U.S. stocks are lower in early Thursday afternoon trading, with the Dow Jones Industrial Average (^DJI 0.18%) and the S&P 500 (^GSPC +0.08%) down 1.08% and 0.84%, respectively, at 12:50 p.m. EST. Shares of embattled pharmaceuticals company Valeant Pharmaceuticals International Inc are falling again today, down 3.46%.
Valeant Pharmaceuticals CEO J. Michael Pearson. Image source: Valeant Pharmaceuticals International.
(I should mention that if you are truly serious about becoming a better investor, you can't afford not to subscribe to Pr. Damodaran's blog; on investing, his writing is exceptional for its insightfulness and cogency.)
For Damodaran, the negative exposure Valeant has received is a watershed:
Even if Valeant emerges unscathed legally from this mess, I just don't see how they can revert to their old business model [of acquisitions focused on repricing drugs, funded with debt and quickly converted into earnings], and it is not clear to me that without it, they are anything more than a middling pharmaceutical company.
He goes on to observe, "big shifts in intrinsic value don't come from earnings surprises or market panics, but from big changes in narrative." Pr. Damodaran's fundamental premise in valuing Valeant is then that the company will revert to the standard pharmaceutical industry model "resting on R&D for (low) growth and making money off its established products." Under that scenario, he makes the following assumptions:
- A 10% permanent decline in earnings (which corresponds to a reversion of Valeant's operating margin to the industry average of 25.5% from 28.3%).
- A significantly reduced earnings growth rate of 3% over the next 10 years.
- R&D investments will reflect the estimated return on capital 15.25%.
- A cost of capital of 7.52%.
On that basis, Damodaran's estimates Valeant's intrinsic value at $77, which happens to be the top of today's trading range. That result stands in stark contrast to the price targets of Wall Street analysts, who appear not to have grasped the tectonic shift in Valeant's new reality.
As of today, according to data from Bloomberg, analysts' average 12-month price target is $179.84, roughly a third (36%) below the $281 high the average reached on Sept. 28. That compares with a decline in the share price from its $263.81 52-week high of more than two-thirds (the decline is 71% as of 11:50 a.m. EST).
Where analysts see a significantly undervalued stock (and therefore, an opportunity!), Damodaran sees a company trading at around its fair value. Who is right? This columnist is siding with the academic (and the market): It's the analysts who will soon be forced to mark down their price targets.
As far as broader lessons, Pr. Damodaran concludes:
The Valeant story reinforces many of my existing biases against companies that grow primarily through acquisitions. I am willing to concede that this strategy can pay off, if companies maintain discipline, but my experience with these companies is that they inevitably hit a wall, either because they become too large to stay disciplined or because the accounting creates too many opportunities to obfuscate and hide problems.
In this case, Valeant appears to have been both too large to stay disciplined and willing to surf on the opacity of M&A accounting. One thing is certain: Valeant Pharmaceuticals is no Berkshire Hathaway.
