Valeant: Damaged Goods or Dirt Cheap Stock?

I have always believed that rats get a bad rap for fleeing sinking ships. After all, given that survival is the strongest evolutionary impulse and the place rats occupy in the food chain, why would they not? That metaphor, unfortunately, is what came to mind as I took another look at Valeant, the vessel in investment portfolio that most closely resembles a sinking ship. This is a stock that I had little interest in, during its glory days as the ultimate value investing play but that I took first a look at, after its precipitous fall from grace in late 2015. While I stayed away from it then, I returned to it in May 2016 after it had dropped another 60% and found it cheap enough to add to my portfolio. I then compounded my losses when I doubled my holding in October 2016, arguing that while it was, at best, an indifferently managed company in a poor business, it was under priced at $14 . With the stock trading at less than $11 and its biggest investor abandoning it, there is no way that I can avert my eyes any longer from this accident. So, here we go!

Valeant: A Short History (from my perspective)

I won't bore you by repeating (for a third time) the story of Valeant's fall from investment grace, which happened with stunning speed in 2015, as it went from value investing favorite to untouchable, in the matter of months. My first post, from November 2015, examined the company in the aftermath of the fall, as it was touted as a contrarian bet, trading at close to $90, down more than 50% in a few months. My belief then was that the company's business model, built on acquisitions, debt and drug repricing was broken and that the company, if it became a more conventional drug business company, with low growth driven by R&D, was worth $73 per share.

I revisited Valeant in April 2016, after the company had gone through a series of additional setbacks, with many of its wounds self inflicted and reflecting either accounting or management misplays. At the time, with the updated information I had and staying with my story of Valeant as a boring drug companies, with less attractive margins, I estimated a value per share of $44, above the stock price of $33 at the time. I bought my first batch of shares then.

In the months that followed, Valeant's woes continued, both in terms of operations and with its stock price. After it announced a revenue drop and a decline in income in an earnings report in November 2016, the stock hit $14 and I had no choice but to revisit it, with a fresh valuation. Adjusting the valuation for the new numbers (and a more pessimistic take on how long it would take for the company to make its way back to being a conventional, R&D-driven pharmaceutical company, I valued the shares at $32.50. That may have been hopeful thinking but I added to my holdings at around $14/share.

Valeant: Updating the Numbers

Since that valuation, not much has gone well for the company and its most recent earnings report suggests that its transition back to health is still hitting roadblocks. While take of imminent default seems to have moved into the background, there seems to be overwhelming pessimism on the company's prospects, at least in the near term. In its most recent earnings report, Valeant continues to report deterioration in key numbers:

	2016 10K	2015 10K	% Change
Revenues	$9,674.00	$10,442.00	-7.35%
Operating income or EBIT	$3,105.46	$4,550.38	-31.75%
Interest expense	$1,836.00	$1,563.00	17.47%
Book value of equity	$3,258.00	$6,029.00	-45.96%
Book value of debt	$29,852.00	$31,104.00	-4.03%

Much as I would like to believe that this decline is short term and that the stock will come back, there is now a real chance that my story for Valeant, not an optimistic and uplifting story to begin with, is now broken. The company's actions of acquiring other companies, using huge amounts of debt, raising prices on "under priced" drugs and paying as little in taxes as possible were perhaps legally defensible but they were ethically questionable and may have damaged its reputation and credibility so thoroughly that it is now unable to get back to normalcy. This can explain why the company has had so much trouble not only in getting its operations back on track but also why it haas has been unable to pivot to being a more traditional drug company; if researchers are leery about working for you, that will be tough to do. It can also indirectly explain why it may be having trouble selling some of its most lucrative assets, as potential buyers are wary of the corporate taint and perhaps have lingering doubts about credibility.

In fact, the one silver lining that may emerge from this experience is that I now have the perfect example to illustrate why being a business entity that violates the norms of good corporate behavior (even if their actions legal) can destroy value. At least in sectors like health care, where the government is a leading customer and predatory pricing can lead to more than just public shaming, the Valeant story should be a cautionary note for others in the sector who may be embarking on similar pathways.

The Ackman Effect

You may find it strange that I would spend this much time talking about Valeant without mentioning what may seem to be the big story about the stock, which is that Bill Ackman, long the company's biggest investor and cheerleader and for much of the last two years, the power behind the management, has admitted defeat, selling the shares that Pershing Square (his investment vehicle) has held in Valeant for about $11 per share, representing a staggering loss of almost 90% on his investment. The reasons for my lack of response are similar to the ones that I voiced here, when I remained an Apple stockholders as Carl Icahn sold Apple and Warren Buffett bought the stock in April 2016. As an investor, I have to make my own judgments on whether a stock fits in my portfolio and following others (no matter how much regard I have for them) is me-too-ism, destined for failure.

Don't get me wrong! I think Bill Ackman, notwithstanding his Valeant setbacks, is an accomplished investor whose wins outnumber his losses and when he takes a position (long or short) in a stock, I will check it out. I did not buy Valeant because Ackman owned the stock and I am not inclined to sell, just because he sold. In fact, and this may seem like a stretch to you, it is possible that Ackman's presence in the company and the potential veto power that he might have been exercising over big decisions may have become more of an impediment than a help as the company tries to untangle itself from its past. I am not sure how well-sourced these stories are, but there are some that suggest that it was Ackman who was the obstacle to a Salix sale last year

Valeant: Three Outcomes

Now what? As I see it, there are three paths that Valeant can take, going forward.

1. Going Concern: To value Valeant as a going concern, I revisited my valuation from November 2016 and made its pathway to stable drug company more rocky by assuming that revenues would continue to drop 2% a year and margins will stay depressed at 2016 levels for the next 5 years and that revenue growth will stay anemic (3%) after that, with a moderate improvement in margins. With those changes put in and leaving the likelihood that the company will not make it at 10%, the value per share that I get is $12.80.

To illustrate the uncertainty associated with this value estimate, I ran a simulation with distributions for revenue growth, margins and cost of capital and arrived at the following distribution of values.

2. Acquisition Target: It is a sign of desperation when as an investor, your best hope is that someone else will acquire your company and pay a premium for it. I am afraid that the Valeant taint so strong and its structure so opaque and complex that very few acquirers will want to buy the entire company. I see little chance of this bailing me out.

3. Sum of its parts, liquidated: It is true that Valeant has some valuable pieces in it, with Bausch & Lomb and Salix being the biggest prices. While neither business has attracted as much attention as Valeant had hoped, there are two reasons why. The first is that Ackman, with significant losses on the stock and a seat on the board, may have exercised some veto power over any potential sales. The second is that potential buyers may be scared away by Valeant's history. One solution, now that Ackman is no longer at the company, is for Valeant to open its books to potential acquirers and sell its assets individually to the best possible buyer. Note that this liquidation value will have to exceed $29 billion, the outstanding debt, for equity investors to generate any remaining cash.

There is one other macro concern that may make Valeant's future more thorny. As a company that pays a low effective tax rate and borrows lots of money, the proposed changes to the tax law (where the marginal tax rate is likely to be reduced and the tax savings from interest expenses curbed), Valeant will probably have to pay a much higher effective tax rate going forward, one reason why I have shifted to a 30% tax rate for the future.

The Bottom Line

Let's start with the easy judgment. This was not an investment that I should have made and much as I would like to blame macro forces, the company's management and Bill Ackman for my losses, this was my mistake. I was right in my initial post in concluding that the company's old business model (of acquiring growth with borrowed money and repricing drugs) was broken but I clearly underestimated how much damage that model has done to the company's reputation and how much work it will take for it to become a boring, drug company. In fact, it is possible that the damage is so severe, the company will not be able to make the adjustments necessary to survive as a going concern.

So, what now? I cannot reverse the consequences of my original sin (of buying Valeant at $32) in April 2017 and the secondary sin (of doubling down when Valeant was trading at $14) by selling now. The question then becomes a simple one. Would I buy Valeant at $11 per share today? If the answer is yes, I should hold and if the answer is no, I should fold. My intrinsic value per share has dropped to just above where the stock is trading at now, and at this stage, my judgment is that, valued as a going concern, it would be trading slightly under value. In a strange way, Bill Ackman's exit is what tipped the scales for me, since it will give Valeant's management, if they are so inclined, the capacity to make the decisions that they may have been constrained from making before. In particular, if they recognize that this may be a clear case where the company is worth more as the sum of its liquidated parts than as a going concern, there is still a chance that I could reduce my losses on this investment.