Description

Valeant is a spectacular platform story that rolls up specialty pharmaceuticals applying "The Outsider" philosophy with the aid of a tax-efficient coporate structure. Rollups like that has virtually unanalyzable accounting statements and forces you to decide whether you trust the management’s non-GAAP pro forma EPS numbers. Wall Street has chosen to operate on faith for this story.

“Trust but verify” is always a wise rule. Trust the non-GAAP EPS number but check whether its reported FCF from its cashflow statement eventually converge to it. In the spring of 2013, Valeant was guiding 2013 non-GAAP EPS of almost $6 when its reported FCF (GAAP cashflows from operations minus capex) was at about $2.3/share. No sweat. It should eventually converge once things normalize. The company is a classic rollup story and so there has always been heaps of one-time restructuring charges. Then Valeant announced the transformational acquisition of Bausch & Lomb and raised guidance of 2013 non-GAAP EPS to over $6 for the first time. This acquisition vindicated the company’s playbook. As long as they keep doing accretive acquisitions like that with cheap debt and tax-efficient structure, sky is the limit to what EPS can be. For sure reported GAAP FCF should be on a steady march toward that meager $6 sooner or later. Valeant claimed to have double-digit organic growth and that the string of tucked-in acquisition added to FCF. So by the time they gave up on the Allergan acquisition, they were already guiding a recurring non-GAAP EPS of over $10 for 2014 (in the 3Q14). The only problem was that Valeant was still struggling to report a GAAP FCF of $6/share then. The company’s trailing reported FCF continued to languish at $5 in the first half of 2015, showing no signs of converging with the $6 that they claimed they were already earning 2 years ago, never mind the $10 run-rate that they would have you believe. There was no sizeable acquisition since Bausch & Lomb closed in August 2013 to explain away the glaring gap. The Salix acquisition comes to the rescue. Because Salix is inherently a messy acquisition with channel inventory and accounting issues (even though it is less than you think), it serves to further suspend people’s skepticism over the Company’s GAAP numbers. The CFO Howard Schiller decided to leave just as the Salix deal closed in April 2015, surely for some legitimate personal reasons. The company is currently guiding over $12 pro forma EPS for 2015 and the Street expects $15 in 2016. The stock has thus rocketed from $80 to $250 during the last 2 years, propelled by a steadily rising non-GAAP EPS guidance.

But a careful review of the GAAP FCF trend would conclude that Valeant does not have much more than $6/share of earnings power before Salix. A casual review would lead you to the same conclusion all the same. This revelation would not have been possible if Valeant had not pursued Allergan and failed, leaving a window of almost 6 quarters of deal-free financial statements.

Many who are familiar with the power of roll-up stories know that faith-based stories like this can go on for as long as people are willing to believe in them because faith precipitates accretive acquisitions which can then fundamentally validate the faith in itself. But there are reasons for Valeant to be near the end of its acquisition spree, at least for a while. Back in 2013 Valeant was the only game in town. Nonetheless, in the intervening 2 years many inversions such as Actavis (now Allergan), Endo, Teva, Mallinckrodt, Mylan, etc have taken place. Deals below the size of Salix are very crowded now while Actavis and Teva are firmly in Valeant’s league for mega deals. The multiples at which M&A are done these days mean that any future acquisitions can only be accretive if a large amount of cheap debt is involved. But the Salix acquisition has exhausted Valeant’s borrowing capacity at least for another year.

If no major acquisition happens, by the end of 2Q16, we would get to see how far the Salix acquisition could lift the company’s trailing FCF/share to from its current level of $5. By then CEO Mike Pearson would probably have convinced everyone that the company earned $12 in 2015 and be guiding $15/share for 2016. If the company’s cashflow statement can report a trailing FCF of $10/share then maybe the stock deserves to trade at $250, or maybe even $300, i.e. 20x 2016 PF EPS. But in the unlikely event that the company struggles to report GAAP FCF of over $6, which they claimed they already earned in 2013, then the story is broken and we are looking at $100 stock if not lower. This scenario is unlikely only because the accounting mismatch is just too mind-blowingly ineffable and also because really smart people love this platform stock. Nonetheless, I like the risk reward in shorting this universally-loved (at least by sell side) stock.

Catalyst

After Salix, the company is tapped out in its debt capacity and so sizeable deals should take a breather, opening a window for investors to verify its lofty non-GAAP EPS guidances. The market meanwhile might continue to ignore the gap due to the Salix noise, but not for too many quarters.

The balance of risk is pretty favorable for a trade that I estimate to have a roughly 12-month horizon to play out.