Valeant: Awash With CashValeant: Awash With Cash Oct. 23, 2017 3:03 PM ET Warwick Simons Quality Firms, Growth Opportunities, at Unreasonably Low Prices https://seekingalpha.com/article/4115562-valeant-awash-cash?auth_param=15ov:1cusf83:bc1cbe1b3dd44ebd97f7b9bb399b3bf8&uprof=11 (401 followers) Summary Valeant stock is extremely cheap, at 3x free cash flow (33% yield). An acquisition at $30/share (2.4x current price) offers the acquiring firm gains worth $15-25bn. The trajectory of Valeant's future profits is the main impediment to a deal, but I believe this uncertainty will be resolved within 12 months. I expect Valeant will be worth $30/share within 12 months. Valeant (VRX) generates $3bn of recurring cash flow Valeant - the firm as a whole - will generate $3bn of recurring cash flow in 2017, as outlined in the table below. This cash flow would be available to any party that acquires the firm, as I already have subtracted capital expenditure, contingent consideration for acquired R&D/drugs, stock-based compensation and restructuring charges. The $3bn cash flow is before interest payments however, as I'm assessing Valeants worth independent of the capital structure used to finance the purchase. There are no tax charges as Valeant has historical losses that can be used to offset any tax liabilities at least for the next 4-5 years. Valeant is extremely cheap Valeants current enterprise value is $30bn ($25.8bn of net debt and $4.2bn of equity). The firm is priced at 10x recurring cash flow, given recurring cash flow of $3.0bn (the middle of the range above). This means that Valeant without leverage is offering double the cash flow yield of the US market (which is currently 4.9%). This is extremely cheap. If we include leverage the value is even more compelling: recurring cash flow to owners of VRX stock is $1.4bn, and this is a 33% yield on Valeants current market capitalization of $4.2bn. This anomaly exists because the market has not yet refuted the bear thesis on the stock. This bear thesis is that Valeants EBITDA is in a slow death spiral one that ends with Valeant defaulting on debt and shareholders being wiped out. I believe this thesis is wrong, and I will show why later in this article. But first lets turn to why potential bidders should get excited. Acquiring Valeant should create at least $15bn of value for the acquiring firm I was at an investment conference two years ago when a very experienced (and skeptical) CEO quipped that bankers only pitch a deal on its strategic merits if the financial numbers dont stack up. This is not one of those cases. The financial numbers do stack up, and very easily. Valeants cash flow would be valued much more highly if it was controlled by another party. This statement is not to disparage Valeants current management team as I believe they are doing an excellent job, but it reflects how the market is currently valuing Valeants cash flow. For illustrative purposes I took a sample of 15 large US and European pharma and biotech firms. Their average P/E ratio is 15x, and their average price/cash flow is 16x. These valuations levels are, unusually, below the US market averages of 19x P/E and 21x cash flow respectively, which indicates the potential regulatory headwinds facing the pharmaceutical space. But uncertainty provides opportunity. If one of these firms were to buy Valeant for $30/share (an EV of $36bn) this should create at least $15bn of value for the acquiring firms shareholders. This $15bn could rise to as much as $25bn, which is an extraordinary level of value creation on a transaction worth $36bn. I recognize that these figures are very high, so I will explain my reasoning behind them. All 15 pharma and biotech firms could use 100% debt financing to pay for Valeant, as the maximum leverage that would result would be 4.2x net debt/EBITDA for AstraZeneca. If we assume a 5% interest cost which is probably too high the annual interest expense would be $1.8bn, so the acquiring firm would add $1.2bn to their cash flows. At 15x cash flow this would add $18bn to the firms market cap. In addition, the acquiring firm could create synergies by integrating Valeant into their existing business. 10% of SG&A costs is a conservative estimate of potential synergies. As Valeant currently spends $2.5bn on SG&A costs these synergies could save $250mn per year and generate another $3-4bn of value from this transaction. And finally, the pharmaceutical company may decide to sell B&L, which is more of a consumer-focused medical technology business than a pharmaceutical business. As half of the reported B&L/International division has these characteristics this is $800mn in EBITA that could be sold. If this was sold for 20x P/E rather than the current 15x pharmaceutical P/E the acquiring firm could capture an incremental $4bn of value (assuming the tax losses are transferable). This scenario shows how an acquiring firm could create up to $25bn of value by acquiring Valeant ($18bn P/E arbitrage, $3-4bn cost synergies, $4bn from a B&L spin-off). Ill admit that $25bn is a bullish estimate, but $15bn appears to be very achievable result if a large-cap pharmaceutical firm were to buy Valeant for $30/share. So why hasnt this happened? The financial rationale for such a transaction is very clear, but it relies on Valeants cash flows being at least stable, and to date they have not been. If the bear case - that Valeants EBITDA is stuck in a slow death spiral is true, then Valeant is much harder to value, and it is reasonable that no buyers have stepped forward. But this reasoning also points to why the stakes around Valeants EBITDA trajectory are so high. If Valeant can show the market that EBITDA is stabilizing and will return to growth soon then the share price will recover rapidly, either organically or because an external party launches a bid for the whole firm. I believe that this lack of clarity will be resolved within 12 months. Valeant will probably earn lower EBITDA in 2018 than in did in 2017, as headwinds from business disposals and Loss of Exclusivities (LOEs) more than offset organic growth from the core business. I expect Valeant will earn at least $3.6bn in EBITDA (and $3.0bn in recurring cash flow) in 2019 however, and that Valeant will grow cash flows at c. 5% from that point onward. I detail my assumptions below. 2018 headline EBITDA will likely be below 2017 EBITDA One challenge facing investment analysts is that Valeants finances are very complex because of the number of historical acquisitions and the myriad of changes taking place with the business. Each division has different business with different prospects, some business units have been sold in 2017, and some drugs are losing exclusivity and will likely see much lower profits in 2018. Ive worked through these issues, for which I explain my assumptions below. I expect Valeant will earn between $3.4bn and $3.6bn of EBITDA in 2018, before returning to growth in 2019. Unwinding disposals Valeant has a $200mn EBITDA headwind in 2018, as theyve sold CeraVe, Dendreon, iNova and other business units during 2017. They received almost $3.5bn in compensation, but they will take a $200mn EBITDA hit in return. Details are in the table below. Loss of Exclusivities Valeant will face LOEs on many products in 2018, and especially those products where the potential LOE was deferred from 2017. In 2017 Valeant upgraded their EBITDA guidance by $210mn due to reduced headwinds from LOEs, after issuing the original guidance in February. $180mn of this was in the US Diversified segment, and $30mn in B&L. I assume, conservatively, that all $210mn of this profit is at risk in 2018. In my more positive scenario I have assumed that only $150mn of EBITDA is lost in 2018 as some LOEs are deferred again. Growth from the core business. On the other side of the ledger is growth in Valeants core business units: B&L/International and Branded Rx (Salix and Dermatology). My (conservative) base assumption is that Valeants remaining business will generate $160mn of growth in 2018. This is a 5% annual growth rate on $3.2bn base EBITDA (after disposals and LOEs). The components of this growth are as follows: B&L $100mn (5% organic revenue growth and 0.5ppt margin uplift) Salix $100mn (9% organic revenue growth and stable margins) Dermatology $0mn (Siliq revenue offsets further decline in the base business) Diversified (ex-LOEs & Obagi) -$70mn (10% decline in line with 2017) Operational efficiencies +$30mn, gained from selling several businesses For comparison purposes, I expect 2017 growth over 2016 to be $120mn for B&L and $80mn for Salix, so $100mn in each division for 2018 is a marginally slower growth rate than in the current fiscal year. These (conservative) assumptions would give an EBITDA of $3.4bn in 2018. On more positive assumptions Valeant could achieve $3.6bn of overall EBITDA in 2018, broadly in line with 2017. This would require these (realistically achievable) improvements on my conservative case: LOEs prove less of a headwind, like in 2017, and are a $150mn drag, not a $210mn drag B&L EBITDA is $70mn higher, powered by Vyzulta (if approved reasonably soon) Dermatology produces $50mn more EBITDA through higher Siliq growth and/or base business stabilization Valeant achieves a further $20mn of efficiencies after simplifying the business Its important to note that while these assumptions are a positive case they are far from being overly optimistic. For example, Vyzulta will be the most effective treatment in the $1.6bn prostaglandin market, and so should easily contribute more than $70mn of annual EBITDA over time. Similarly, Siliq is the most-effective and lowest-priced treatment for moderate-to-severe psoriasis, which it has an addressable market of $5bn-plus. As it is hard to know how much these new treatments will contribute in 2018 I have only made moderate assumptions, even in my more positive scenario. 2018 EBITDA guidance While I expect Valeant will earn $3.4-3.6bn of EBITDA in 2018, Valeants initial guidance may be slightly lower than this. CFO Paul Herendeen is a conservative operator, and he may build in an extra $100mn of buffer to ensure he can meet and beat guidance throughout 2018. We will get our first indication on Valeants prospects for 2018 on November 7th. This may not be a release of guidance, but CFO Paul Herendeen did state that (We) are working on some presentation in our Q3 call where well provide better clarity about how you might factor the LOEs out of 2017, so you can think about the core parts of our business that grow into 2018 at the recent Deutsche Bank Leveraged Finance conference. I would prefer to hear as much information as possible, including preliminary guidance for 2018, as I believe the market doesnt currently appreciate the strength of Valeants underlying core business. But we will have to wait until November 7 to find out. 2019 will be the first year of headline EBITDA growth Valeant will face fewer headwinds to profits after 2018. The B&L/International and Branded Rx divisions will be more than 80% of the business from 2018 onward, and their organic growth will more than offset the diminishing drag from the remaining LOEs and US Diversified unit. I expect Valeant will grow at c. 5% p.a. from 2019 onwards, driven by growth in the current B&L business, Vyzulta, Xifaxan, Siliq and other psoriasis treatments. This chart provides an example scenario starting from $3.5bn of EBITDA, which is the middle of my two scenarios for 2018. Summary Valeant is awash with cash, but this cash flow has not (yet) been rewarded by the market. I believe this value will be rewarded over time, and that Valeants return to EBITDA growth will prove to be the critical turning point. This analysis shows that Valeant is approaching that critical turning point. While 2019 should show EBITDA growth at the headline level, 2018 is more complicated. 2018 may be another down year for headline profitability, but the core business of B&L/International and Branded Rx will grow for the second year running, and it should be a year of growth for the whole business on a pro forma basis (i.e. including all of US Diversified, including LOEs, but excluding the business units that were sold). Once Valeant can demonstrate growth the bear narrative that Valeants EBITDA is stuck in a death spiral one that ends with shareholders being wiped out will finally be shown to be false. Growth also will mean that Valeants leverage begins to work for the shareholders rather than against them. For these reasons I expect that Valeants true worth will become a lot clearer for prospective owners over the next twelve months, and that's why I expect a bid of $30/share, or an organic share price rise to a similar level, within that timeframe. I plan to start a Marketplace service on Seeking Alpha within the next 3 months. I will cover a range of investment opportunities, from contrarian value opportunities such as Valeant to high quality, high growth firms that rely less on valuation improvements. Please follow me if you want to get updates. Disclosure: I am/we are long VRX.