Is Valeant’s Buy-to-Grow Strategy Sustainable?: Real M&A

Valeant Pharmaceuticals International Inc.’s deal-fueled quest to become a $150 billion company has some investors doubting the strategy as it loads up on debt.

The world’s most acquisitive drugmaker loses money on a pre-tax basis, and its dealmaking frenzy left it paying triple in interest what the business earned in operating profit last year. The stock is slumping from a February peak as Valeant goes after its biggest target yet: Allergan Inc., whose $50 billion market value now dwarfs Valeant’s $45 billion. The company is saddled with the highest leverage ratio in its peer group, according to data compiled by Bloomberg. That’s before it borrows an additional $15 billion to buy Allergan.

Valeant’s private-equity-like approach of continually acquiring companies and then slashing staff and other costs created a 96 percent gain for its own shareholders last year, which has led other drugmakers to emulate the strategy. Even so, it’s beginning to draw skepticism from equity and credit analysts as well as short seller Jim Chanos who raised questions about Valeant’s ability to continue growing this way as its debt burden increases and its stock becomes a less attractive form of payment.

“Valeant’s strategy depends on people continuing to drink this Kool Aid it’s serving,” Vicki Bryan, an analyst at New York-based Gimme Credit LLC, said in a phone interview. “They have to keep buying at a heavier and heavier and more expensive pace to keep this up. What happens when they can’t? There’s no inherent growth, and the debt side of this is a very big part of the story that the stock market is ignoring.”

Stock Concern

Bankers and lawyers advising other health-care companies have told their clients to take cash instead of stock if any are approached by Valeant, according to people familiar with the matter. Because Valeant’s business model and share price are dependent on the drugmaker making acquisitions, it risks running out of steam without more large deals, said the people, who asked not to be identified because the matter is private.

Valeant’s “philosophy” of doing both large and small deals won’t “change at all,” Chief Executive Officer Mike Pearson said on the company’s earnings call in February, before the Allergan bid was announced.

Laurie Little, a spokeswoman for Valeant, said in an e-mailed statement last week that the company is “confident in the sustainability of” its business model.

“Valeant believes that there is a tremendous opportunity to increase efficiency, reduce overspending, and generate long-term shareholder value in the pharmaceutical industry by consolidating complementary operations,” she wrote.

Big Goal

Valeant built itself into a dealmaker through its 2010 merger with Biovail Corp. It took on Biovail’s Canadian domicile and lower tax rate, paving the way for future cost-cutting deals. Valeant’s goal is for these transactions to catapult it over the next three years into one the world’s five biggest drugmakers by market value, a title currently held by companies more than triple its size such as Pfizer Inc.

The company said in a February earnings presentation that same-store sales growth -- products it had on the market for more than a year -- was flat in 2013. With the impact of its acquisitions and excluding drugs that are losing revenue to generics, growth was 7 percent.

“Everything Valeant is doing here is with the goal of near-term value creation,” David Amsellem, a New York-based analyst at Piper Jaffray Cos., said in a phone interview. “Is this built for the long haul? That’s something I have real concerns about.”

Buying Spree

Following the Biovail merger, Valeant bought more than 30 businesses and boosted its stock price 469 percent to a record on Feb. 20, data compiled by Bloomberg show. Since then, the shares have slipped 10 percent as it tries to convince Allergan, the maker of Botox wrinkle injections, to accept its takeover bid.

Today, Valeant shares fell 3.2 percent to $129 at 10:25 a.m. in New York.

In its pursuit of Allergan, Valeant teamed up with hedge-fund manager Bill Ackman, whose Pershing Square Capital Management LP is Allergan’s largest shareholder. The firm amassed a 9.7 percent stake in Allergan after reaching an agreement with Valeant to jointly undertake a hostile bid.

Allergan has said the offer is too low and “creates significant risks and uncertainties” for its shareholders because they would be receiving Valeant stock.

Bank of Montreal’s David Maris has estimated a less than 50 percent chance the deal gets done. The $2.7 billion of cost cuts Valeant proposes seem “both unachievable and damaging” to Allergan’s business,’’ Maris wrote in a May 12 report.

Sweetened Bid

Valeant said this month that it plans to sweeten the bid and will hold a webcast May 28 to explain why Allergan’s owners should agree to a sale. The current offer was valued at $159 a share last week, and only about a third of that is for cash.

Little, the Valeant spokeswoman, said the company “will address the benefits of our acquisition-focused model, along with many other topics, at the event we are hosting on May 28.”

Valeant has a debt-financing commitment of $15.5 billion from Barclays Plc and RBC Capital Markets, a unit of Royal Bank of Canada. If it increases the cash portion of the offer, it may need to borrow more money.

The company already had $17.4 billion of debt as of March 31, which is equal to 6.1 times earnings before interest, taxes, depreciation and amortization from the past 12 months, data compiled by Bloomberg show. That’s a higher ratio than any other drugmaker valued at more than $10 billion, the data show.

It paid $844 million in interest expense last year which, along with restructuring costs from its deals, contributed to a $1.3 billion pre-tax loss.

Borrowing Costs

Valeant’s strategy partly depends on low interest rates so it can take out loans cheaply. If investors become skeptical and see increased risk in Valeant, banks may start charging higher rates, which will make it harder for the company to keep making acquisitions, said Bryan of Gimme Credit.

“The clock is running on these guys,” she said, because August will mark one year since Valeant closed on its $8.7 billion takeover of eye-care company Bausch & Lomb Holdings Inc. “They’ll no longer have a chunk of acquisitions to mask the top-line deterioration, which means the third quarter could be a really nasty surprise.”

The Allergan deal may actually reduce leverage, Moody’s Investors Service said last month, changing its outlook on Valeant’s credit profile to “developing” from “negative.” Valeant is rated Ba3 by Moody’s, the third level of junk status.

More Scrutiny

“You’ve definitely seen more scrutiny, especially with Allergan management calling out Valeant’s strategy, but we think Valeant’s done very well and can execute the strategy well,” David Krempa, a Chicago-based analyst at Morningstar Inc., said in a phone interview. “They have kind of the highest quality management team, and so they’d be the most likely to succeed with the strategy.”

Most analysts still recommend buying Valeant shares, and their average estimate is for the stock to climb about 25 percent in the next 12 months, data compiled by Bloomberg show.

According to BMO’s Maris, some investors say the Allergan deal will give Valeant’s earnings and stock price a short-term boost, at which point they say they will dump their shares to get out before “the blow-up.”

Jim Chanos, founder of New York-based hedge fund Kynikos Associates LP, is among those betting against Valeant, the New York Times’ DealBook reported May 16. Chanos’s assistant said in an e-mail last week that he wasn’t available to comment on Valeant.

Short Interest

While Valeant’s short interest is still relatively low compared with the average level for the Standard & Poor’s 500 Index, it jumped about 60-fold between mid April and last week to about 0.7 percent, according to data from Markit compiled by Bloomberg. In a short sale, traders sell borrowed stock in a bet the price will fall, allowing them to buy back the shares more cheaply and pocket the difference.

Allergan may give Valeant the boost it needs to put the skepticism to rest, though it’s unclear whether its cost-cutting plans would ultimately damage Allergan’s business, Amsellem of Piper Jaffray said. Allergan’s products, which include Botox and Restasis eye drops, are helped by promotions and marketing, so if Valeant cuts investment that may hurt sales, he said.

“If you strip Allergan bare, can the business sustain itself?” Amsellem said. “What Valeant is proposing, I don’t know that it would necessarily harm Allergan in the next one to two years, but beyond that it’s a legitimate question to ask.”

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