Last month investors gathered at the annual Delivering Alpha conference presented by CNBC and Institutional Investor. It was another star-studded affair for the financial sector, with hedge fund managers and investors gathered to share their latest trading ideas.
Highlights included Carl Icahn’s aim to own up to 50% of Herbalife (HLF), Treasury Secretary Jack Lew’s praise of regulators over the Wells Fargo (WFC) scandal and Alibaba (BABA) Executive Vice Chairman Joseph Tsai’s response to Jim Chanos over his firm’s operations.
One of the most interesting calls came from LMM founder and CIO Bill Miller, who sees value in the embattled drug giant Valeant Pharmaceuticals (VRX). The stock had been a darling of Wall Street for some time. Hedge funds piled on two years ago when Pershing Square Capital’s Bill Ackman compared the company to an early-stage Berkshire Hathaway Inc. (BRK.A). The stock rallied from roughly $60 per share in early 2013 to more than $257 by July 2015.
Under former CEO Michael Pearson, the company’s expansion strategy included a legacy of more than
$30 billion in debt and a frantic pace of mergers and acquisitions. Since that record high, the stock plunged by more than 90%. As Reuters notes, “political concerns about Valeant’s sharp drug price increases and investor scrutiny of its dealings with pharmacy Philidor RX dragged down Valeant’s shares.” The company also saw its stock plunge after it delayed and restated earnings and replaced Pearson earlier this year with industry veteran Joseph Papa.
This month, Modern Trader explores the future of VRX.
Legends Duke It Out
Speaking at Delivering Alpha, Miller says that his firm missed the big run of VRX stock to north of $250 per share. However, the stock represents one of his fund’s largest positions as of mid-September. Miller argues that the company’s success will be found in improving free cash flow, which he projects will hit $2.5 billion in 2016 and $3 billion in 2017. “It’s a completely different company,” Miller says. “It’s just a slow-growth specialty pharma company that will generate a lot of free cash and you should be able to make 25% to 30% on Valeant over the next five years.”
However, Chanos had been shorting the stock for months. “We started shorting the stock in the low $100s, added to it in the $200s, choked on it at $290 but stayed short and added to the short as recently as early this year,” Chanos told CNBC. With the stock hovering near $28 per share in mid-September, Chanos has had the chance to walk away. He says he isn’t going to stop shorting the stock as he raises concerns about the firm’s $37 billion in net debt and long-term liabilities.
One of the stocks biggest critics has been financial author Michael Lewitt. A 25-year veteran of the securities industry, Lewitt founded advisory The Credit Strategy Group, where he manages several credit-oriented hedge funds and separate managed accounts. Last October, Lewitt called Valeant a stock that is “everything that’s wrong with the markets.” With the stock at $168, he predicted that it was on its way to $100 per share. Within five days, the stock lost 31% in a day. Since then, he has remained bearish and is recommending using puts to ride it down to $18 per share in June. The stock has rebounded slightly, prompting debate about its future.
“VRX is worth $0,” Lewitt says. “If you look at the balance sheet, the company is functionally insolvent and nothing has changed. They have new management, but it will be difficult for them to generate enough cash flow.”
Lewitt says the stock price has stabilized for now, but he questions what will happen should the markets face another downturn. “We’ve had very friendly markets but when the market gets less trending, and they’re not able to borrow money at very low rates and their debt comes due, it’s going to be a problem.”
Valeant has unloaded billions of dollars of non-core assets. Lewitt expects the company to unload more assets and to try to reduce its size and debt. It may receive offers shortly for its core Bausch & Lomb eye care, dermatology and Salix gastrointestinal assets.
“That’s their only pathway to survive,” he says. “It’s going to take a while, and they’ll probably hold out for prices that are too high.”
Ackman Back in Focus
After Bill Ackman had joined the company’s board of directors, the company engaged in a series of shakeups. However, Lewitt argues Ackman mismanaged his position from early on.
During Valeant’s sharp decline, Ackman has bolstered his stake to 6.2%. The massive decline in VRX stock was at the center of Pershing’s 20.5% loss in 2015. The firm’s $3.3 billion VRX investment was worth roughly $618 million in mid-September.
“His investors can’t be happy,” says Lewitt. “He showed incredible recklessness to put that much capital [into Valeant, watch it slide by 90% and then not do anything except keep doubling down. It was just inexcusable, but that’s between him and his investors.”
Of course, Ackman wasn’t the only one to pile into VRX. Hedge funds Paulson & Co., Viking Global and Brahman Capital all made big bets on Valeant. Lewitt blames the failure on more than just a herd mentality.
“Hedge funds talk and think alike,” he says. “It’s very hard to make money in non-directional strategies these days, so [the hedge funds] all got, if you’ll excuse the expression, pimped into the stock by Pearson who was motivated into ridiculous deals that were unsustainable. They didn’t do their due diligence. I don’t think [Pearson] was honest with the board. He was honest with his investors about what was going on. He wasn’t honest about Philidor. He wasn’t honest about their business practices.”
Lewitt argues that Valeant’s stock collapse represents a major failure for Wall Street.
“Dozens of analysts on Wall Street had buy ratings on Valeant. They’re complicit because all their employers want investment banking business. But few people on Wall Street looked at the balance sheet and said, ‘Wait, this is unsustainable. This is unethical, and it’s not going to keep going.’”
It was just eight years ago that investors saw massive balance sheet problems at Lehman Brothers, Bear Stearns and Fannie Mae and Freddie Mac, yet they continued to pile into those stocks. It wasn’t made much better when prominent pundits argued that Bear Stearns was solvent just days before its collapse. Lewitt says that we’re in an environment where companies like Valeant are in even greater danger when looking at the markets. “It’s human nature; emotion just overrides intelligence,” Lewitt says. “Anybody rational would have looked at Valeant’s balance sheet, looked at what they were doing, and said, ‘Wait a second, this is garbage.’”
Where VRX Goes from Here
Despite his analysis of the company’s balance sheet, Lewitt argues that Wall Street could easily push this stock higher. But he’s especially critical of anyone pushing the stock with a lofty valuation moving forward. That includes a Buy rating on the stock from investment bank H.C. Wainwright and a price target of $90 per share.
“It’s not impossible that the stock bounces back because there’s a bottomless pit of stupidity on Wall Street,” Lewitt says. “But anybody who’s recommending people buy this stock on an $90 stock target works for an investment banker who is long the stock, has never looked at a balance sheet and has no clue what he’s talking about. The company is insolvent. It has negative net worth, tens of billions of dollars. Could the idiots on Wall Street bid it up to $90? Yeah, they could, but that’s not how you invest. Of course, short sellers can get caught in the short squeeze, and it will go up to $90. But there’s no fundamental value of the company at $90.”
Like Chanos, Lewitt argues that the firm’s $30 billion debt load remains the anchor pulling the stock downward. “The equity value is what’s left after they pay back
$30 billion, and it makes no sense to me. I don’t think the company is going to be able to service its debt because I expect its debt costs will rise significantly. Remember, they raised all that money with rates at very low prices. Now the market has already repriced their debt, and it’s going to reprice it more when rates go up.”
As of mid-September, TipRanks consensus rating has VRX stock as a hold (see “What the experts think,” below). Four analysts have issued a Buy rating, while two have issued a sell. Seven analysts rate VRX as a “Hold.”