Contrarian investor Jim Grant recently wrote that he's "confidently bearish" on Valeant Pharmaceuticals (NYSE: VRX ) in a Grant's Interest Rate Observer article, making his case against the skin- and eye-care drugmaker. The piece, which credits respected short-seller Jim Chanos for the initial idea, pushed the stock down 5% on publication. But does its bear case hold up to scrutiny? To find out, I examined a few of its major arguments, which are largely attributed to Evan Lorenz, an analyst at Grant's Interest Rate Observer.
1. Adjusted Numbers
Valeant provides auditor-approved GAAP financial statements, but also reports a number of non-GAAP measures, such as "Cash EPS." It also provides quite a few different ways to gauge organic growth. Lorenz concludes that Valeant's use of non-GAAP measures is an attempt to mask the company's true performance.
Certainly, there are examples of companies using non-GAAP numbers to mislead investors -- but I don't think that's the case here. Valeant is growing rapidly and via acquisitions, which has made the GAAP financials quite difficult to interpret. I've been through the company's GAAP financials and its reconciliation of "Cash EPS" to GAAP EPS. In my opinion, this additional measure helps investors understand the business' underlying economics. In short, what Lorenz interprets as obfuscation, I consider transparency.
Lorenz also implies that the company is overvalued based on free cash flow (defined as cash flow from operations minus capital expenditures). He says: "In 2013, free cash flow amounted to $927 million, or $2.89 per common share... The 2013 reading would give Valeant a less-than-lordly free-cash flow yield of 2 percent." Admittedly, the trailing free cash flow yield of 2% is quite meager, and I won't quibble with his calculation of free cash flow for 2013.
However, I find this claim highly flawed. Valuation is based on future profits, and historic numbers for Valeant don't necessarily indicate its future as well. The company is regularly acquiring companies that will increase future earnings power, and using backward-looking numbers doesn't account for this. For instance, the full effect of Valeant's $8.7 billion purchase of Bausch & Lomb, which closed in August of 2013, won't be seen in its 2013 numbers.
3. Declining organic revenue
It depends on which measure you use (same-store sales or pro forma), but Valeant reported 2013 organic growth of 0% to 2%. This has led Grant and Lorenz to conclude that the company's acquisition strategy isn't working. Grant says: "We don't see the data to support the contention [that acquisitions will bear fruit]." And Lorenz claims that "the longer a business is under a Valeant umbrella, the worse it performs." The implication is that Valeant is acquiring declining assets, which may temporary boost sales, but will eventually prove to be poor investments. Of all the bear arguments, serious investors should give this the most consideration.
Even so, I don't find it compelling. Although I'll keep continue to keep a close eye on organic growth, Valeant's results don't look bad enough for me to conclude that it's making poor acquisitions. More importantly, the track record and incentives of Valeant's management and board of directors give me confidence. CEO Mike Pearson has a great track record, and he owns more than $700 million worth of shares that he's committed to hold until at least 2017. ValueAct Capital, a savvy activist hedge fund with $2.9 billion invested in Valeant, has a board seat.
As an investor, it's important to be humble. Bear arguments are always worth a look, especially when they come from respected people such as Jim Grant or Jim Chanos. But while the bears are often right, that doesn't seem to be the case here. Based on my examination of the arguments, the bears haven't found a smoking gun.
Right now, it seems like the market is reacting more to the notoriety and name-value of Grant and Chanos than to a compelling bear argument. Investors in Valeant shouldn't look to sell their shares based on this bear case. If anything, it could even represent an opportunity to buy shares at a better price.
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