Description

It’s only a slight exaggeration to say that Valeant Pharmaceuticals is a private equity firm masquerading as a specialty pharmaceutical company.  But it’s not an exaggeration to say that Valeant is a different type of pharmaceutical company whose primary mission is to generate cash and create value for shareholders.  Despite strong performance over the past four years, it remains an undervalued and underappreciated company.  Based on continued growth, cost reduction plans, and modest acquisitions, over the next few years Valeant should trade into the mid-$70s and potentially into the high-$80s or even higher.

Before 2008, Valeant was a typical specialty pharmaceutical company with an over-reliance on a handful of drugs, significant investments in R&D, and a global infrastructure built out on the hope that R&D would pop out a number of valuable drugs.  After the stock declined to around $11 in late 2007, a new board replaced the existing management team.  The incoming CEO, Michael Pearson, had run McKinsey’s global pharmaceutical practice for over 20 years. 

Based on his experience of advising JNJ, Teva, and countless others, Pearson had and has a different vision of the pharmaceutical business.  He believes that too many pharma companies are run or held hostage by bureaucrats or scientists, who become attached to the potential of a drug and continue to throw good money after bad.  Pearson’s strategy was to (a) get out of bad markets with government-controlled reimbursement and exposure to patent cliffs (i.e.: Western Europe) and invest in good markets with drugs with enduring lives (OTC/branded generics in Eastern Europe, Mexico, Brazil); (b) streamline operations; (c) acquire undermanaged drugs from companies that don’t appreciate them; and (d) acquire and gut companies who were overinvesting in R&D and SG&A on the promise of new drugs that probably wouldn’t live up to their hopes.  For more detail on their strategic principles, see page 10 of Valeant’s recent investor day presentation.

In 2010, Valeant did a transformational merger with Biovail, a company that was somewhat similar to the pre-Pearson Valeant.  It had a handful of valuable drugs that were facing stiffer generic competition or patent cliffs, and a recent board/management turnover that was more focused on creating shareholder value.  Importantly, however, Biovail, a Toronto-based company, had a very low cash tax rate since its intellectual property (the core value of a pharmaceutical firm) was in Barbados and the company took advantage of a tax treaty between Canada and Barbados.  Even though Valeant was the slightly larger company at the time, the deal was structured in a way to give a large dividend to Valeant shareholders so that the acquiring company was technically Biovail, preserving the tax structure.  (That’s why, if you look at a historic chart, you’re actually looking at Biovail before the merger.  You would need to look up the old Valeant for Pearson’s pre-merger stock chart.)

The merger with Biovail made Valeant what it is today:  a globally diverse pharmaceutical company with strong positions in their niches, with a very low tax rate, and an acquisition machine that reinforces the core areas and adds additional platforms for further growth.  A platform could be either geographic (such as Russia, where they got exposure through the PharmaSwiss acquisition in 2011) or in therapeutic area (such as U.S. podiatry or U.S. dental).

 Why does this opportunity exist?

1)      Roll-up taint:  While Valeant has been described as a roll-up, and it certainly has made a lot of acquisitions (33 over the past 3 years, excluding Biovail, ranging in annual revenues from $2m to $250m), there is generally a common theme to the acquisitions.  First, the acquisitions are made in a disciplined fashion.  Valeant generally doesn’t participate in auctions (or if they do, they generally disrupt the auction process).  In their Q311 earnings presentation, they showed how the major deals going back to 2008 had grown in the aggregate at a 22% revenue CAGR since acquisition (pages 11-12; presentation here: http://goo.gl/Nucam), and only 3 out of 18 were behind their expectations on a cash basis.  Second, the business is run on a decentralized basis so the management teams at the business units are responsible for sourcing and executing on their deals.  It’s not all reliant on Mike Pearson (though it can seem that way). Third, usually, there is something strategic about the acquisitions.  For example:

1. In late 2008, VRX acquired Dow Pharmaceuticals, which had had 10 dermatology drug approvals in the prior 4 years – a great track record.  In addition, they had a contract service business utilized by many top dermatology companies which helped to subsidize their own R&D spend.
2. Valeant had a Mexico plant with an old facility.  With their acquisition of Tecnofarma in 2009, they not only expanded their generics business, they also acquired a new plant which was and is the source of improving margins.
3. In Australia, from 2008 to 2010, Valeant consolidated many skincare and suncare products.  If the Australian business had remained small, Valeant could have sold that logical collection of assets at a higher multiple than the various acquisitions that they had done.  But in late 2011, they doubled their Australian business with a new acquisition, so they will be taking the skincare products to a new footprint in Southeast Asia.

2)      Skepticism over continued presence of good acquisitions:  While it’s possible, Valeant’s advantage is that it can source acquisitions from nearly every corner of the globe.  If a target in the US wants to hold out for more, Pearson can take his cash to Russia or Brazil.  If someone in Australia wants more, he can look to Mexico.  Valeant’s increasingly diverse platform allows for more potential for a proper fit at the right price.

3)      Specialty pharmaceutical skepticism:  Specialty pharmaceutical analysts like to analyze pharmaceuticals and track prescription trends from IMS or Wolters Kluwer.  For Valeant, it almost doesn’t matter.  With the largest drug representing ~7% of revenues (and getting smaller as acquisitions take place and grow) and more and more of Valeant’s business coming in disparate places like Brazil, Australia, and many countries in Eastern Europe, it becomes impossible to analyze the typical way.  Nonetheless, as a “specialty pharmaceutical company”, Valeant’s multiple is dragged down by traditional specialty pharmaceutical companies that can trade as low as 4x EPS.

4)      It’s confusing:  Valeant does so many deals and largely does them by raising debt, it’s hard to keep track of everything.  Over the past few years, there have been concerns about: (a) how organic growth is calculated; (b) drug reimbursement in Poland; (c) accounting related to an asset-deal completed last year; (d) add-backs of acquisition-related expenses; (e) financial weakness of distributors in Slovenia (or was it Slovakia?).  Every time, management has responded by disclosing more, usually in more detail than I’ve seen in any other public company.

Investment Thesis:

1)  Valeant has a strong and diversified global platform from which to continue to grow:  Valeant’s revenues come from over 30 countries and over 500 products (see http://goo.gl/X0WY0 for a slightly dated list of their drugs by country).  

Here is a summary of each of their business units (Note that here I cite Pro Forma organic growth.  I suggest you take a look at Valeant’s recent investor day slides and their Q212 earnings release for some background on the two ways they calculate organic growth.)

• U.S. Dermatology [~$1b revenues estimate; latest PF organic growth +29%]:  Valeant has had a dermatology business for years, but in the past year it has been transformed into one of the three largest dermatology companies in the U.S.  The big leap came with December’s acquisition of Dermik and Ortho Dermatologics.  To give you a sense of Valeant’s efficiency, prior to close, Valeant let the Dermik sales force promote one of Valeant’s drugs, and it let the Ortho sales force sell another.  This way Valeant could evaluate the effectiveness of its new sales forces and optimize them as soon after close as possible.  Dermatology is attractive because (a) drugs are often paid for in cash, (b) it is more difficult for generics to prove bioequivalence to topicals, and (c) there aren’t that many dermatologists out there.
• U.S. Neurology and Other [~$700m revenues estimate; latest organic growth -10%]:  The biggest component in this segment is Wellbutrin XL, an anti-depressant which has faced generic competition for years but still has a loyal, though declining, following.  This segment has characteristics of typical specialty pharma companies: lots of drugs, many in run-off or slow-growth mode.  Nonetheless, it is a significant source of cash and has some potential in a niche ophthalmology platform.  In the latest quarter, the organic growth was -10%, though the decline should slow down as they were hit with some patent cliffs on smaller drugs in the last 12 months.
• Canada / Australia [~$600m 2012E revenues; latest organic growth 4%]:  Valeant and Biovail both had good-sized businesses in Canada, and now they are one of the largest drug companies in the country, which has made them a good partner for many smaller drug companies looking to enter the country.  In Australia, Valeant has a significant presence in skin-care and sun care, with many OTC products.  Their Australian business was transformed last year with the acquisition of iNova, which gave them OTC brands for weight management, cold and cough.  Neither Canada nor Australia will grow very fast, but they generate a lot of cash.
• Emerging Markets: Central/Eastern Europe [~$760m 2012E revenues; latest PF organic growth 14%]:  Through a series of acquisitions over the past four years, Valeant is now the 15^th largest pharmaceutical company in the region, which stretches from the Czech Republic to Russia.  Their focus is on branded generics, which, as the name suggests, are a hybrid of branded drugs and generics. In many emerging market countries, truly generic drugs are not trusted for safety, so a brand is important.  Since existing drugs have a long tail but do not grow faster than the economy, the key to faster growth is bringing new drugs into the market.  This year, Valeant will bring over 250 new branded generic drugs to their markets (think of these as drug-country combinations).  In addition, it’s important to note that only about 30-40% of their revenues are subject to government reimbursement.  Valeant is now focused on growing Russia and shifting to more OTCs and other niche markets where they have strengths in the U.S, like dermatology and ophthalmology.
• Emerging Markets:  Latin America [~$360m 2012E revenues; latest PF organic growth 15%]:  Currently, Latin America is comprised of operations in Mexico and Brazil.  They sell a combination of OTC and branded generics in those countries.  In Mexico, only about 25% of revenues get government reimbursement.  In Brazil, the number is zero.  Also, in Brazil, the largest drug represents less than 7% of revenues.  Their most recent large acquisition there was for Probiotica, which is the largest sports nutrition and supplement company in Brazil (31% share).  Brazil should be a target market for some of Valeant’s dermatology expertise as well.
• Emerging Markets: Southeast Asia/South Africa [~$100m 2012E revenues; latest PF organic growth 40%]:  Valeant acquired this business unit with the iNova acquisition last December, and it gave them a foothold across a wide region.  South Africa is the largest part of this (~35%); but other important countries include Malaysia, Thailand, Singapore, Philippines, and Japan.  The drugs sold in these regions are largely cough, cold, and pain management medicines from iNova’s portfolio.  As time goes on, expect Valeant to bring to this region some of its global OTC brands for skin and sun care.

2)      Valeant is a cash flow machine.  The model is quite simple, and consists of:

1. A diversified platform without much reliance on any single drug provides stable revenue foundation,
2. High gross margins (~75%), modest R&D, and efficient SG&A result in very high EBITDA margins,
3. Low tax rate derived from multiple locations (largely Bermuda and Switzerland; they pulled out of Barbados recently)

The cash funds acquisitions of undermanaged and underappreciated assets and companies in geographies around the world.  Valeant then runs those acquisitions better and typically with a lower tax rate, further increasing cash flows.

Their acquisitions often have something special that either creates a new platform for additional growth and acquisition (such as iNova’s South Africa/Southeast Asia business or the Russian business in Sanitas) or something that can benefit the rest of Valeant’s distribution (like the state-of-the-art topical manufacturing facility from Dermik or a sports nutrition business like Probiotica).

3)      Excellent and highly-aligned management team, with significant insider buying over the past 12 months.  Mike Pearson sets the tone here.  He is extremely hard-working, but spends a significant amount of time making sure the right people are in the right positions in the company – and then holding them accountable for their results.  The COO, Rajiv De Silva, worked with Mike at McKinsey for many years.  Their CFO, Howard Schiller, joined at the end of 2011 after 24 years at Goldman Sachs, where his last role was COO of the Investment Banking Division.

The management team’s and board’s stock ownership is clearly outlined in the proxy.  Pearson owns 2.28m shares, 4.9m options, 1.4m time-vesting restricted shares; and 1.1m performance-vesting shares (more below).  All executive officers have to own shares representing 2x the combined amount of their salary and target cash bonus.  In addition, there is a restricted share matching program (three or four-year time-based vesting).  Finally, officers are granted performance-based restricted shares, for which vesting is based on the annual rate of return of the stock price over three or four years, or Total Shareholder Return (“TSR”).  For TSR below 15%, nothing vests.  For 15% TSR, 100% of performance shares vest.  For 30% TSR, 200% of performance shares vest, and for 45% TSR, 300% of performance shares vest.  And for Pearson, for TSR of 60%, 400% of performance shares vest.

Since July 2011, seven insiders have purchased shares at prices ranging from $38 to $53.  Notably, Pearson purchased an additional $1.6m worth last August.  The new CFO purchased $4m soon after starting work.  The head of HR (who had worked with Pearson at McKinsey) bought $476k.  And four directors have purchased shares in the last three months.  The most noteworthy of those is ValueAct, who helped bring Pearson in.

4)      Right approach to corporate governance, capital allocation, and shareholder communication.  As you would expect, Valeant’s board has the requisite pharmaceutical, biotech, international, and financial experience.  What’s different, however, is that the proxy actually reports how many committee meetings occur and what the attendance is (see the table on pages 17-18 of the proxy).  You get the sense that this is how Valeant measures everything, from the board on down.

On capital allocation, Valeant understands that the stability of the business should be able to support a large and consistent debt load, so they fund their acquisitions with debt, and on occasion use excess cash to buy back stock (their current plan still has $1.1b remaining).  At the latest investor day, Pearson mentioned that the pipeline of good acquisitions is so large, however, that they will likely use their cash for those rather than for stock buybacks in the near future.  For their acquisitions, they target 20+% IRR – excluding the benefit of their lower tax rate.  Capex is light, at maintenance levels of ~$60m/year (to be increased slightly in the next 18 months, explanation below).  It’s worth noting that the new Valeant has abandoned the luxurious headquarters of both the old Valeant in California and Biovail in Toronto.  Headquarters are now in Montreal since they have a number of operations there and the provincial government gave them a $6m incentive to move.

On shareholder communication, despite all the moving parts, Valeant tries very hard to be transparent. When the stock sold off last August, there were lots of theories around about what the problem was.  On their Q3 2011 call, Valeant came straight out with the list of questions they were getting from investors and set the record straight.  When the Street didn’t like how they were reporting their organic growth (pro forma vs. same-store sales basis), Valeant started reporting it both ways.  When they heard complaints about all the large amount of adjustments between “Free Cash Flow” and “Adjusted Free Cash Flow” due to the acquisition-related adjustments, they began to show the detail of the adjustments on a deal-by-deal and categorical basis.  I have never seen this level of disclosure from a public company before.  Furthermore, they do a lot of little things that should speak to value investors.  For example, they write off any receivables over 90 days and in their calculation of cash net income, the do not add back stock-based compensation.

5)      Attractive current valuation and free option on additional acquisitions:  Based on 2012 Cash EPS (excluding one-time items), Valeant is trading at 8.5% FCF yield or below 12x P/E.  Excluding additional acquisitions, I believe that over the next couple of  years, Valeant will trade at least in the mid-$70s.  Assuming they continue with the smaller-type acquisitions they have done this year, the stock could trade into the $80s.  And there’s probably a good chance that Pearson does something even bigger that creates even more value.

Valeant reports a Cash EPS number that adjusts for acquisition-related amortization and restructuring expenses.  Cash EPS tracks pretty closely with FCF since depreciation has historically tracked capex.  This year they are expecting and on track for Cash EPS per share of $4.18 to $4.38, which excludes some one-time items (clearly disclosed in their Q212 earnings presentation).  Rolling that forward into 2013 and 2014 with decent but slowing organic growth, and no improvement in gross margins, Cash EPS should be about $4.75 and $5.50, respectively.  Longer-term, with more modest organic growth (~6%), Valeant should be generating well over $7 per share by 2016 – excluding any additional acquisitions.

In addition to leaving out acquisitions, this assumes no benefit from improvements in gross margin.  On the latest quarterly call, Valeant offered their plan to increase gross margins by about 500 bps to 80% over the next few years.  Valeant is quick to get cost synergies out of SG&A and R&D, but wisely slow with manufacturing processes.  Now that they own multiple plants in Canada, Brazil, Australia, Mexico, and Eastern Europe, they are going to consolidate manufacturing further.  This will cost another $50-60m in capex in the next 18 months, but since each 100 bps of gross margin represents about $25m of cash, the investment is well worth it.

On the upside, with modest amounts of acquisitions (say $200m in revenues/year) and 80% gross margins, Valeant Cash EPS could approach $9 by 2016.  

On the downside, given the diversity of the Valeant’s businesses, it’s unlikely that something could derail them permanently (though see the risks below).  If something negative happens in the short run, based on past experience, I would expect to see management and directors purchase more shares and the company buy back its stock, giving it some support.

If you’re going to dig into the numbers, I suggest you start with the June 21 Investor Day presentation, especially the CFO’s section.  http://goo.gl/d31rb.  Another good presentation is their debt market presentation from May 31.  Think of it as a “greatest hits” of the investor day, which is quite long.  http://goo.gl/J8o66

Risks:

1)      The acquisition strategy requires access to the debt markets:  Valeant’s debt/cash flow ratio is about 5.7x.  (Debt/EBITDA isn’t so relevant due to the low tax rate.)  Getting new and low-cost debt has not been a problem, but it’s certainly a risk, since acquisitions are key to Valeant’s strategy.

2)      Execution, execution, execution: They’re trying to do a lot of things in many regions of the world.  So far, acquisition integration has gone smoothly (at least seen by outside shareholders).  So far they have done good due diligence on the deals they’ve done.  Will this track record continue?

3)      Zovirax generic?:  Zovirax is a cold sore ointment that represents about 7.5% of Valeant’s current revenues and has been a large contributor to growth in the past 12 months (that will slow as they anniversary a packaging and pricing change they made).  Some recent draft guidance by the FDA eased the pathway for a generic to compete with Zovirax.  Valeant does not know where this came from or whether or not anyone is working on a Zovirax generic.  Valeant has a backup plan should something come up, but this is another risk.

4)      Regulatory/reimbursement environment:  Valeant is diversified across geographies, but a major change to a large market could have a negative impact on them.

5)      Currency fluctuations:  Valeant has minimal exposure to the Euro, but they do to lots of other currencies (most importantly are Australia, Canada, Poland, Serbia, Mexico, Brazil)

6)      Changes to tax environment: Considering that Valeant has diversified even its tax strategy, it is hedged here, but one never knows what governments might do.

Catalyst

1)      Continued execution and cash flow generation

2)      Accretive acquisitions, and in the absence thereof, continuation of stock buyback plan.

3)      Data released on IDP-108, a topical nail fungus drug that supposedly has very good potential (not explicitly in the financial forecasts outlined above).