Every so often the market offers a risk-reward that is both truly asymmetric and very simple. We believe that VRX equity is currently such an instance.

There is a heated and now very public debate amongst investors regarding what Valeant is ultimately worth – what’s true organic growth, what’s terminal value, what are the correct EPS adjustments, etc. While these are very important questions for a long term investor in VRX (or short seller of VRX) to ponder, the more immediate opportunity is a binary bet based on the outcome of Valeant’s bid for Allergan, which we believe offers a very compelling 7:1 risk-reward. The arithmetic is as follows:

• If VRX is unsuccessful in its attempt to acquire Allergan, and if VRX fails to close any incremental transactions or allocate any incremental capital through the end of 2015, consensus believes that Valeant will earn $10.55 in 2015 Cash EPS. We follow the company closely and believe that this no-deals consensus EPS estimate is reasonable. Conservatively assuming that Valeant trades at 11x forward earnings in this scenario, this implies 11x *  $10.55 = $116 share price, or down 8% from the current ~$127 price. An 11x multiple may prove conservative, given the stock was trading at higher multiple pre-deal, but this reflects investor frustration with a failed attempt.

• If VRX is successful in its attempt to acquire Allergan, we believe that the deal, as currently constituted, will add $3 to VRX’s 2015 EPS on a fully-synergized basis, implying $10.55 + $3.00 = $13.55 in fully synergized 2015 EPS (actual EPS may be slightly lower since synergies may not be fully captured in 2015). Our analysis suggests that the revenue-weighted average historical EPS multiple for the combined VRX-AGN is 15x. As such, 15x *  $13.55 = ~$203 share price, or up 60% from the current ~$127 price. The EPS number here may prove conservative, given that it doesn’t assume any incremental deals, whereas continuation of their history of doing a number of small deals could add $1+ to ’15 EPS. It’s worth noting that future smaller and medium size deals will likely be debt financed (this AGN deal delevers VRX on a pro forma basis, opening up ~10 billion of debt capacity), so their accretion relative to the size of the deal is higher than a deal like AGN where VRX needed an equity component.

Up 60% / down 8% is a 7:1 risk reward based on VRX’s ability to close the proposed AGN transaction, which we think is slighly more likely than not.

Disclosure:

We and our affiliates are long VRX and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anyone of any changes in our views of VRX. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.