Canadian health care magpie Valeant (NYSE:BHC) certainly knows how to stay in the spotlight. Investors simply aren't all that interested in quarterly earnings at a time when the company is actively trying to ratchet up the pressure on Allergan (NYSE: AGN) to accept the company's acquisition offer. Valeant continues to look undervalued as it is likely still in the early to-middle years of a debt-fueled grab for scale. However, as the pushback from Allergan shows, not all of the targets Valeant may choose will welcome the company's efforts at empire-building.
Sluggish sales, healthy margins in the first quarter
Valeant reported first quarter earnings on Thursday that saw revenue grow 77%, but miss the average analyst estimates by around 4%. The shortfall appeared to fall pretty evenly across the business, where management reported a "same store" organic growth rate of 1% and a pro forma organic growth rate of 4%. Importantly, the huge Bausch + Lomb business that Valeant acquired in 2013 showed 11% organic revenue growth and 9% growth in the U.S.
What Valeant missed on the top line, it more than recovered through cost control. Gross margin fell more than three points from last year, but surpassed expectations by almost two points. Operating income rose 53%, just barely missing expectations as the operating margin came in a point and a half stronger than the sell-side expected.
Rallying the base to pressure Allergan
Judging by management's comments on the call, they have no intention of giving up their pursuit of Allergan, nor bidding against themselves. Valeant management believes that they have made a compelling offer and, while Allergan's board may not agree, Valeant is looking to address Allergan's shareholders more directly. The exact roadmap is still unclear, but the gist of Valeant's message is that they'll try to marshal Allergan's own shareholders into forcing a referendum or special meeting to consider Valeant's offer.
Allergan is an important asset for Valeant. With its strong position in aesthetics, dermatology, and ophthalmology, there are few assets that offer more strategic synergy. Even allowing that regulators would likely force some product divestitures, Valeant would emerge as a stronger player than Johnson & Johnson in the overall aesthetics market, extend its lead in dermatology, and fill in the sizable gap in its ophthalmology business created by the lack of glaucoma products (glaucoma is about one-third of the ophthalmology drug market).
Tying together $7 billion in Allergan sales with nearly $3 billion in cost synergies and the leverage of a much lower tax rate would make this an exceptionally value-additive deal for Valeant. With that, it's also worth remembering that Valeant is not a crazy bidder. Management has done enough deals to appreciate the sort of synergies it can reasonably expect and the company has shown price discipline in the past (letting Bausch + Lomb outbid for ISTA Pharmaceuticals, for instance).
Is Congress looking to close the door?
There have been increasing rumblings in Washington, D.C. regarding "doing something" about closing the door on future tax inversion deals. The current proposals would make it much harder for an American company to acquire a foreign company and redomicile in a lower-tax region, but current proposals wouldn't seem to have any meaningful impact on companies like Valeant, Actavis, and Endo Health that have already made such moves. Even so, it is not unimaginable to think that the U.S. government may look to alter the rules and force a tighter link between the profits a company earns in the U.S. and the taxes they pay.
The Bottom Line
Should Allergan rebuff Valeant (either by executing a deal of its own or finding another buyer), I believe there are other attractive fish in the sea, including Galderma. Valeant's core growth-by-acquisition model does carry above-average risks from execution/integration, higher rates, and below-normal R&D spending, but Valeant is already well on its way to proving that it can effectively and profitably acquire and market the fruits of other companies' R&D spending.