Funds Face Off on Valeant

Two of SumZero’s most successful and outspoken members, Navi Hehar of Mile 26 Capital in New York and David Trainer of Novo Capital in Nashville, came down on opposite sides of one of the most talked about stocks of the year, Valeant Pharmaceuticals. With highly publicized investigations by the SEC and activist interest from Bill Ackman, ValueAct and others, Valeant has received much media attention in both directions. The company restates previously investigated and audited financial statement this coming Monday, 3/14. In light of this, SumZero sat down with Messrs. Hehar and Trainer to get the timely long and the short on Valeant.

The following interview was published in part on Business Insider.

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David Trainer, Novo Capital - The Short Thesis

1. Valeant has a history of trying to mislead investors. Those that bend the rules most are the most likely to break rules.

In June 2014, we pointed out Valeant was bending the truth to present itself in a more favorable way to bolster its takeover bid of Allergan. The main issues at the time were:

a. Dubious claims of “undervaluation.”Valeant argued that it was undervalued based on P/E ratios, which we know to be a poor measure of value. Valeant failed to mention that it compared its adjusted P/E, which removed numerous “one-time costs” related to acquisitions, to the unadjusted P/E ratios of its industry, sector, and S&P 500. By comparing its non-GAAP metrics to others’ GAAP results, VRX was comparing apples and oranges. More rigorous metrics, like price-to-economic book value (PEBV), showed that VRX was significantly overvalued versus its peers.

b. False claims that previous acquisitions were value creating. In order to entice Allergan to consider the buyout, Valeant wanted to tout its acquisitions as value creating. However, Valeant’s return on invested capital (ROIC), which provides a true measure of if/how much value the company creates, had fallen from 15% in 2009 to 4% in 2013. The prior acquisitions had increased its invested capital 13 times over while net operating profit after-tax (NOPAT) i.e. cash flows, only tripled.

2. “Cash earnings” are a mirage. In my view, they represent a blatant attempts to mislead investors.

In July 2014, Valeant made my list of companies with the most misleading non-GAAP earnings. This most alarming “adjustment” for non-GAAP earnings is exclusion of the costs related to its acquisitions. Does it make sense to exclude the costs related to how you grow your business from how you measure profits? I find that fishy.

We revisited the non-GAAP red flag again in November 2015, and the story had only gotten worse. While the company’s non-GAAP “cash earnings” have been highly positive, growing from $421 million in 2010 to $3.55 billion over the latest trailing-twelve months (TTM), free cash flow has been highly negative with a cumulative -$38.4 billion in losses over the same time frame when adding back in the costs of acquisitions. Cumulative non-GAAP earnings during the same time are $11.2 billion. Valeant uses non-GAAP metrics to make its business look better than it really is while burning through cash at an unsustainable and alarming rate.

3. Other accounting shenanigans and official investigations into the company by regulators and congress are big red flags.

This isn’t the first time analysts have raised questions about Valeant’s accounting.

- John Hempton of Bronte Capital, has argued that the company may be misclassifying recurring items as one-time charges in an attempt to boost its non-GAAP earnings even further.

- Questions about the accounting practices between Valeant and Philidor (the reason for the VRX’s upcoming restatement of financials) have been around since October 2015.

- In addition to investigations by the U.S. Attorney’s offices in Massachusetts and New York, in February 2016, it was revealed that Valeant received a subpoena from the SEC in the fourth quarter of 2015 about its relationship with Philidor.

- Members of the House Oversight Committee have been looking into drug pricing schemes to determine whether Valeant’s practices of acquiring a drug and immediately increasing its prices are legal actions.

The investigations are not only focused on Valeant as a whole but also its subsidiaries. In early 2016, it was revealed that former executives at Salix Pharmaceuticals’ were under investigation by the SEC to determine if they misled investors relating to inventory disclosures. This investigation comes on the heels of a previous investigation that revealed Salix had overstated revenue and income dating back to 2013. Valeant acquired Salix in April 2015.

4. Executive compensation is not aligned with shareholders’ interests.

By focusing on non-GAAP metrics, Valeant executives can line their pockets with little regard to the real economics of their decisions. Executives receive bonuses, which can be 200% of annual salary, that are determined by meeting specific criteria, such as revenue growth and “cash EPS.”

Thus executives are incentivized to grow revenue through acquisition, regardless of effects on of cash flow or shareholder value, and increase “cash EPS,” which just so happens to remove acquisition related costs. It’s not hard to see the cycle this incentive plan creates. Acquire a company, grow revenue, remove cost of acquisition, and increase “cash EPS” to distract from cash burn. Wash, rinse, and repeat. Until executives are held accountable to metrics that are proven to create shareholder value, like ROIC, Valeant executives’ actions will remain misaligned with shareholders best interests.

Valeant’s debt has increased from $372 million in 2009 to $30 billion over the last twelve months. Similarly, from 2009-2014, Valeant’s shares outstanding increased from 158 million to over 356 million, or 16% compounded annually. If Valeant has been so successful, as its non-GAAP accounting would have you believe, why has it consistently required so much more capital?

5. Even after recent declines, huge downside risk remains in the stock.

Since my initial warning on Valeant in June 2014, the stock is down 48%. The stock performance is even worse over the short term, having fallen 75% since August 2015. After such a drastic price decline, one might think shares are a bargain. Not even close. Those purchasing Valeant now would be buying a highly overvalued stock with a long history of misleading accounting. Not exactly the characteristics of a quality investment.

By my calculations, in order to justify its current price of $65/share, the company would need to grow NOPAT by 13% compounded annually for the next 10 years. In this scenario, Valeant would be generating $33.4 billion in revenue, greater than that of AstraZeneca’s (AZN) 2014 revenue and just below GlaxoSmithKline’s (GSK) 2014 revenue.

Even in an ideal scenario, in which Valeant focuses on internal growth and not destructive acquisitions, I calculate VRX still has significant downside. If you believe Valeant grows NOPAT by 9% compounded annually for the next decade, the stock is only worth $24/share today – a 63% downside.

Navi Hehar, Mile 26 Capital - The Long Thesis

1. Simply put, I challenge anyone to present a cash flow forecast for Valeant that doesn’t equate to an excellent compounding return at current prices.

Valeant is an enormously cash flow generative business with very diversified cash flows; outside of Xifaxan, no single drug is makes represents greater than 4% of revenue. This makes the cash flow of the Company far less risky than that of most drug companies. Even if payers like CVS push back on sales for Jublia, even with Valeant losing distribution through Philidor, even if lawmakers forbid price increases above some arbitrary level (impractical in my opinion), even as certain drugs fall off patent – Valeant’s revenue and profitability will remain incredibly robust. In addition, Valeant has a very large pipeline of new products and drugs in late stage development that could more than make up for any shortfalls.

There are numerous cash flow forecasts available for Valeant. Pick one, any one, and I think you’ll see something interesting. Practically every knowledgeable Valeant analyst – whether sell side or buy side, believes Valeant will earn enormous cash flow in the next 1-4 years! The debate is what earnings look like 5 years from now (when Xifaxan and Jublia patents begin to roll off).

To the extent that investors think Valeant will face declines past 2020 (when Xifaxan / Jublia patents begin to roll off), you would have to argue that Valeant is unable to find new drugs to offset those that roll over. This is a more compelling argument, and one where investors can have reasonable skepticism. However, I would point out that Valeant generates a very significant chunk of its profits from durable consumer franchises like Bausch & Lomb, which have compounding growth and little patent risk, and the Company has a pretty robust pipeline of late stage drugs, many of which could be meaningful profit drivers.

Additionally, Valeant will acquire assets, and the irony is that with biopharma companies trading far lower than they were a year ago, and one of Valeant’s biggest rivals in the M&A market (Allergan) being busy with its merger with Pfizer, Valeant may be able to achieve even higher IRRs on its acquisitions going forward.

When I initially wrote my Sumzero write up, I estimated that Valeant shares were priced to earn investors a 10-15% compound rate of return over the long-term, far above what an investor would earn in the S&P 500 (~5-7%). Today, I think Valeant shares may be priced to achieve an even higher return: 12-18%. Interestingly, even sell-side analysts that have recently downgraded Valeant shares have come to the same conclusion!

In every bearish short report I have read on Valeant, the analysts have played with their numbers and made unrealistic expectations to back into the lower valuation they want to show. One of the most egregious examples is how Wells Fargo ($67.00 target) recently made unrealistic working capital estimates to justify their “Sell” rating. This type of work is incredibly inaccurate, bordering on misleading.

2. Valeant’s CEO, Mike Pearson, has a unique knowledge of the drug industry that no other large drug company CEO has.

During his 20+ years at McKinsey, Pearson learned that drug companies were earning sub-par returns on early-stage drug discovery and research. He learned that the drug industry had a very bloated cost structure, since companies did not compete on efficiency, but rather, discovery. Furthermore, Pearson realized that the best drugs to own were ones that customers pay for out of pocket, reducing reimbursement risk, and that less competitive segments like dermatology were more attractive than “blockbuster” drugs in areas like cancer or cardiology.

When he took over Valeant, he went about to exploit the opportunities he recognized. Pearson began acquiring dozens of companies and doing what seemed impossible: he grew sales while cutting billions in costs. He proved his thesis.

Valeant today is a very intentionally constructed portfolio of drugs with less patent cliff risk, less reimbursement risk, less competitive risk and focused in very specific segments (eye care, dermatology, gastro) while operating with a very lean cost structure. It has developed into a platform: the Company’s sales force allows it to acquire drug brands and actually increase organic revenue while cutting out most of the costs.

While investors can rightly debate whether Valeant should have been valued at $250/share (or $115B enterprise value), one cannot argue that Mike Pearson has created enormous value since joining Valeant. He took a small-cap company with a $5.00 share price and transformed it into a business that earns over $10.00 per share. He did that in only five years. To deny Mike Pearson knows how to create enormous value in pharma is to deny the facts.

3. There is a huge difference between the perception of Valeant on “Wall Street” and on “Main Street”

While investors may debate Valeant’s operations, doctors continue prescribing Valeant’s products because they work. Philidor didn’t demand Valeant’s drugs – doctors did!

There are a couple of common criticisms about Valeant’s core drug portfolio: that its drugs are egregiously expensive relative to widely available generics, and that the company was using Philidor to either falsify revenue or to get payment for prescriptions that insurance companies wouldn’t have otherwise paid for. Two of Valeant’s dermatology drugs in particular, Jublia and Solodyn, are most cited for issues related to cost, efficacy, and ties to Philidor.

The discovery into Philidor’s wrongdoing came from a damning investigation by the Wall Street Journal into Philidor’s aggressive, and arguably illegal, sales practices. After the WSJ article, several pharmacy benefit managers (PBMs) quickly cut ties with Philidor, and Valeant followed by cutting ties with the specialty pharmacy as well.

Investors were rightfully concerned that Valeant may not be as successful in selling its drugs without Philidor. However, IMS data is readily available on a weekly basis, and the data shows that since Valeant has shifted its distribution to more “traditional” channels (like Walgreens), doctors have continued to prescribe Jublia, Solodyn and Valeant’s other dermatology drugs. The fact is, Valeant’s drugs are prescribed for a reason – they have unique factors that make them different and more effective than generic alternatives for certain situations. Payers may push patients to try cheaper alternatives first, which will likely lead to some lost prescriptions over time, but to say Valeant’s drugs are outright fakes or have no market justification is wholly inaccurate.

4. To make an investment in Valeant, I think investors have to get comfortable with four things – ironically, they have nothing to do with accounting, federal regulation or Philidor. I call them the “4D’s” – Debt, Drugs, Departures and Discount rate.

Debt: Valeant is a heavily levered company. If Valeant’s debt costs rise significantly, the Company’s operating flexibility could be constrained, and its ability to do new acquisitions challenged. Luckily, Valeant’s next large debt maturity is not until 2018. The Company’s current pipeline of drugs should generate more than enough cash flow for the Company to repay the 2018 bullet, and management has committed to paying down debt even sooner. However, Valeant will need to show the ability to continue earning significant cash flow beyond 2020 in order to pay off its significant debt load.

Drugs: Like any drug company, the most important factor investors have to get comfortable with is the future cash flow expected from Valeant’s drugs/products. Overall, the core drug / product portfolio at Valeant appears to remain very robust and durable, at least for several years. Beyond that time, as with any other drug company, investors need to have some view on Valeant’s R&D pipeline and potential growth of its drug portfolio through new indications.

Departures: One of our main concerns with Valeant has gotten little discussion by the investment community, namely the impact of the recent issues on employees. The ultimate success of any company is driven by its team of people. Valeant’s share price declines and headline pressure could lead to departures and turnover amongst Valeant’s key executives. Given that Valeant runs a very lean and decentralized model, these executives have significant responsibility and often very strong relationships with employees around them. An exodus could be very damaging for the firm. Indications appear that the firm has successfully retained employees, but it is still too early to be sure.

Discount rate: Finally, investors should get comfortable with an acceptable discount rate. If Valeant shares were priced to achieve a compound return of only 8% a year, though this is slightly better than what an index will likely achieve (5-7%), I think many investors can rightly say that it may not be worth the risk of buying a heavily levered company currently driving through a Perfect Storm just to earn an extra 1%. However, with shares currently priced to earn mid-teens compound returns over the long-term, we think investors are getting a more-than-adequate reward for the risk.

5. All of the typical criticisms against Valeant fall apart when one looks at the Company’s largest business: Bausch & Lomb.

Valeant bought Bausch & Lomb in 2013 for only $9B. Many investors thought they overpaid. Only three years later, Bausch & Lomb is likely worth over $25 billion, its margins have doubled under Valeant’s ownership, it is growing faster than before Valeant acquired it, and it will generate profits for decades to come.

If my estimate of value for Bausch & Lomb is correct, a bear would have to argue the rest of Valeant is worth less than $20B – an implausible outcome given that just the Salix business was valued at $15B only a year ago!

Bausch & Lomb has no ties to Philidor, no congress/payer risks (mostly cash pay), no patent risks, and no “R&D is too low” risks (huge growth pipeline). Bausch & Lomb is almost certainly worth billions more than what Valeant paid, so typical criticisms of a failed acquisition, excessive cost-cutting, low ROIC or non-GAAP EPS simply fall apart when looking at the success of this investment.

Furthermore, the business is growing organically, globally, as over a billion low-income people around the world have their first opportunity to afford eye-care products. By any reasonable measure, this acquisition has been a total home run, and is perhaps the best illustration of the power of Valeant’s model.

To any bear case on Valeant – I point people to Bausch & Lomb. If the criticisms don’t fit, you must acquit.