There are several reasons to dislike Valeant Pharmaceuticals (VRX, Financial). Lack of management credibility, accounting irregularities and other legal investigations related to a price increase on a couple of drugs have caused its share price to fall from the high of $260 to $28.95. Investors in the company, including me, had a stomach-churning experience.
It's always disheartening to see the value of the investment fall within a space of few months, or even days in this case. The market has a way of humbling even the best of hedge fund managers:Â Bill Ackman (Trades, Portfolio), Value Act, Sequoia and Lou Simpson (Trades, Portfolio) all have large stakes in Valeant. A few of them had a cost basis in the mid 100's.
Still, I believe at a certain price level a stock even with all the issues Valeant has can be a buy. At that price level, the investor should re-evaluate their investment thesis, see if the thesis is still intact and conclude what action to take: sell, buy or hold, depending upon the risk appetite.
I am not recommending a reader to sell, buy or hold the shares of Valeant, but I'm presenting my perspective on the current situation and the number of possible outcomes.
In the current situation, there are three possible outcomes:
- Bankruptcy: This is possible given the high debt level of approximately $30 billion. Even with these issues, the underlying business is solid and cash generative. The accounting irregularities may change the accounting EPS, but the cash EPS, which I use for the valuation purposes will remain the same. Additionally, there is no major debt repayment due until 2018. Therefore, the probability of bankruptcy is very low.
- Management change: The most likely outcome. CEO Micheal Pearson and his team have lost credibility with investors. The board will act in the interest of the investors by putting new management in place. Not many CEOs can remain in their position after such a steep fall in price. The string of misstatements and lack of disclosure have not only undermined Pearson's credibility, but also undermined the Valeant's brand and reputation. As of this writing, the board has announced that they are seeking a replacement for Pearson.
- Break up the company: This outcome is highly likely, given the high debt level. If Valeant generates a lower level of free cash flow from the business, it is highly likely that new management will sell part of the business to pay off debt. Prior to the crisis, management has earmarked neurology business for sale, but it's been put on a back-burner for the moment.
My investment thesis prior to recent crash in price from $90 to $28 was based on:
- Strength of Valeant's business franchise, which consists of a strong portfolio of durable products in the growing therapeutic areas such as dermatology, eye care, branded generic drugs with limited patent cliff after 2016, healthy drug pipeline, non-reliance on government reimbursements and loyal physician base.
- Reliant and efficient business model through revenue diversification across the number of products, gradual price increase, in mid-single digits across the portfolio, decentralisation of operation with a focus on lower operating cost and generation of a high level of cash from operations.
- Lower risk and output-focused R&D as opposed to higher risk R&D based on discovering and developing blockbuster medicines.
- Cheap valuation and getting 50 cents on a dollar. I conservatively estimate an intrinsic value of the business to be around $200 a share without any growth assumptions and contribution from drug pipeline. I ignored the net income stated in the P&L statement, because it is unreliable due to the number of acquisitions that Valeant did in the last three years. Instead, I focused on the FCF, cash EPS and conversion rate from cash EPS to FCF, which is around 90%. Based on cash EPS of $10 and putting 20x, which is lower-end of the range for the drug companies with a similar profile to Valeant's, the valuation comes to $200.
My investment thesis has remained intact even after the string of issues. I continue to believe in the durability of the products, its low cost operating model and the support Valeant can receive from activist investors like Bill Ackman (Trades, Portfolio) and others. I also believe that cash EPS and FCF are isolated from accounting irregularities; therefore, my valuation has not changed.
However, with the steep fall in the price, the gap between the intrinsic value and price has widened so much so that the investors are getting company at 2.8x cash EPS, offering a significant margin of safety to the investors in the event of a significant revenue and cash EPS contraction.
For the share price to reach its intrinsic value, the new CEO has to restore confidence and credibility among the investor community, must fix accounting irregularities and has to put tight internal control over financial reporting and disclosures. I believe that over the next 12 to 24 months, the issues will abate and the share price will be based on fundamentals rather than bad news and emotions.
Patience and courage are key here. The outcome of 5x to 7x returns over next two to three years is far too enticing to ignore for the sophisticated investor, especially when the downside risk is minimal. Heads I win and tails I don't lose much!
