Departing for a moment from discussing existing investments, this post focuses on a new one I just looked at.
Valeant (VRX)
Valuing Valeant is an interesting problem, that valuation guru Aswath Damodaran recently tackled. I read a few articles about Valeant, but did not consider investment until reading the aforementioned valuation post. With so steep declines from highs, my contrarian instincts got triggered and I looked more closely on Professor’s valuation, not to criticize it, but to see if I can understand the business enough and own it.
Just from naive, sum-of-the-parts point of view, the $5.6B market cap for company that owns household brand Bausch & Lomb (bought for $8B+ and unlikely to lose value in the meantime) and so many other assets, seems like a bargain. But the $30B+ debt is a big red flag. In his valuation, prof. Damodaran computes firm value and subtracts debt to arrive at equity value. He assigns 10% chance to failure and adjusts firm value, but before subtracting debt. Because in distress the equity will be wiped out, I think the 10% adjustment should come after subtracting debt from unadjusted assets. In other words, we should allow debt holders to carry part of the default burden in addition to equity being wiped out, instead of assuming entire default cost on equity. After all, this is what company pays for in increased interest rates. This is a minor point though, as 10% probability is arbitrary to begin with, and valuation does not change much (and for the upside, actually).
The big problem I see is with credit rating plummeting from Ba1 to B3. Presumably, most of the debt was obtained with former rating in place and B3 carries much higher spread, according to Professor’s table. Rising riskless rates don’t help. If we roughly calculate interest for current debt as 3.25% + 2% = 5.25% and future interest on rolled over debt as 7.5% + 2.5% = 10%, we look at almost doubling the interest expense. Eyeballing the “10. LONG-TERM DEBT” section in the latest 10Q I see ~6% rates at outstanding notes which would confirm it. Extrapolating last 9 months gives $1.8B annual interest expense today and $3B after refinancing. Valeant says: “We believe our existing cash and cash generated from operations will be sufficient to cover our debt maturities as they become due”. But judging from “Payments due by Period” in “Long-term debt obligations, including interest” in their 2016Q3 10Q, and the ~$3B of earnings before interest in Professor’s calculation, they could be short on cash as early as 2017 & 2018 when $7.7B of interest and principal is due and even more in 2019 & 2020 when the number raises to $12.7B. Of course if they pay down principal and stabilize business they can get upgraded and roll over debt at less than 10%. They could also divest some businesses - but a few subsidiaries guarantee debt and there may be other covenants I am not even aware of.
Finally, the assumption of flat revenues in first years might prove to be optimistic, as the reversal of previous price gouging can reduce it, maybe even substantially.
I recognize the potential for non-trivial upside, elevated by the optionality of positive surprises on the business side and successful divestitures. But the downside is also substantial, potentially 100% with hard-to-estimate probability.
But I can also see other another possibility. Famously, Bill Ackman’s Pershing Square bet heavily on Valeant and even doubled down. His fund trades at 22% discount to NAV, I think one of the highest to date. Buying into PSH gives me exposure to Valeant, with more diversification but also leverage (through NAV discount, PSH’s $1B debt, their long-short strategy and IIRC them holding not only Valeant’s stock but also deep out of money options).
Of course buying PSH also exposes me to high hedge fund fees, their bet against Herbalife (I think and hope HLF will fail, but I am wary about unlimited downside of shorting) and the risks that their leverage brings. But there are also additional upsides - if Ackman ‘wins’ Valeant or Herbalife the NAV discount may turn into premium and his overall performance/luck might also ‘revert to the mean’. I was actually considering QSR, MDLZ and CMG which were his other bets, as of Sept 30th. These seemed to be good businesses, but I didn’t spend enough time to value them. I am sure he did.
Lastly, as I understand PSH might currently have a headwind of performance fees for the successful 2014. I assume that poor performance of 2015 and 2016 will reduce the performance fees in the next couple of years, should the fund perform well.
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