Monday, May 15, 2017

Taking the bull case for Valeant seriously

Last night I had dinner with a friend who had a friend who was buying Valeant. Whatever - it led to a discussion of Valeant fundamentals - and that in turn led to this blog post.

The stock has been on a tear lately - rising from $10 to $13.59 in the last week - poking above $14. To some degree this is just standard volatility for a bombed out stock. But it was prompted by Valeant producing results with a sharp rise in "adjusted EBITDA" and guiding for higher adjusted EBITDA. As the FT put it Valeant "bumped guidance".

The Valeant adjusted cash flow caper

I want to explore this "adjusted EBITDA" number. Then I want to lay out the valuation directly.

Valeant has a history of producing little or no GAAP earnings but very large adjusted cash flow. The adjustments are after a collection of exceptions chosen by management and not subject to audit. This blog has demonstrated in the past that some of these exclusions from cash flow are recurring expenses. That said here is the history going back to the final quarter of 2012.

QuarterMeasures presented$million
2012-04Adjusted Operating Cash Flow423
2013-01Adjusted Operating Cash Flow345
2013-02Adjusted Operating Cash Flow423
2013-03Adjusted Operating Cash Flow408
2013-04Adjusted Operating Cash Flow607
2014-01Adjusted Operating Cash Flow636
2014-02Adjusted Operating Cash Flow500
2014-03Adjusted Operating Cash Flow771
2014-04Adjusted Operating Cash Flow624
2015-01Adjusted Operating Cash Flow708
2015-02Adjusted Operating Cash Flow773
2015-03Adjusted Operating Cash Flow865
2015-04Adjusted Earnings*541
2016-01Adjusted Earnings, Adjusted EBITDA**442, 1076
2016-02Adjusted net income, Adjusted EBITDA***487, 1087
2016-03Adjusted net income, Adjusted EBITDA#543, 1163
2016-04Adjusted net income, Adjusted EBITDA##441, 1045
2017-01Adjusted net income, Adjusted EBITDA###273, 861


Alas this table of changing measures requires some notes.

*In the fourth quarter of 2015 the company presented a late annual report. It announced preliminary earnings that contained a new measure: "adjusted EPS". The "adjusted EPS": was not reconciled in any way to previously announced "adjusted cash flow". The "adjusted earnings" in the above table are is the total adjusted earnings that was used to calculate the "adjusted EPS".

**In the first quarter of 2016 the company reported an adjusted EPS number and and adjusted EBITDA number  started guiding for an adjusted EBITDA number. You would think this number to be broadly consistent with previously used "adjusted operating cash flow" numbers. It wasn't. Remarkably there was an unexplained mismatch between the 2015 first quarter adjusted EBITDA number and the originally reported "adjusted operating cash flow". The old number was 708 million as in the above table. The new number was 1127 million. Somehow as Valeant was collapsing they surreptitiously changed their adjustment to even further increase their stated adjusted cash flows.

***In the second quarter of 2016 the company reported an "adjusted net income" which was inconsistent with previously reported numbers. The previously reported number was "adjusted operating cash flow" of $773 million in the second quarter of 2015. Now they reported "adjusted net income" of $751 million for the same quarter. I cannot reconcile the old $773 million number to the new $751 million number.

#In the third quarter of 2016 the company produced an "adjusted earnings" and adjusted EPS number. There is a number for adjusted earnings in the previous corresponding period (that is the third quarter of 2015). That number is $845 million. Again I cannot reconcile this number to the previously stated number.

##In the fourth quarter of 2016 the same issue arises but this time with respect to adjusted EBITDA which is now reported as $1374 million in the fourth quarter of 2015.

###In the first quarter of 2017 the adjusted EBITDA presented for the first quarter of 2016 was $1008 million. Again it cannot be reconciled to the previously reported $1076 million.

Huge cash flows - company is on its knees

Its pretty obvious here that the "adjusted" numbers need to be taken with some salt. Firstly the adjustments simply do not reconcile quarter on quarter. Secondly despite all these adjustments GAAP earnings look limp and the company is on its knees.

In the last quarter the GAAP earnings look fine until you realise that more than 100 percent of them come from writing down previously accrued deferred tax liabilities. The earnings are good because the company won't be paying as much tax in the future (possibly because losses are large and unrecoverable).

The headline: guiding up non GAAP adjusted EBITDA

That said the headline for the Valeant numbers were that they bumped up guidance for their own non-GAAP measures. (They do not and never have guided GAAP numbers.) Here is the key text:

Valeant has raised guidance for 2017, as follows:

  • 2017 Full Year Adjusted EBITDA (non-GAAP) in the range of $3.60 - $3.75 billion from $3.55 - $3.70 billion

This guidance reflects the impact of the sale of the CeraVe, AcneFree and AMBI skincare brands. This guidance does not reflect the impact of the sale of the Dendreon business, which is expected to close mid-year.

What this does not state is that they missed previously announced revenue guidance - and missed it quite badly.

This was the previously announced guidance (announced with the fourth quarter 2016 results):

Valeant has provided guidance for 2017 as follows:

  • GAAP Total Revenues in the range $8.90 billion - $9.10 billion,
  • Adjusted EBITDA (non-GAAP) in the range of $3.55 billion - $3.70 billion

But in the first quarter revenue came in at $2.109 billion. That is a really big drop. You would have to think that Valeant is going to miss its annual earnings guidance by $500 million or so. The FT article notes an 11 percent decline in revenue.

The common sense test

I am an old fashioned sort of guy. There are really only two ways you can raise real EBITDA (and hence I would think that there are only two ways you can raise adjusted EBITDA).

  • The first way is you increase revenues.
  • The second way is you decrease costs.

I think that is the end of the story.

So Valeant revenues are on track to miss guidance by about half a billion dollars. But they are going to beat their adjusted EBITDA number.

This can only be done if they have decreased their costs by an unanticipated half a billion dollars.

Possible: but I would like to know what costs they are cutting that they had not previously anticipated.

Remember this is a company that was notorious for cutting costs (possibly to excess) whenever they purchased an asset.

This was the company who fired almost all non-revenue producing people.

Scientists doing research: fire them.

Compliance officers: fire them.

So I am left with a choice. Either

  1. The entire myth of Valeant - that it was a ruthlessly low cost operation is bullshit and there are still plenty of unanticipated costs to cut allowing the company to miss on revenue and beat on adjusted EBITDA, or 
  2. They are cutting hard into revenue producing staff, but this is going to raise adjusted EBITDA or 
  3. The adjusted EBITDA number and guidance is BS.

As you can guess common sense leads me to the third choice. The adjusted EBITDA number and guidance remain BS.

Alternative valuation measures

You can't value this company against the "adjusted EBITDA" because - as this post demonstrates that number is almost certainly BS.

You can't value this company against earnings because (other than writing off future tax liabilities) this company has no earnings. 

So you are left trying to value it against revenue. 

So lets play this game. 

Let's presume that Valeant revenue is as good as Gilead revenue. Gilead is of course the super-champion drug company with $90,000 drugs that cure nasty diseases like Hepatitis C. It is one of the finest drug companies in the world - and is strongly profitable.

Assuming that Valeant's rag-tag of declining generic drugs with increasing competition is - per dollar of revenue - as good as Gilead - is of course generous.

But lets assume that...

Gilead Revenue is running at $29 billion per annum. The revenue is declining though because the drug works - and people are being cured of Hepatitis C. The market cap is 86.3 billion and cash and equivalents are 11.9 billion. The enterprise value is just under 75 billion - so this is worth just over 2.5 times sales.

If you project pretty gnarly falls on Gilead Revenue (simply because their drug works) it is hard to get below 3 times sales for Gilead.

Valeant sales are about $8.4 billion. Put that on three times sales and you can't even cover the debt. The equity will wind up being worth a brass razoo


Now I am being harsh. Growing pharmaceutical companies with franchises and new drugs in the pipeline regularly trade at 4.5 times sales. If you put Valeant on 4.5 times sales you something in the mid 30 billion range - but only if Valeant sales rapidly stop their catastrophic decline. 

Valeant debt is about 28.5 billion. That gives you potentially - and this is if everything goes right and you put it all on a pretty decent multiple of revenue - about $7 billion in residual equity value. The market cap is about 4.7 billion now.

So if all goes really well you can make some money. But you need to make some pretty heroic assumptions. 

Firstly you need to assume that the various litigation that is inevitable doesn't impair that too much. (I think it will...)

Then you need to assume that the revenue doesn't continue to fall. (I think it will. The company will not be allowed to charge over $200 thousand per year for drugs like Syprine indefinitely. There is probably half a billion to a billion in revenue that will go away simply as competition hits the massively overpriced generics. Actually half a billion is generous.

On top of this you have to ignore the inevitable competition that will come to their biggest drug (Xifaxan). That drug will have a generic supplied by Allergan.

All up I forsee well over a billion dollars of likely revenue declines.

Finally you have to ignore the lack of integrity that allows you to guide up "adjusted EBITDA" when the revenue misses by a lot and where you have not obviously cut costs.

Still - if this is the gamble you want - good luck to you. There are easier ways to make money.



AC said...

Two comments:

1) Gilead's EV is closer to $100 bn, as their net debt is $12 bn, so their EV/Sales is actually 3.5x (just pointing this out - does not really change your analysis).

2) I think there is a path to turnaround for Valeant, and it lies in selling Salix (Takeda was going buy it for $10 bn last year apparently), and maybe their Diversifieds segment (say $4bn at 2x sales since revenues there are shrinking their anyway). This would bring debt levels down to a more manageable level, and management could focus on developing their pipeline. Then you can get to a residual equity value of $13-$16 bn on remaining revenues with your 4.5x multiple. This, of course, hinges on excellent execution from management.

Anonymous said...

Guidance does not say they will miss revenue by half a bullion. During the call they reaffirmed the revenue guidance even though they are divisting Denderon. They are raiding guidance by improving operating margin.

Me XMan said...

Study up on these and let me know how are they: ENDP TEVA MNK GILD AGN. Are they all playing the same game?

Anonymous said...

I agree with the bulk of your post. Now can you tell me some of these easier was to make 50%?

brb said...

1.)You are claiming that VRX has actually missed its revenue guidance in the first quarter by a wide margin. This is not entirely correct:

While VRX missed analysts quarterly revenue estimates, which are based on the companys annual revenue guidance, management never provided a quarterly guidance at all. I do not know why the analysts revenue estimates were off the mark, but I heard rumors that some analysts had increased estimates but cut PTs before the earnings call. You correctly argue that regardless of the way you put it, revenue dropped in Q1 and VRX is fighting an uphill battle to meet annual revenue guidance because annualized Q1 revenue figures would miss the guidance by $500m. While being correct here, you are missing two important points:

First, revenue shows strong seasonal patterns with Q1 typically being the worst quarter of the year. Therefore it is unappropriate to compare Q1 2017 with Q4 2016 when using sequential growth and annualized revenues based on the first quarter figures. So if you compare revenue YoY, revenue declined only by $263m (Q1/2016: $2372m Q1/2017: $2109m).As Valeant guided for $785m LOE impact on revenue for the full year, there is still a gap of $67m ($268m annualized) between what you would expect ($785m/4 = $196m) and what actually happened ($263m). Branded Rx revenue declined by $38m, $23m of that is Xifaxan alone which suffered from poor prescription trends in the beginning of Q1 which seemed to improve afterwards. Given the temporary turmoil related to salesforce turnover in the GI division this underperformance is neither surprising nor expected to be lasting.

Second, previously announced guidance explicitly excluded impact from pending divestitures. As the sale of the skincare brands closed at the beginning of march, one month of revenues is missing, which should amount to approx. $14m in revenue ($168m annual revenue /12).

If you account for these two issues the unexpected drop in revenue is only $67m ($268m annualized) minus $23m (Xifaxan,$69m annualized) minus $14m (divestiture, $56m annualized, which is $30m ($143m annualized).

2.)Moreover, you claim that there is no way for management to meet EBITDA guidance without impairing operations by aggressive cost cutting. While the latter is an area of concern, as they downsized derm salesforce significantly, management was very clear regarding the main source of the guidance improvement: "LOE upside +$110m" (p.13 Q1 2017 Presentation, Appendix for details). Apparently, LOE's did not hit revenues as severe as expected.

3.) You are comparing VRX on sales multiples with currently depressed valuations of other pharma companies like Gilead. While I consider Gilead as undervalued, comparing VRX and GILD on sales multiples is comparing apples with oranges as Gilead's HCV impact on revenues is much more severe than LOE at VRX and B&L is operating in an rapidly growing non-cyclical industry where patent cliffs / LOE are less of a concern, which is not the case at the HIV division which may grow at 3-4% annually but is subject to LOE risk.

Apart from that, you are applying revenue multiples on your lowballed revenue estimate of $8.4b while the guidance was $8.9b and TTM was $9.4B. Using guidance of 8.9b and applying an EV/Sales Multiple of 4.5 this yields an EV of $40.5b, minus $28.5b plus $1.2b cash, yields 13.2b intrinsic value or about 38$ per share.

Anonymous said...

My cost base : 9.20 USD, Current price : 14.37 USD (Time span : Around three weeks)...
This is the VRX part. My recent ENDP play tells me a similar story...
If there are easier ways to make money, I'm all ears...

Unknown said...

article with tons of BS word can hardly be unbiased

random itinerant said...

Are you aware that your spiritual godfather Steve Cohen has gone long VRX according to latest SEC filings? Surely you of all people know that betting against the Cohen gang is not a wise thing to do.

A tip to other readers: Google search for 'Hempton Cohen' turns up interesting things.

Amar P said...

Just a dead-cat bounce in $VRX. Crossing 14.50 and then 20 is a Herculean task.

Amar P said...

The good news with $VRX however is that it can't go below 0!! So not much downside in terms of absolute numbers.

Anonymous said...

so i guess you re long Gilead at these levels????

Anonymous said...

Maybe at least tell us how low can Gilead still go?

Anonymous said... Read my article where I discuss why VRX is a particularly good investment. Let me know what you think about it, I'd be curious to what your thoughts are in response.

Anonymous said...

This is a rant not an analysis. Product lines? Pipeline? Cash flow

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