Why Valeant Lusts After Allergan
Board: Value Hounds
Valeant Pharmaceuticals may be more Netflix than JNJ. While they do sell generic and branded pharmaceuticals, consumer products and medical devices much like JNJ, they don’t create much of their product. Instead Valeant buys the product rights and the brand names much like Netflix buys the rights to streaming content and amortizes the cost of the product they distribute. Without buying patents and secret recipes Valeant would have nearly no product to sell.
We rely on a combination of regulatory and patent rights to protect the value of our investment in the development of our products.
We have obtained, acquired or in-licensed a number of patents and patent applications covering key aspects of our principal products.
In the aggregate, our patents are of material importance to our business taken as a whole.
Since Valeant acquires most of their products that are of material importance to their increasing revenue and earnings, it seems fair to count those as expenses. However, because the acquired assets are capitalized, Valeant amortizes the cost of the acquisition over a period of years and when the company discusses earnings, they always prefer analysts and investors to consider cash earnings as the true measure of Valeant’s progress. Cash earnings exclude the amortization (expense) of the price paid for the portfolio of products they sell since it’s a non-cash charge like depreciation.
It’s as if Netflix would ask analysts to pay no attention to the cost of streaming content they amortize and include in cost of sales because it’s non-cash.
An extreme case
If Netflix asked us to disregard GAAP reporting and add back the amortization of their streaming content as a non-cash expense, for the March 2014 quarter EPS would have been $7 per share instead of 86¢. Reed Hastings to his credit doesn't emphasize this type of non-GAAP P&L accounting.
Valeant never reports quarterly or annual results without stressing the true value of Valeant is only measurable by non-GAAP numbers that add back acquisition expense and non-cash expenses including amortization.
[See Post for Tables]
Earnings per share for 2013 were ($2.70) but Valeant turned the GAAP loss into cash EPS of $6.24. How was this magic done? Start with the ($866,142,000) in net income loss and add back expenses like:
-In progress R&D impairments
-Integration and acquisition costs
-Amortization of finite intangibles
-Impairments of finite intangibles
..and a few more
The biggest GAAP expense added back was amortization at $1.3 billion but this should be considered as a rough proxy for the cost of the products acquired in mergers including rights, patents and brand names. Of course they also get the secret recipe for making the product.
Valeant asks analysts to disregard this cost and to consider the company as a lean mean drug company because they don’t spend much on R&D like biotechs and big cap pharma wasting cash on R&D and producing very little shareholder value in return.
It’s as if Valeant gets their earnings free of those pesky costs of either developing the drug with R&D or acquiring it through mergers. If a business is built on acquisitions and not R&D then acquisition expenses should be counted as a cost of doing business and not one-time charges or ignored as non-cash expense. They are no longer atypical one-offs unaccounted for to pretty up EPS for analysts and investors. Those expenses are how the company grows and growth is not free. Pearson criticizes drug companies for R&D spending that returns little and believes low returns and wasted spending are pervasive across traditional biotech and large cap pharma. Valeant is the outsider shaking up the traditions of the pharmaceutical industry.
Through them magic of non-GAAP accounting Valeant turned net earnings of ($866,142,000) into just over $2 billion in net income—mostly by throwing out the cost of product represented by amortization of finite intangibles.
Valeant and Netflix are not identical in their treatment of amortization. Netflix does have to pay a cash cost for product every reporting period based on how much of the product is put on the balance sheet as a liability. The higher the change in the liability, the less cash they pay. They always pay something and it does approximate amortization.
Valeant pays no expense for the acquisition of its portfolio every period since it has been “paid” with debt and some equity. That delays the day of reckoning and cash outflow for those products until the debt matures. Valeant can ignore amortization and call it cash EPS because the cash they owe is sitting on the balance sheet waiting to be paid and maturing. It looms large in their future, but isn’t using up cash at present (except In interest). If non-GAAP earnings make investors, analysts and the market happy, Pearson is glad to supply that as a measure of Valeant’s cutting edge business model’s success.
That brings us to the debt
From the 10K
We have a significant amount of indebtedness. Our ability to satisfy our debt obligations will depend principally upon our future operating performance.
This means that Valeant will have to generate enough cash flow from operations to pay maturing debt. At this point the cash EPS become an anachronism and the rubber really hits the road.
If we do not generate sufficient cash flow to satisfy our debt service obligations, we may have to undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital investments or seeking to raise additional capital.
With only $1.042 billion in cash flow in 2013, Valeant is going to have to up their game and find a lot more cash flow to start paying the principal coming due.
Valeant catches a break in 2015 and can continue to acquire aggressively. In 2016 and 2017 there is only $487 million and $499 million due respectively. In 2018, that all changes and $3.5 billion matures and will have to be paid or rolled forward.
Debt has funded acquisitions with no use of equity until BoL. As the biggest single acquisition and possibly in deference to their high debt levels and rates of borrowing, VRX issued new shares to buy B+L. They sold 27 million shares for $2.3 billion creating the largest dilution of shareholders since 2010 and the original Biovail/Valeant merger.
In order to keep debt ratios from increasing (77% debt/capital) the proposed Allergan merger will use 0.83 shares of Valeant for each Allergan share creating roughly 247 million new shares and diluting the count by 74%. They will use $12 billion in junk rated notes and bonds and $7 billion will be term loans to make up the rest of the cost.
Allergan had $1.7 billion in CFFFO and $1.8 billion in operating income in 2013. In order to make the merger work, pay the additional interest that will approach $1 billion in annually and cover the new and old debt maturities coming due, Pearson will have to make deep cuts fast. There is only $1 billion available in R&D—not enough. SG&A will get most of the ax at $2.5 billion --where to make the cuts? That's the $2 billion question. As Pearson found out cutting sales reps is a bad idea and a large part of the Allergan salesforce may need to stay. That's a big part of SG&A Cutting the sales force is not a good idea as Pearson has discovered. Finding sufficient fat to pare will be challenging.
Even though Valeant has no maturities due 2014-2015, by 2016 (if they acquire Allergan), synergies will have to be in place and far ahead of what they accomplished for Medicis (a large acquisition at $2.6 billion) and the original Biovail/Valeant merger. Valeant found it difficult to move Medicis' dermatology products without an experienced sales force.
Allergan presents the same potential problem. The sales reps are key to moving product especially in dermatology and firing most of the sales force is not an option. Bottom line is that creating enough synergy (euphemism for mass firings) to cover high interest and pay off debt in 2016 will not be a slam dunk and Valeant will see some cash flow crunch in a couple of years. Cash flow problems mean fewer acquisitions and fewer acquisitions will slow growth to uninteresting levels from a market perspective. If 2013 is any indication of the power of organic growth, Valeant will need to be busy creating better potential organic growth in 2014-2015 while it can pay for it. That’s one reason they are so desperate to get Allergan at any price.
And that brings us to how to cut costs without cutting your throat —- keep the sales force and fire everybody else and gut R&D:
J. Michael Pearson
We plan to keep -- one thing that we've learned in the Medicis and B+L acquisitions is don't touch the sales force, right? I think in Medicis, we did touch the sales force, and that was problematic for a period of time. Our sales force in dermatology now has been stable for a few quarters, and quite frankly, all of our promoted products in dermatology are growing. And so that was a lesson we learned.
Valeant can continue to advise analysts that GAAP earnings are not a good measure of Valeant’s growth and profit prowess and cash non-GAP earnings are better, but that’s not exactly true. The cash flow statement is the best place to look at the cash flow of the company not the profit and loss--- yet companies persist in trying to hybridize the P&L if GAAP earnings are not pretty. While Valeant ignores the cost of acquisitions and adds back amortization of definite lived intangibles (product cost) to non-GAAP earnings and calls it tremendous growth, that only lasts as long as the maturities of the debt. In 2014-2015 Valeant is in a “ product cost-free” bubble. After that, things get more interesting.
Next-to-last word(s) —-- organic growth
If the worst happens and Valeant finds itself without sufficient credit and cash flow to continue its business strategy of growth by acquisition, organic growth will take center stage. How is that going for them? Not well.
IMO since Michael Pearson has a background as a consultant and no experience running a pharmaceutical company, he has made some poor acquisitions.
Leading market share in dermatology? Organic growth prospects are fading (unless they buy Allergan who really does have the leading edge in derm at present in aesthetics and acne)
Targretin acquired in Feb. 2013 from Eisai for $67 million will go generic July 2015. Annual US sales are only $54 million. VRX will only have a little over 2 years worth of sales before Targretin dries up. No organic growth here. It is indicated for cutaneous T-cell lymphoma -- a rare dance and not a big cohort of patients.
Zovirax was acquired from Glaxo in March 2011. The price tag was $300 million. By 2013, Zovirax was a major component of stalling organic growth from generic competition.
At the time J. Michael Pearson was very excited about the deal and its potential to add growth to Valeant for years to come.
"We believe that Zovirax is a strong brand with continuing growth opportunities," said J. Michael Pearson, chief executive officer. "The current distribution agreement between GSK and BLS was problematic for both companies and this new arrangement should solve this issue for both organizations. We believe that our sales and marketing organizations in the United States and Canada have the ability to revitalize and grow the brand."
Just two years later Zovirax is a big reason 2013 organic growth is flat:
The decline in pro forma revenues in the year ended December 31, 2013 as compared to the year ended December 31, 2012 was primarily due to lower sales of the Zovirax® franchise, Retin-A Micro®, BenzaClin® and Cesamet® due to generic competition.
The entire Medicis deal is suspect---merger was 2012. Medicis was notable for its eccentric and indifferent CEO Jonah Shacknai who wouldn’t go to the office. His son died in July 2011 while Shacknai’s girlfriend was babysitting. She was found two days later hanging naked feet and hands bound—called a suicide. Just a little dish to make the story more colorful.
Medicis made its living mainly from Solodyn – an acne drug. Solodyn is a timed-release minocycline that was originally available in 3 doses and provided a large chunk of Medicis’ revenue. As the patent expiration closed in on them -- November 2011 -- Medicis was feverishly bringing additional doses to market that would be patent protected. Acne revenue (namely Solodyn) was 70% of revenue at the time. Mylan launched the generic November 2011.
Insurance won’t cover brand names if generics are available and it was clear Solodyn didn’t have long to live. By the third quarter of 2012, acne products declined by almost 30% (mostly Solodyn) and were only 47% of revenue.
That doesn’t mean that non-acne derm products were growing and taking up the slack. In fact, aesthetics (Dysport Restalyne Perlane Sculptra) were flat and growth was due entirely to the Graceway acquisition mainly Zyclara (a topical skin cancer treatment). Zyclara wasn’t much of a catch either being another generic-challenged product with the concentration altered to try to preserve some vestige of sales.
Graceway was hoping that tinkering with the dose and patenting the new formula would save them from bankruptcy – it didn’t. Medicis bought the almost useless company out of bankruptcy. Zyclara has some sales but not what Valeant needs to make the Medicis deal a bargain and an avenue to organic growth.
The best part of the Medicis deal for Valeant was getting Nestle to buy the aesthetic products for $1.4 billion.
Obaji (2013) with a $437 million price tag grew revenue at a tepid 7% over two years (2011-2012) and had only $20 million in CFFO in 2012. This product (cosmeceuticals sold in doc’s offices) requires an aggressive sales force to get skin treatments stocked and used by docs. SG&A was 55% of revenue in 2012! This model doesn’t fit well with Valeant’s 23% spending on SG&A. Pearson will find if he slashes this sales force, sales will erode rapidly. It’ a second tier product and relies on the good graces of the doctors to stock it in the office and use it. Even with a big sales force, revenue growth was low and operating margins were small. Organic growth from Obaji is going to be disappointing as it enters the same store sales base.
These are the companies acquired in 2011 that contributed to 0% organic growth:
1) iNova: $657 million in December 2011
• weight management OTCs
• OTC products and Rx medications in Australia and NZ
• OTC cold and cough meds in Africa and Asia
2) Dermik: a dermatological unit of Sanofi cost $422 million acquired December 2011
• Sculptra an injectable filler was sold with Dysport and Restalyne to Nestle announced May 2014
• Still own the manufacturing facility for $40 million—can they use it or is it a waste of cash?
3) Ortho Dermatologics division of Janssen acquired for $345 December 2011
• Retin A micro for acne-- (sales dropping fast generic competition)
• Biafine –a decent wound healing aid you can never get filled by insurance and pharmacies rarely have it
• Ertaczo—a brand name antifungal that competes with generics like terbinafine, econazole and ciclopirox and will never get approved by your insurance while these are available
4) Afexa Life Sciences Inc $68 million in October 2011 and Valeant bought 74% of company
• OTC cold and flu
5) AB Sanitas $392.3 in August 2011 Valeant 87% of company then bought 6% more for $27.4 million
They sell 350 generics branded in mainly emerging markets and are probably a decent business except J. Michael Pearson doesn’t divulge the results for the branded generic segment or tell us what drugs they sell or provide a table of sales of the top sellers over 3 years like most of the lumbering big cap pharmas do (it’s annoying)
6) Elidel /Xerese license agreement for $206 million June 2011
• Elidel sales were $120 million in 2010 and may never create tremendous organic growth. Elidel is a second-line topical for atopic dermatitis (eczema) and saw sales evaporate by 75% when they were forced to put a black box warning on the prescription about lymphoma back in 2009. Since this is largely prescribed for kids, that had a decidedly deleterious effect on sales. Novartis sold it in 2010 for $420 to Meda. BTW, the patent expires in 2016.
7) Zovirax was acquired for $300 million in February 2011/March 2011 from Glaxo
• Zovirax is a topical treatment for herpes simplex and has generic competition
8) PharmaSwiss S.A acquired for $491 million in March 2011
• They sell branded generics in emerging markets as well as some consulting services. This is probably the best business they bought in 2011 but we will never know much about it specifically.
*OTC is over the counter
*Rx is prescription
Valeant has wasted a fair amount of cash on some bad acquisitions and that accounts for the lack of organic growth and low ROIC. The best part of the Valeant business is emerging market branded generics and two acquisitions drove growth—Gerot and Atlantis. Unfortunately we have no idea what these are doing dollar-wise or what drugs are involved since Valeant doesn’t give drug specific or acquisition specific growth. Emerging markets is only 26% of revenue.
• Developed market organic growth was (5)% and 74% of revenue
• Emerging market organic growth was 11%
• Total organic growth was 0%
Why is this important in light of some of the acquisitions described?
As these acquisitions enter the same store sales/organic pool, they don’t hold out a lot of promise for outstanding growth and could possibly tip Valeant into negative organic growth. If Valeant spends everything on Allergan and can’t afford as many acquisitions in the next decade or so, growth may slow as Valeant struggles to pay interest and debt out of cash flow that is stalling.
Just something to think about with a company that lives by acquisitions and whose organic growth and track record of dodgy acquisitions faces overleverage and necessary scaling back on mergers.
ROIC for some lumbering large cap pharmaceuticals and a biotech vs. the more nimble Valeant
Gilead has returns on invested income (ROIC) of 21% and R&D/revenue is 18%
JNJ’s ROIC is 21% and R&D/revenue is 11.5%
Novartis has returns of 11% and R&D is 17% of revenue
Allergan’s ROIC was 24% and R&D was 16.5%
Valeant’s ROIC is 4.1% and R&D is 5% of revenue
FYI and in contradiction of Pearson’s blanket statement that all other pharma fails to make good returns on capital and research.