Valeant (NYSE:VRX)
Valeant’s stock price declined significantly in the quarter as a result of statements by politicians regarding drug price increases, subpoenas from regulators, attacks by short sellers, and the termination of Valeant’s relationship with Philidor, a specialty pharmacy distribution channel used for dermatology products. On October 30, 2015, we held an investor conference call to answer the many questions we received about our investment in Valeant.
Approximately six weeks ago, Valeant’s board formed an ad hoc committee to investigate the recent allegations made against Philidor, including claims that Valeant management was involved in the alleged wrongdoing at Philidor. The committee has hired former U.S. Deputy Attorney General and Kirkland & Ellis partner Mark Filip to lead the investigation.
Valeant will hold an in-person, half-day investor meeting tomorrow, Wednesday, December 16th, to provide updated financial guidance for 2016, review the company’s strategy, and answer investor questions. We believe that this is an important step for Valeant to restore investor confidence.
On November 23rd, we filed a 13D reflecting our increased stake in Valeant. Before we increased our position, we did substantial due diligence by re-underwriting our investment in the company. In particular, we reviewed all of the short sellers’ allegations, the potential political and regulatory risks, the impact of the shutdown of Philidor, and the company’s capital structure, debt covenants, and overall financial risk. We updated our financial model in light of recent business developments in order to better assess free cash flows, how quickly the company would be able to reduce leverage, the probability of financial distress, and to determine a conservative estimate of Valeant’s intrinsic value.
Ultimately, we concluded that the risk of bankruptcy or financial distress was de minimis in light of (1) the highly cash-flow-generative nature of the business, (2) the minimal debt maturities over the next several years, (3) the nature of Valeant’s financial covenants, and the highly diversified (both by therapeutic area and geography) product portfolio. Because Valeant owns a highly diversified, divisible, and desirable portfolio of products that can be sold product -by-product and/or division-by-division in an industry with many well-capitalized buyers, it could deleverage at an even more rapid rate if it chose to do so. Once we determined that the risk of financial default was extremely small and the stock was trading at an enormous discount to intrinsic value, we considered various approaches to increasing our investment.
Generally, we purchase stocks outright to get exposure to a particular investment. In this case, we took advantage of the high volatility of Valeant stock, its extremely low share price, and the high degree of market uncertainty in choosing to build a position that offered us a compelling reward for the potential risk. Rather than purchase common stock outright, we increased our investment through a contemporaneous series of over-the-counter option transactions. The bulk of the increase in our investment in Valeant was created through the sale of European-style put options struck at a $60 stock price, the purchase of American-style call options at a $95 stock price, and the sale of European -style call options at $165 stock price, all of which expire in January 2017. This derivative position gives us the upside of the stock from $95 per share up to $165 per share until January 2017. The net purchase price of the options was $6.75.
In summary, if the stock rises to $ 165 or more by January 2017, we will make more than 10 times our net investment over this period. Our downside is equal to the net purchase price of each option plus the decline in the stock price, if any, below $60 per share as of January 2017. By selling European-style put options, the shares cannot be put to us until January of 2017. By then, we estimate that Valeant’s stock price will be substantially in excess of $60 per share, potentially several multiples of this price.
The upside of our derivative investment is approximately equal to that of owning the stock outright at $95 per share with 30% less downside, i.e., if the stock were to go zero, we would lose approximately $67 per share, (the put strike price plus the net option premium). By selling two options for every option that we have purchased, we have also minimized the effective cost of this investment and limited the impact of rapid time value decay which is characteristic of an outright option purchase on a highly volatile stock. In a worse-case scenario, which we believe is extremely unlikely to occur, we risked approximately 4% of additional capital on this investment while increasing our notional exposure to Valeant by about 6% of the portfolio.
We added to our investment because we believe that Valeant shares are enormously undervalued. While we expect a degree of disruption to Valeant’s dermatology business, we believe that the fundamentals of Valeant’s overall business remain strong. Just this morning, Valeant announced a 20-year agreement with Walgreens Boots Alliance, Inc., the largest pharmacy chain in the U.S. with more than 8,000 units, which will “more than replace” Valeant’s Philidor specialty pharmacy distribution. We believe that this agreement will go a long way to addressing concerns about the disruption to Valeant’s dermatology business by expanding convenient and affordable access to Valeant products, and will help restore credibility by the company partnering with the largest and best-managed pharmacy chain. The agreement provides for discounted pricing for Valeant’s dermatology and ophthalmology products reducing costs for the health care system.
Valeant’s stock price is currently impacted by the high degree of uncertainty created by the shutdown of Philidor and the corresponding investigation of allegations, recent political scrutiny of the pharmaceutical industry, negative press coverage of Valeant, and technical trading factors. These technical factors include: (1) the large amount of tax-loss selling which will likely continue until year end, (2) redemption-related sales from funds whose performance was affected by the decline in Valeant’s stock price, (3) “window dressing” where investment managers who held Valeant stock sell it before year-end so they do not need to show their investors the actual losses they incurred holding the position, and (4) the inherent complexity of the company that requires substantial due diligence before new investors establish their investment.
Because of the controversy around Valeant, many portfolio managers have been unwilling to retain an investment in the company as client scrutiny and headline risk became intolerable. In light of the above technical factors, we believe that most new investors would prefer to wait to establish an investment in Valeant until after the upcoming analyst day and when year-end technical factors abate.
There are a number of relatively short-term catalysts that we believe may lift the overhang on Valeant shares. We expect that this morning’s announcement will reduce if not eliminate concerns about disruptions in the distribution of Valeant’s dermatology products. We expect that additional uncertainty will begin to dissipate at tomorrow’s analyst day when the company will announce its revenues and earnings guidance for 2016 and answer questions from existing and prospective investors. In addition, we expect the results of the Philidor investigation to be announced sometime in the first quarter of next year. The company will likely file its 10-K in February with the results of Price Waterhouse’s year-end audit. This should comfort investors who have concerns about Valeant’s accounting.
While we expect a messy fourth quarter due to the shutdown of Philidor and investigative costs, the company should be able to post “clean” quarters beginning in the second quarter of next year. With the passage of time, the reduction in uncertainty, increased transparency, the reporting of operating results which we anticipate to be strong, along with the deleveraging of the balance sheet, we expect Valeant stock to rise substantially.
From Bill Ackman (Trades, Portfolio)'s Pershing Square Holdings third quarter 2015 letter to shareholders.
