An Attempt to Value Valeant Just for Fun

Until last week, I had been just a casual observer of Valeant (VRX, Financial). My knowledge of the company was limited to:

1. It was a rollup company growing through acquisitions.
2. It had a CEO who was considered a genius until the short seller Citron wrote a report that was really not high quality beyond the point of Philidor. (The Philidor problem later turned out to be material).
3. Valeant has accumulated a lot of debt in the process of serial acquisitions.
4. It owns Bausch and Lomb.

My dislike for acquisitions has led me to many companies who like to be acquirers. But when Valeant's stock fell 50% in a single day last week, I started to be bugged by the fourth point above – Valeant does have some attractive assets. The stock price has been like a firework on the way up and on the way down, and sells at less than 4x “adjusted earnings” of $8.50 to $9.50 a share in 2016 (if you believe in the guidance). Was there an overreaction? Could there be an opportunity?

Without doing any work beyond reading company filings, I'll discuss what Valeant could be worth.

I won't go into the question of the quality of the numbers for now, although the delay of the annual filing gives us enough room for imagination. I will assume that all the numbers are more or less right as I need to have some basis. This is a big assumption to begin with. If you do not think Valeant could be a good investment after the replacement of the CEO and Bill Ackman joining its board, you could stop reading right here. All your concerns are legitimate. But if like me, you think Valeant has attractive assets and would be willing to have an open mind, I would like to hear your thoughts.

First, who is Valeant?

Valeant was the result of a merger of several pharmaceutical businesses in the 1990s. The company had been just another ordinary small company in the U.S. until Michael Pearson from McKinsey was recruited to be the CEO in 2007. Pearson pioneered a “new” pharmaceutical business model. Previously, companies spent tons of money on in-house R&D. In many cases the research dollars bear no fruit when the science does not work. Valeant, on the other hand, would buy companies with potential winning research, therefore increasing the odds that the science would work and then, of course, raising the expected value of the drug portfolio it purchased.

From 2008 to 2010, Valeant was tiny and bought a few pharmaceutical businesses for a couple of millions at most. Then in September 2010, Valeant was bought by Biovail, a Canadian company. Pearson became the CEO and Valeant moved the headquarters to Canada, saving taxes. Valeant became aggressive in acquisitions, making about 25 deals a year. The largest deals were the $8.57 billion acquisition of Bausch and Lomb in 2013 and the $14.5 billion acquisition of Salix in 2015. It certainly had more attempted acquisitions: In 2011, Valeant was unsuccessful in its bid to buy Cephalon for $5.7 billion. In 2004, it failed to buy Allergan (AGN, Financial) with an initial bid of $46 billion that was raised to $53.3 billion. The majority of the successful deals were financed by debt, which ballooned to more than $31 billion as of today.

Valeant’s typical moves after the acquisitions were to cut the corporate cost and R&D to minimum and raise the drug price.

How much does Valeant earn?

Good question.

Careful investors have noticed that there is a big gap between Valeant’s GAAP earnings and reported adjusted earnings. For example, Valeant presented the following table for the third quarter 2015 earnings. You would notice that GAAP EPS is not in the table, and in fact I could not find it in the PowerPoint. I had to find GAAP earnings from the earnings releases and the lousy formatted Q and K’s. For Q3 2015, the GAAP EPS is 14 cents. For Q3 2014, the GAAP EPS was 81 cents. The problem is, I could not find any reconciliation between GAAP and reported earnings (cash EPS). I would have to do my own work to find what possibly made of the big gap from reported “cash EPS” to GAAP EPS.

Source: Company earnings presentation

So I did. The following is a copy of consolidated income statement from Valeant’s 2014 10-K, which is likely to be restated soon.

Source: Company 10K.

From this table the brave made the following reconciliation. Note that the shaded areas in the table above are copied into the shaded below with necessary sign changes.

Observations:

1. Even after adding all line items beyond cost of goods sold, SG&A, and R&D back to the earnings at a low tax rate of 10%, I still cannot get the reported earnings of $2.85 billion in 2014. Which lines that were used to arrive at the adjusted net income is a mystery. I didn’t see the information anywhere, either in the filing or in the company’s earnings presentation.
2. The amortization of intangibles is the dominant line item in the above table. I am certain that this item is surely excluded from the adjusted earnings in its entirety. This amount is what Valeant paid to acquire companies for their in process R&D (IPRD). This amount is amortized over a finite period. Should this line item be excluded from the earnings number?

Now let’s focus on number two. Amortization of intangibles is indeed a non-cash item, and I agree that it should be excluded from considerations of earnings in majority of the cases. However, Valeant’s case is not among those in my opinion. Pharmaceutical companies are in the business of R&D. Without R&D, whether in-house or outsourced, a pharmaceutical company is unlikely to survive as existing drugs will be replaced by new, more effective drugs. Many pharmaceutical companies conduct research in house. Valeant’s “new” business model is essentially outsourcing R&D. Valeant capitalizes those R&D expense lawfully due to M&A accounting. But if in-house R&D is an expense, why should outsourced R&D not be an expense?

If we exclude the amortization of IPRD from Valeant’s earnings, we essentially exclude the de facto all R&D expenses from the earnings. Therefore if we follow the management’s guidance to adjust Valeant’s earnings by adding back amortization of IPR&D, and then overlay a P/E ratio to value Valeant, it would overestimate the value of the company. This because without those de facto R&D expense in the name of investment cash flow, Valeant’s earnings are likely much smaller in 10 years. We can either expense R&D properly in earnings and overlay an appropriate P/E ratio, or use DCF to estimate VRX’s value. But we should not use an inflated earnings number that does not include the crucial R&D expenses and overlay a P/E as if the business were sustainable without property R&D spending.

But the amount of amortization is indeed somewhat arbitrary. It may not be fair to add 100% to earnings. I agree. Taking the reference of Pfizer (PFE, Financial), Merck (MRK, Financial), Gilead (GILD, Financial) and Allergan, 15% R&D expense to sales seems to be a norm to spend on R&D. I am hesitant to assume a smaller number for Valeant because those companies are much larger in scale and can attract the best researchers in the industry. Valeant currently spends 3% in R&D. Let’s say to be a normal pharmaceutical company, it needs to spend an extra 10% of sales on R&D. In 2016, VRX is guiding for $11 billion in sales. Ten percent would be $1.1 billion, which at 10% tax rate would reduce their guided adjusted EPS by $3 to about $6 (guidance EPS $8.50 to $9.50 per share). If you are willing to apply 10x then you could have a $60 per share value for a heavily indebted company in the middle of a major transition in business model. Today’s price is $34.

It is an interesting case. I do not have a long or a short position in Valeant because to me, the current situation is murky to say the least. But here I've shared my thinking.

Judgment is all yours.