Sequoia, Rory Priday, stated that Valeant’s reliance on debt rather than equity for acquisitions (if increasing share count 10% is limited) was a good thing. I think by the time this is done, Valeant’s shareholders will be very, very sad that Pearson did not rely even more on equity for his purchases…but perhaps he did not have a choice.)

Debt Repayment

As John Hempton pointed out during Valeant’s attempted merger with Allergan, Valeant’s debt, despite its rhetoric, had steadily increased from 2010-2014.

I’ll reproduce the chart he used from Capital IQ.

Balance Sheet as of: Total Cash & ST Investments Total Debt Net Debt
Q2Jun-30-2010 183 319 136
Q3Sep-30-2010 598 3236 2637
Q4Dec-31-2010 400 3595 3195
Q1Mar-31-2011 406 4716 4310
Q2Jun-30-2011 242 4547 4305
Q3Sep-30-2011 258 5227 4969
Q4Dec-31-2011 170 6651 6481
Q1Mar-31-2012 332 7003 6672
Q2Jun-30-2012 395 7557 7161
Q3Sep-30-2012 258 7640 7382
Q4Dec-31-2012 916 11026 10110
Q1Mar-31-2013 414 10617 10203
Q2Jun-30-2013 2539 10794 8255
Q3Sep-30-2013 596 17405 16808
Q4Dec-31-2013 600 17380 16779
Q1Mar-31-2014 600 17387 16787

I think it speaks for itself. Whatever cash Valeant was making, was generally not going to paying down the debt prior to 2014. (I think but am not sure, that the weirdness in 2013 involved issuing equity for B&L).

2014: Valeant shows its hand

But, in 2014, Valeant did succeed in paying down some debt early! Per the 2014 annual,

“Long-term debt (including the current portion) decreased $2.1 billion , or 12% , to $15.3 billion as of December 31, 2014 , primarily due to (I) $1.3 billion in net repayments, in the aggregate, under our senior secured credit facilities in 2014, (ii) the redemption of $500.0 million aggregate principal amount of the 2017 Notes in October 2014, and (III) the redemption of $445.0 million aggregate principal amount of the December 2018 Notes in December 2014.”

So, it appears that when Valeant puts its mind to it, pre Salix, it could find $2 billion-ish in cash for debt repayment.

But, there were two presumably one-time sources of income that Valeant took advantage of in 2014.

First, Valeant received $397.5 million of net profits from Bill Ackman’s investment in Allergan. (Valeant had a right to 15% of the net profits – which indicates that total profits from Ackman’s trade were 2.6 billion post short-term capital gains tax, and he kept about $2.3 billion. If you want to know how Ackman achieved 44% returns last year, or why he tried to front run Valeant on Zoetis, then you probably have your answer.).

Second, Valeant received $1.5 billion from its sale of facial aesthetic fillers and toxins (aka – many of the assets from its Medicis acquisition).

So, that comes to a total of $1.9 billion. Very, very close to the amount of debt that Valeant was actually able to repay. For the sake of simplicity, let’s cancel that out and say Valeant basically reduced debt with these one-time inflows.

So how much cash did Valeant actually make from operating activities in 2014?

Valeant started the year with total cash of $600 million. By the end of the year, Valeant’s cash was $320 million, so it spent about $280 million.

During the year, Valeant spent $1.3 billion on acquisitions. (Solta & Precision Dermatology).

Humoring Valeant, it experienced “one-time integration costs” of 381.7 million.

Putting it together, this indicates that Valeant in 2014 had operating cash flows of about $1.4 billion ($1.3 billion + $381.7 million – the decrease in cash of $280 million).

(There were some other cash expenses – $291.6 million for Plants & Equipment, $55.2 million for debt financing, $106.1 million for contingent consideration. I’m not including them here because I think these are just the costs of doing business – every year, I would think, Valeant will have costs like this. I consider this a fair tradeoff for not questioning their classification of integration expenses).

At the end of 2014, Valeant had a total enterprise value of $63 billion dollars and it’s stock price was 94.26. It’s ratio of operating cash flow of 1.4 billion to total enterprise value of 63 billion was about 45 to 1. (I’m using this reverse engineered metric for cash flow because I think it gets across just how much cash Valeant is really, truly generating.)

How does it compare to some leading competitors at the end of 2014 (using GAAP operating cash flows to total enterprise value)

Company Ratio Stats
Teva 10.5 (57 bil. EV / 5.4 bil. Fcf)
Gilead 11.2 (143 bil. EV / 12.8 bil FcF)
Pfeizer 12.9 (196 bil EV/ 15.1 bil FCF)
Johnson & Johnson 15.4 (291 bil EV / 18.8 bil FCF)

So, pick your comparable. If Valeant is Teva (primarily a generics and branded generics manufacturer), then it’s enterprise value at the end of 2014 should have been 14 billion. That would have meant that the equity was worthless, because the debt (even after those repayments) was over $15 billion.

If Valeant is Johnson & Johnson (and I hope/pray for the investors in Pershing Square that even Bill Ackman doesn’t think Valeant is Johnson & Johnson), then it’s enterprise value at the end of 2014 should have been $21.5 billion. Taking out $15 billion of debt would leave $6.5 billion of equity.

Rather than a share price of $94 at an equity value of 47 billion; Valeant would instead have share price of $13 at an equity value of $6.5 billion. And, again, this is if Valeant is given the same multiple as Johnson & Johnson. (Currently, Valeant appears to have a trailing twelve months GAAP cash flow of about $2.5 billion – giving it the Johnson and Johnson multiple indicates that the enterprise value should be $37.5 billion, leaving us back at $6.5 billion of equity value again, and a share price of $18).

If Valeant had simply continued to pay down its debt, and show its operating cash flow to the world, I think the equity value would have started to sink down to $13.

For an ambitious executive team almost entirely incentivized by stock compensation, this is a very, very big problem (especially because I think they had been counting on being able to successfully merge with Allergan).

So, speculatively, I think at the end of 2014/beginning of 2015 they decided to make two major moves.

First, they ramped up Philidor to squeeze cash out of their dermatology business.

Second, they purchased Salix – a pharmaceutical company that many drug manufacturers had been circling and that was very, very, very much for sale.

The first decision has received tremendous attention, obviously. The second decision comparatively little and, with certain exceptions, has generally been considered positive. In a subsequent post, I will advance an entirely speculative argument that it is actually the second decision that will doom Valeant, and that the purchase of Salix will go up on the shortlist of horrible corporate acquisitions along with luminaries like HP/Autonomy. (My thumbnail case – Valeant was counting on tremendous growth from Xiafaxan’s entrance into the IBS-D market – growth that would be explosive largely because many people suffer from IBS-D and it is a chronic condition. I think this assumption was disastrously misguided because: 1) Salix’s gastrointestinal team had already been aggressively pushing Xiafaxan’s usage for IBS-D off label, so much of the growth was priced in, and 2) the FDA only approved Xifaxan, presumably because it is an antibiotic with the potential for resistance, for two 14 day treatment cycles total (perhaps over the course of a patient’s lifetime?). It is hard to make a pill for a chronic condition into a blockbuster when the FDA does not allow you to prescribe it chronically.)

Conclusions

Returning now to the repayment of debt.

Based on 2014, Valeant should have about $1.3 billion in cash for debt repayment.

Based on Q3 of 2015, Valeant should have about $2 billion in cash, at most, for debt repayment.

That’s quite a ways from $3 billion.

A few expected responses.

Can’t Valeant just sell assets to pay down the debt?

Yes, Valeant could, but then it would have less income to pay down the remaining debt. It would have to get a good price. Nonetheless, there is some validity to this point. My biggest worry as a Valeant bear is that a buyer will come along and pay a very nice price for one of Valeant’s assets. In my subsequent posts, I will explain why, after a fair amount of thought (and a tiny bit of hope/faith in the rationality of CEOs) I decided that this was not a significant concern.

Isn’t Valeant going to have an EBITDA of $7.5 billion in 2016 and thus, loads of cash?

That would involve trusting Valeant’s management and I don’t trust Valeant’s management. Heuristically weighing Valeant’s obstacles (Philidor shutdown, PBM retaliation, continued currency headwinds, genericization of key products like Glumetza and Xenazine, backlash to exorbitant pricing, potential fines/clawbacks from government/insurers) vs. Valeant’s positives (errrm, Salix?), I think it’s reasonable, perhaps even generous, to project that EBITDA will be flat based on Q3.

And, in its most recent conference call, even Valeant was not willing to reiterate its $7.5 billion EBITDA guidance.

(One note on that magical $7.5 billion EBITDA figure. Much like my desire to lose that last 10, err 15 pounds, Valeant has long desired to get to a net debt to ebitda of below 4 (although it uses an adjusted metric to achieve that goal). In 2014, it bragged when it was able to bring it down to 3.5. Post Salix, it was back up to 5.6 even under their adjusted metric. One could argue (one = rhetorical straw man), that Valeant chose it’s $7.5 billion ebidta for 2016 because it is the amount that could allow them to achieve a ratio of 4 without actually paying down any of the $30 billion in debt). Alternatively, one could argue that Valeant thought it could grow its ebidta from $4.5 billion to $7.5 billion in one year. The miracle of adjustments!

So, what will happen?

I think the most likely scenario for Valeant is the slow bleed out – it tries to pay down debt over the next year, it makes too little progress, and equity holders slowly exit the sinking ship as bond holders prepare for the fight to recover their assets in the Chapter 11.

The worst case scenario is that Valeant did something else Philidor-esque and blows up very quickly

The best case scenario is that buyers emerge and Valeant equity holders get something back – but, in that case, I don’t think it would be over $30-40 a share at absolute most. I will discuss valuing Valeant’s businesses in my next several posts.

Disclosures

I am short Valeant through put options.

I do not trust the public statements of Valeant’s management. I rely on Valeant’s SEC filings and external sources of information. If you do trust Valeant’s management, then you should probably buy stock in the company. They say it’s a fabulous deal.

I am obviously biased but I try to be reasonable and avoid motivated reasoning and epistemic closure. If I have erred, please let me know.

Can Valeant find the $3 billion in cash it may need in 2016 to avoid breaching its debt covenants?

Valeant’s Q3 Report: Curious & Curiouser

I will be writing a series of articles about everybody’s favorite financial topic – Valeant. These articles will have one central assumption: the statements of Valeant’s management not recorded in SEC filings are not to be trusted. Subsequent articles will discuss the reasons for this assumption in more detail, but it is important to remember. Thus, things such as Valeant’s prior guidance of $7.5 billion EBITDA for 2016 will be regarded as hot air.  Instead, these articles will rely primarily on Valeant’s quarterly/annual reports and outside sources. If you trust Valeant’s management, then you will understandably disagree with these articles. And, in that case, you should definitely raise whatever funds you can to buy more stock – after all, according to Mike Pearson, it was a bargain at 160.  At 75, it must be a fantastic bargain.  And, you will have the market to yourself because Valeant, according to them, will be too busy paying down debt to take advantage of this amazing opportunity.

(NOTE: The original article, I think, contained a significant and unfortunate error regarding the payment of bills, which was exacerbated by some excited rhetoric. I attributed the increase of 281 million in the Q3 accounts payable, accrued and other current liabilities exclusively to the accounts payable portion of the line item. In fact, as the first page of the balance sheet would have indicated, the increase in accounts payable between Q2 and Q3 was only about $60 million, the rest was made up of a difference in accrued and other liabilities. I do not know where that sum came from. The innocent, and probably most likely explanation is that it had something to do with Salix, but Salix did close in Q2. A more interesting, but difficult to understand explanation is that it had something to do with Philidor because here is Valeant’s description of how it accounts for Philidor: 

Gross product sales for products dispensed through Philidor Rx Services, LLC (“Philidor”) pharmacy network (which is consolidated  as a variable  interest  entity within our consolidated  financial  statements)  are  recognized  when a prescription  is dispensed  to a patient.  Net sales recognized through the Philidor pharmacy network represents 7% and 6% of our total consolidated net revenue for the three months and nine months ended September 30, 2015, respectively.  Any inventory on hand in the Philidor pharmacy network is included in inventory in our consolidated balance sheet.    Provision  balances  relating  to  estimated  amounts  payable  to  direct  customers  are  netted  against  accounts  receivable,  and  balances  relating  to  indirect customers are included in accrued liabilities.  

This suggests that there is at least an argument that the increase occurred, at least in part, because Valeant increased its estimation of the returns and rebates it may need to make to its indirect customers (PBMs/Insurance companies). In any case, my apologies for the error in the original post, I have adjusted the language throughout. I think my point on GAAP cash flows remains (relatively) unchanged.) 

Let’s begin with the most recent quarterly report. A close reading reveals two strange and potentially important things.

-If Valeant’s accounts payable and accrued and other liabilities balance had not increased by 281 million, it would take Valeant more than 15 years to pay down its debts if that was the only thing that it did with its GAAP operating cash flows.

-Valeant’s revenues from existing businesses (i.e. businesses not acquired this year) has grown by less than 1% in 2015 if the financial impact of foreign currency rates is included and a majority of Philidor’s revenues are excluded.  If all of Philidor is excluded, Valeant’s revenues from existing businesses has declined so far this year.

Valeant’s accounts payable/accrued and other liabilities has increased by $281 million and thus increased its GAAP cash flow by 38%.  If this had not occurred, and its GAAP operating cash flow stayed flat, then it would take Valeant more than 15 years to pay back its debt even if it used all of its operational cash flow for the task.   

Valeant’s bulls frequently argue that amortization is not a valid expense (the key to the cash EPS figure that is their favorite statistic).  That argument seems questionable according to at least one Oracle.  But regardless, let’s take them at their word and turn to GAAP cash flow from operating activities.  As its name suggests, this, and not cash eps or Ebitda, is a measure of how much cash Valeant is actually generating from its business. And GAAP cash flow is a measurement that even Valeant uses in its own presentations – so it must have some validity.

Last quarter, Valeant had a GAAP cash flow of 737 million from operating activities.  That’s not bad.  Pro-rated, and extended, it would still take them over 10 years to pay off all of their debt if that was all they used their cash for (3 billion a year of cash flow, 31-ish billion of debt).

But there is a significant reason to wonder about that number.  Lurking at the bottom of the statement, Valeant credits its cash flow with 281.6 million for “Accounts payable, accrued, and other liabilities.”  Simply put, these are bills that it hasn’t paid yet.  Unlike amortization, this is a real obligation that Valeant has to satisfy.

And we have external evidence that Valeant has stopped paying its bills.  Approximately a week ago, PDL Biopharma stated that Valeant had missed three months of royalty payments.   Valeant did pay its obligation of $16.9 million in late October, but this evidence suggests Valeant has not been timely paying very real obligations.

281.6 million is a very large number (presumably the missing royalty payments to PDL made up a portion of it).  It accounts for approximately 38% of Valeant’s Q3 GAAP cash flow from operating activities.  If Valeant paid all its bills on time, then its operating cash flow would be 450 million.  Pro-rated (1800 million a year), and extended, it would take them over 17 years to pay off their debts.

I have not found an easy explanation for where this number comes from.  It is presumably not from Salix, because the Salix balance sheet was incorporated into Valeant for Q2.  (In Q2, Valeant’s cash flow from operating activities was only 410 million, with accounts payable standing at 110 million).

I searched Valeant’s Q3 document and found no specific explanation for the accounts payable number.

Valeant explained its increase in GAAP cash flows this way (pg. 50)

“Net cash provided by operating activities increased $118 million , or 19% , to $737 million in the third quarter of 2015 , primarily due to:the inclusion of cash flows in the third quarter of 2015 from all 2014 and 2015 acquisitions, including Salix, Marathon and Dendreon; and incremental cash flows from the continued growth of the existing business, including new product launches.”

They do not provide any direct explanation for why they have an increased credit of 281.6 million in accounts payable and accrued and other liabilities.

Innocent explanations: Salix? Deferred severance packages? Perhaps some friendly supplier doesn’t mind his bills being late? Valeant throwing its weight around?

But that would constitute newfound leniency on the part of Valeant’s suppliers, because the number also dwarfs Valeant’s previous credits for this line item. Valeant’s total line item for all of 2014 was 188 million.  The line item balance was negative in both 2012 and 2013.  In short, deferring its liabilities is a new development for Valeant.

And, to answer the retort of Valeant bulls, Valeant only lodged $75 million in restructuring expenses during this period.  Let’s take Valeant at its word that these are one-time charges and include that back into the cash flows while excluding the $281 million.  Now we’re at $531 million. Pro-rated and extended ($2100 million a year), Valeant, using all of its cash from operating activities, could then repay its debt in only 15 years.  I’m sure the bond holders will be thrilled.

Without Philidor, revenues from Valeant’s existing businesses appears to have grown about 1% over the last 9 months    

Buried rather deep in the Q3 report, is the following series of statements. (page 43)

For developed markets, Valeant states that it experienced:

“(1) a “negative foreign currency exchange impact on the existing business of $66 million and $198 million in the third quarter and first nine months of 2015 respectively.” (2) a negative impact from divestitures and discontinuations of $5 million and $116 million in the third quarter and first nine months of 2015

Excluding the items described above, we realized incremental product sales revenue from the remainder of the existing business of $236 million and $820 million in the third quarter and first nine months of 2015 , respectively. The growth … incorporates sales directly to wholesalers and retailers as well as use of specialty pharmacies (primarily Philidor).”

But, what if we don’t exclude the impact of foreign currency exchange (Valeant’s debt is dollar denominated) and include the impact of Philidor’s demise?

For 2015 so far, Valeant’s existing product lines in developed markets has grown by 820 million.

First, let’s include the impact of foreign currency ($198 million). Now we’re down to 622 million.

Valeant says that Philidor accounted for “approximately 6% of the Company’s total consolidated net revenue.” Philidor only operated in the U.S., and Developed Markets are 82% of Valeant’s total revenue, so let’s bump up Philidor’s effect on Developed Markets to 8%.  8% of Valeant’s developed markets revenue so far in 2015 is 498.6 million. (total developed markets revenue is 6,322.77).

Now, what portion of Philidor’s revenue (which per Valeant was immaterial in 2014) should we take out?  Let’s be pessimistic but not doom & gloom and say Valeant will lose 75% of this revenue. That gets us to 373.92 million.

We take that out from the $622 million and now we’re down to a $249 million increase in incremental revenue in developed markets.

So, for developed markets, Valeant grew revenue 249 million over the last 9 months.  Valeant’s developed markets revenue for the comparable period in 2014 was 4,409.4 million.  That’s an increase of about 5% total.

But wait, there’s those pesky emerging markets where Valeant has been acquiring businesses left and right.

Over the first 9 months of the year, Valeant realized an incremental product revenue increase of approximately 71 million in the emerging markets.

Unfortunately the emerging markets had a negative foreign currency exchange impact of 275 million.

So Valeant’s actual revenues (in those pesky debt denominated dollars) from the existing emerging market businesses actually decreased by 204 million. Total emerging markets revenue for the comparable period in 2014 was 1,574.1.  So Valeant’s revenue from existing products in emerging markets fell by over 10%.

Put it all together – total product revenue for existing product lines (excluding discontinued lines) grew by a whopping $45 million.

Based on a 2014 revenue base of 5,983.5 million, Valeant managed to increase revenue from its existing products by less than 1%. Not great Mike!

If all of Philidor’s revenue is written off, then Valeant’s revenue from existing products actually fell between 2014 and 2015.

Valeant bulls, presumably, will say that it’s not fair to include the impact of foreign currency exchange.  But, if Valeant wants to truly live in the financial world where the dollar is weak rather than strong, then there are steps that it can take. It can pay cash for currency hedges, like many businesses do. It can attempt to borrow money in those pesky zlotys and rubles that are causing it so much trouble, and then repay the debt in the same currency.  But, Valeant is a business, not a George Soros currency trader.  I see no reason why Valeant should be granted the right to decide what is the normatively correct currency level and assume that things will inexorably revert to this state.  (There is also a more sinister assumption – Valeant is making up foreign currency adjustments to disguise the fact that it’s business is shrinking. After all, this is a completely opaque measurement. But, again, even if we accept Valeant at its word, these foreign currency adjustments result in less U.S. dollars.)

For reference, this is the only explanation that I could find in the 2015 annual report of how Valeant performs its foreign currency translation. I do not see any discussion of the base that Valeant uses for the translation and, because Valeant operates in so many different markets with no discussion of revenues from each country, I see no easy way to double check their work:

The assets and liabilities of the Company’s foreign operations having a functional currency other than the U.S. dollar are translated into U.S. dollars at the exchange rate prevailing at the balance sheet date, and at the average exchange rate for the reporting period for revenue and expense accounts. The cumulative foreign currency translation adjustment is recorded as a component of accumulated other comprehensive income in shareholders’ equity. Foreign currency exchange gains and losses on transactions occurring in a currency other than an operation’s functional currency are recognized in net income.

(Relatedly, and a much smaller point, Valeant’s ability to even show some measly GAAP income is entirely dependent on its ability to exclude foreign currency adjustments from that calculation. For example, for all of 2015 so far, Valeant has had a net income of 74.6 million.  But it also has had a foreign currency translation adjustment of negative 548.3 million.  If that is included, then Valeant has had a comprehensive loss so far in 2015 of 477.3 million.  Makes one wonder why Valeant continues to expand into emerging markets so aggressively.)

Conclusions

So, let’s put it together.

According to the GAAP operating cash flow, Valeant right now would be generating around $500 million a quarter in cash if its accrued liabilities had stayed flat.

Valeant’s revenue from existing product lines is basically flat if most of Philidor is excluded.

If Valeant cannot grow its revenues significantly, and it is not doing so for its existing products right now, then it will take it at least 15 years to pay down its debt even if it devoted all of its operating cash flow to the task.  In this scenario, Valeant would not have much money to invest in R&D and little clear-cut remedy for when many of its important products (including even precious Xifaxan) began to lose patent exclusivity.  Valeant would have little margin for error if either interest rates rose, or it had to refinance its debt at a significantly higher rate. It seems likely that little, if anything would be left for the equity holders of the company.

But, I think, this is probably a generous assessment. If there are serious questions about Valeant’s ability to actually repay its bond holders, then the equity will simply become a call option on whether there will be anything left after the bond holders are satisfied – especially once the bond holders begin to increase pressure to ensure repayment. The equity will be a leveraged call option on Valeant’s ability to survive. I don’t think this leveraged call option is worth $75 a share. In fact, I’d be surprised if it ends up in the money at all.

Disclosure: I am short Valeant through put options.

Valeant’s Q3 Report: Curious & Curiouser