# Market Musings - November 9, 2017

We continue our blog series: Market Musings, Volume 1, Edition 6, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Clash of the Titans III: Allergan versus Valeant.

As with our prior Clashes (TM), we stress that qualitative arguments only get one so far in investing. Valuation also needs to be taken into account, since a definably excellent company can be a sell if it is priced too high, while a clearly troubled company can be a buy if it priced too low. With that preamble, we analyze herein two of the more controversial large pharma companies, Allergan (ticker AGN) and Valeant (ticker VRX). As per our prior blogs, we invert the investment equation by asking "Under what scenarios will AGN justify its current valuation?" and the same for VRX.

ALLERGAN WHAT-IF SCENARIOS: First take AGN, whose current market cap is $57.5 billion and enterprise value (or EV) is $69.8 billion. Off the bat we note that the company bleeds red ink every quarter, so we cannot perform our usual discounted earnings stream analysis. Here are the most recent financials, taken from the Q3 2017 10-Q filing (see line entitled "Net (loss) from continuing operations, net of tax"):

Instead of using earnings, then, let's be charitable to the company and assume that AGN's positive cash flows are indicative of the company's earnings power (despite the massive GAAP losses from operations). Below are the latest cash flow statements:

From these we see that AGN's cash flows are quite variable, but for the sake of argument let's assume that $1.3B of cash from operations per quarter is normal (this would equate with $3.9B for the first 9 months of 2017, higher than the actual number above). But we still need to deduct something for depreciation and amortization to arrive at a free cash flow number (i.e., a figure equalling true economic or "owner" earnings). So again being generous, we will assume that AGN only needs to spend $750MM/quarter on capex and/or acquisitions to maintain a constant economic output (well below its actual reported D&A figures). This means that the company's current owner earnings are $2.2 billion per year (4X $1.3B minus 4X $750MM), or about $6/share per year based on 332.6 million shares outstanding as of October 27, 2017 (as per the cover page of the 10-Q). We thus find that AGN now trades at a hefty 29X owner earnings per share ($173/$6), well above the prevailing multiple for the overall market.

Next assume that that AGN can grow its owner earnings 12% per year through 2025 and 8% annually from 2026 through 2036. These are pretty optimistic earnings assumptions for a company that consistently loses money on a GAAP basis, with no end to the losses in sight (in this bullish scenario the company would achieve owner earnings of almost $35/share in 2036). So what would the value of this 2017-2036 earnings stream be worth, if we discount it back to a net present value (via the "NPV" function in Excel) using a 5% discount rate? Approximately $69.3 billion, slightly below the current EV and only $11.8 billion above the current market cap, indicating minimal upside against the prevailing market price for the stock.

In order to achieve at least a 10% expected CAGR for AGN shares, we would need to increase these growth assumptions to approximately 20% growth per year through 2025 and 10% annually from 2026 through 2036. Given the current adverse political climate regarding drug pricing and the company's patent expiration issues, it is highly unlikely that AGN will be able to grow economic earnings at anything close to 20% per annum for quite some time. In our view, even the 12%/8% growth scenario outlined above is unlikely (note that analysts predict a decline in AGN's misleading self-graded "performance net income" metric from 2017 to 2018 - source here). What would be a reasonable growth scenario for AGN? We would posit 3% growth through 2025 and 6% growth from 2026-2036 as a base case. This scenario yields us an "owner's earnings" stream with an NPV equal to $36.3B, significantly below both the current market cap and EV, indicating substantial further downside ahead for AGN shareholders (the amount would equate to $109/share in NPV). Thus, in our view there appears no good news on the horizon, even in the face of the relentless decline in the stock price over the past two and a half years...

VALEANT WHAT-IF SCENARIOS - Next take VRX, one of the poster children for big pharma greed over the past few years, whose current market cap is $5.35 billion and enterprise value (or EV) is $31.4 billion. Much like AGN, we cannot use GAAP earnings since the company loses money consistently. Here are the financials for the first 9 months of 2017 (per the company's Q3 2017 10-Q filing)--see the line entitled "Loss before recovery of income taxes":

Let's review the statement of cash flows, however:

Much like AGN, we can calculate an "owner's earnings" figure for VRX. Let's assume that $425MM of cash from operations per quarter is normal (this would be quite a bit higher than the actual number above for the first 9 months of 2017, after backing out changes in operating assets and liabilities). But--as we did with AGN--we still need to deduct something for depreciation and amortization to arrive at an owner's earnings amount. So again being generous, we will assume that VRX only needs to spend $350MM/quarter on capex and/or acquisitions to maintain a constant economic output (well below its actual reported D&A figures, but in line with what the company has actually spent so far this year). This means that the company's current owner earnings are $300MM per year (4X $425MM minus 4X $350MM), or about $0.86/share per year based on 348.6 million shares outstanding as of November 2, 2017 (as per the cover page of the 10-Q). We thus find that VRX now trades at 17.8X owner earnings per share ($15.35/$0.86), fairly in line with the overall market.

Next assume that that VRX can grow its owner earnings 12% per year through 2025 and 8% annually from 2026 through 2036. In this scenario the company would achieve owner earnings of almost $5/share in 2036. So what would the value of this 2017-2036 earnings stream be worth, if we discount it back to a net present value (via the "NPV" function in Excel) using a 5% discount rate? Approximately $10.4 billion, about one-third of the EV, indicating huge downside risk against the prevailing market price for the stock (using these growth assumptions, the company would find it impossible to pay off its massive debt load). Clearly, VRX will need much faster growth in "owner earnings" in light of its still-quite-large EV. So what if we assume 20% growth through 2025 and 12% growth during 2026-2036? Now the DCF is up to $20.7B, unfortunately still far short of the company's debt load, let alone its EV.

In order to achieve a DCF equal to VRX's EV, we would need to increase these growth assumptions to approximately 25% growth per year through 2025 and 14% annually from 2026 through 2036. As with the AGN discussion above, we don't see on the horizon any near-term hope for robust pharma industry revenues or margins. In fact, we could easily see revenue and earnings declines over the next few years. Therefore, we believe that even the 12%/8% growth scenario is optimistic. Bad news for VRX longs, who have enjoyed a recent bump in the share price...which will likely not last very long.

DISCLOSURE: Short AGN, no position in VRX.