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?

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