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Dear Fellow Fools,
I can recall a time not long ago when the Healthcare sector of the S&P/TSX Composite was at best nothing more than an afterthought. How things change! Today, it’s home to not just any old hotly contested potential acquisition, but what might turn into the biggest acquisition the Canadian market has ever seen.
Prior to June 2010, few (if any) Canadian investors had ever heard of then-U.S.-domiciled Valeant Pharmaceuticals (TSX:VRX)(NYSE:VRX). That month, a merger of near equals occurred with Canadian-based Biovail. Technically, Biovail took over Valeant, but it was the Valeant name and executive team that remained when the dust had settled.
At the time, nobody could have envisioned that four years and 25 acquisitions (worth $16.4 billion) later, this entity would be on the verge of making another acquisition currently valued at about $48 billion. Yet, that’s where we stand.
In this week’s Take Stock, we’re going to get to know a bit more about Valeant, and explore why the company it’s pursuing, Allergan (NYSE:AGN), isn’t exactly thrilled by the hostile bid that’s been sent its way.
Background
Before we get to the acquisition that’s on the table, let’s step back and review the past four years of Valeant’s existence. (We’re taking the Biovail merger as the start date, as it really served as a launching pad.)
Thanks to what I’d call a rather checkered past, Biovail was in a bit of a messy position when the two combined. So was Valeant. However, Valeant and its relatively new (February 2008-present) CEO Michael Pearson had a strategy, and Biovail had something that was going to make this strategy hum. Seemingly, the most attractive aspect of Biovail in Pearson’s mind was that it wasn’t domiciled in the U.S.
Not only was Biovail incorporated in Canada, but its main operating subsidiary that owned the company’s intellectual property was based in Barbados. (It has since moved to Bermuda.) I won’t pretend to fully comprehend the ins and outs of offshore tax havens but the fact that Canada allows companies to move intellectual property and profit centres to low-tax jurisdictions and repatriate profits without further taxation is a huge part of this story. As a result of this dynamic, Valeant currently pays cash taxes at a rate of just 5%.
This low tax advantage is one of the primary reasons why the company has been able to be so aggressive on the acquisition front. Though it claims to assess potential acquisitions based on more normalized taxes, in my view, this is a huge advantage when you consider it’s able to cut a target’s tax rate from, say, 30% to 5% once it’s folded into the mix.
Taking it to the next level, and then some
Prior to the Allergan bid, the biggest deal that Valeant had completed was the $8.7 billion acquisition of Bausch & Lomb last year. Before that, it was a $2.6 billion deal for a dermatology company by the name of Medicis in September 2012.
This company and management team seem to have a real growth bug. And with acquisitions as the obvious path to achieving the growth that management (and the market) so craves, it was only a matter of time until a significant step-up occurred.
As indicated, the deal for Allergan stands at about $48 billion and currently amounts to $48.30 in cash per share and 0.83 shares of Valeant for each Allergan share. About 30% of the deal is to be financed with cash and 70% equity. As it stands, Allergan shareholders stand to receive a significant swath of Valeant stock if the deal gets done.
For some, this is great news
Valeant has been a market darling thanks to its growth-by-acquisition model. Its shares have appreciated by 464% since September 2010, when the Biovail merger closed.
The case for Valeant’s run to continue goes something like this:
Because of its proven ability to strip out costs (as well as that attractive tax advantage), management has demonstrated that growth by acquisition can lead to far better returns in the pharmaceutical space than spending a pile of money and effort on research and development (R+D) — at least in the short to medium term.
Through its acquisitions, the company has built a portfolio of more than 1,500 products that is not reliant on one or two blockbusters to succeed like many Big Pharma companies. This alleviates a big risk generally associated with this space. In addition, patent expirations aren’t that big of an issue due to this diversity.
But what gets a lot of investors (and the sell-side analysts) really charged up is Valeant’s stated intention to become a top five pharmaceutical company (in the world) by the end of 2016. This will require it to more or less triple its market cap from the current level.
Who doesn’t want to invest in a company that expects to triple over the next 2.5 years?
For others, not so much
Those with a more skeptical view of the company and its prospects — which includes Allergan’s management and board of directors, as they have rejected Valeant’s bid — see these high-growth ambitions in a different light.
There are three issues that are generally sighted by the naysayers:
- The business model and strategy that got Valeant to where it is today is not sustainable. In the early days, relatively small acquisitions made a difference, and seemingly the company was happy to continue to hit singles and doubles on its path to greatness. With stated ambitions of becoming a top 5 player in 2.5 years, and by taking a swing at a target more than 5 times bigger than anything it’s ever swung at before, clearly, the strategy has shifted. Even if Allergan falls through, deals valued at $100 million to $500 million no longer really move the needle for this company. This means that it’s now in a league in which it has no proven record of being able to play in.
- The balance sheet is rather terrifying. Not only has management taken advantage of historically low rates and used debt to fund the bulk of its acquisitive spree, every year the company’s tangible book value ticks lower and lower and now sits at a somewhat astounding -$52.55/share. Significant goodwill and intangibles have been added over the years and this leaves the company very susceptible to write-downs at some point along the line. This in turn could trigger debt-related downgrades, which could increase borrowing costs, and begin a rather ugly downward spiral. Financial risk is a big part of this story.
- Valeant’s results as presented by generally accepted accounting principles (GAAP) are rather disgusting. Though free cash flow appears strong, the income statement and profitability figures are a mess. Because of the myriad of acquisitions over the years, it’s nearly impossible to compare current results to the past. The company presents several alternative, non-GAAP measures to better assess its performance, but the skeptics tend to greet these with, well, a healthy dose of skepticism.
Where we stand
A number of people (including Valeant’s CEO) have made a pile of money on this stock and there are some great investors that are onside with what the company expects to do. Perhaps the most obvious is Bill Ackman, who has wholeheartedly endorsed Valeant’s proposal by taking a 9.7% interest in Allergan and indicating that he’s planning to take back a full allocation of Valeant stock if/when the deal closes. There will be no cash component for him.
Heck, even one of the Fool’s U.S. advisory services has recommended Valeant and our CEO owns the stock!
However, we’re a motley bunch with a variety of opinions, and in my mind, this story feels fragile. This fragility mostly comes back to the first two points from above as they are somewhat intertwined.
The company needs to take bigger and bigger swings as it grows, yet it doesn’t generate enough internal funds to afford these swings on its own. That means the debt and equity markets are going to be relied upon, heavily, to keep this train on track.
Call me old-fashioned, but this scares me. I prefer my companies to be self-sufficient and not reliant on the kindness of strangers to help get them to where they want to go. With more than $17 billion of debt, and (much) more to come (at least $15.5 billion) if this Allergan deal closes, whether it’s rising interest rates, or some other hiccup, we can’t know when, but it won’t take much to upset Valeant’s ride to glory.
If I owned Allergan and stood to receive a chunk of Valeant stock in exchange for my shares, though there might be an even higher bid in the works, I wouldn’t be sticking around much longer. Even though the management team and board might be playing hardball to drive a higher bid by rejecting Valeant’s foray, their overall tone of skepticism is warranted, in my opinion.
As for Valeant’s loyal following … It’s important to be aware of where the company has been, where it’s going, and most of all, how it’s going to get there. Be wary of the significant boost and ongoing support it’s going to take from the financial markets, both debt and equity, to achieve this company’s aspirations.
Valeant’s destiny is not necessarily in its own hands.
Foolishly yours,
Iain Butler
Chief Investment Adviser
Motley Fool Canada
