It is easier and more fun to write about your winners than your losers, but it is also far more important and valuable to revisit your losers, where the story has not played out the way you hoped it would. It is important because it is easy to lapse into denial and hold on to your losers too long, not only because you let hope override good sense but also because the act of selling is the ultimate admission that you made a mistake. It is valuable because you can learn from these mistakes, if you can set aside pride and preconceptions. So, it is with mixed feelings that I am returning to Valeant, a stock that I bought in May at $27, contending that it was worth $44, but where the market has clearly had other ideas.

Valeant: Revisiting the Past

I first wrote about Valeant just over a year ago, when it was entering its dark phase, surrounded by scandals, management intrigue and operating problems. At the time, the stock had completed a very quick descent from market star to problem child, with its stock price (market cap) dropping from $180 on October 1, 2015 to $80 on November 6, 2015. While there were many in the value investing community, where it had been a long time favorite, who felt that the market had over reacted, my valuation of $77 left me just short of the market price of $80 at the time. Over the next few months, things went from bad to worse on almost every dimension. The management team disintegrated, with many of the top players leaving in disgrace, and the company held back on reporting its financials because it was having trouble getting its books in order, never a good sign for investors. Testimony by its top managers in front of congressional committee shredded its corporate character and the company faced legal challenges on multiple fronts. The market, not surprisingly, punished the stock as the company lurched from one crisis to another and the stock price dropped almost 75%:

Valeant

In May 2016, I revisited the company, just after it hired a new CEO (Joseph Papa) and Bill Ackman, a long-time activist investor in the company, decided to take a more active role in the company. In revaluing the company, I noted that the missteps at the company had hamstrung it to the point that it had during the period of a year made the transition from Valeant the Star to Valeant the Dog. The value that I estimated for the company, viewed as such, was $43.56.

Valeant

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In keeping with my theme that the value of a company always comes from an underlying story, it is worth being explicit about the story that I was telling in this valuation. In May 2016, I viewed Valeant as a mature pharmaceutical company that would not only never be able to go back to its “acquisitive” days but was likely lose ground to other pharmaceutical companies with better R&D models. Consequently, in my valuation, I assumed low revenue growth and lower margins and a return on capital that would converge on the cost of capital over time. My decision in May 2016 was to buy Valeant at $27 because I felt that, notwithstanding the fog of missing information, management changes and legal sanctions, the company was a good buy.

The Market Speaks

In the months since my buy in May 2015, there has been little to cheer about for Valeant investors. The stock had an extended swoon in late June, recovered somewhat in August, before continuing its descent in the last two months, with three possible explanations for the price performance. One is that the debt overhang, with $30 billion plus in debt due, making it the most highly levered company in the pharmaceutical business, creates market spasms each time worries about default resurface. In fact, every few weeks, another rumor surfaces of Valeant planning to sell a major chunk of itself (Bausch and Lomb, Salix) to remove the debt burden. The second is that the consolidation and cleaning up for past mistakes seems to be taking a lot longer than expected, with revenues stagnating and huge impairment charges pushing equity earnings into negative territory. The third is that the legal jeopardy that was triggered by the events of last year is showing no signs of abating, with the most recent news story about indictment of Valeant executive, Gary Tanner, and Philidor’s Andrew Davenport  continuing the drip-drip of bad news on this front.

Valeant

For most of the last few months, as the price dropped, I have been waiting for something more concrete to emerge, so that I could revalue the company. On November 8, Valeant filed its most earnings report for the third quarter, reporting that revenues were down more for the third quarter of 2016 and larger losses than expected. It accompanied the report with forward guidance that suggested continued stagnation in revenues and no quick profit recovery next year, leading to a sell-off in the stock, pushing the price down to just below $14 on November 9. While I the reports is definitely not good news, I must confess that I did not see much in that report that was game or story changing. To see why, take a look at the numbers contained in the most recent earnings report:

2016, Q3 2015, Q3 Change 2016, Q1-3 2015, Q1-3 Change
Revenues $2,480 $2,787 -11.02% $7,271 $7,689 -5.44%
COGS $658 $649 1.39% $1,946 $1,855 4.91%
S,G &A $661 $698 -5.30% $2,145 $1,957 9.61%
R&D $101 $102 -0.98% $328 $239 37.24%
Amort & Impair, finite-lived intangible assets $807 $679 18.85% $2,389 $1,630 46.56%
Goodwill Impairment $1,049 $- NA $1,049 $- NA
Acquisiton Costs (all) $67 $213 -63.93% $131 $648 -65.06%
Operating Income $(863) $448 -292.63% $(716) $1,366 -152.42%
EBIT pre-acquisition costs $(796) $661 -220.42% $(585) $2,014 -129.05%
EBITDA $1,060 $1,340 -20.90% $2,853 $3,644 -21.71%
EBITDAR $1,161 $1,442 -19.49% $3,181 $3,883 -18.08%

 

It is true that the company is delivering lower revenues than the revenues that I had forecast for the company in May 2016 and it is also true that the company’s profit margins are dropping. However, and this may just be my confirmation bias speaking, as I look at the third quarter numbers, it seems like a significant portion the bad news reported for the quarter reflects repentance for past sins, not fresh transgressions. The company has had to respond to its “price gouger” reputation by showing restraint on further price increases (dampening revenue growth in its drug business) and the losses in the third quarter can be largely attributed to impairments of goodwill and assets acquired during the go-go days. In the table below, I break down the drop in operating income of $2.08 billion from the first 3 quarters of 2015 to the first 3 quarters of 2016 into it’s constituent parts:

Effect on operating Income % Effect
Declining Revenues $(317) 15.27%
Change in Gross Margin $(192) 9.24%
Change in SG&A $(188) 9.05%
Change in R&D $(89) 4.29%
Change in Acquisition Costs $517 -24.89%
Change in Amortization (Assets + Goodwill) $(1,808) 87.05%
Change in Operating Income, , First 3Q 2016 vs First 3Q 2015 $(2,077) 100.00%

The numbers suggest that almost 87% of the decline in operating income can be traced to amortization either of finite lived assets or goodwill, though there has been deterioration in the business model as manifested in the decline in sales and gross margins. It is for this reason that the effect this earnings report has had on my “Valeant as Dog” story is muted, largely because the story was not an uplifting one in the first place. My updated version of the story

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