Valeant’s (VRX) 2014 guidance, released Jan. 7, was in line with our estimates, but the more remarkable announcement concerned management's ambitious goal for 2016. Management expects 2014 revenue of $8.2 billion-$8.6 billion and adjusted earnings per share of $8.25-$8.75; our estimates for both figures fall in the middle of these ranges. Management’s expectations for the business in 2014 carried no major surprises. The firm hopes to develop all of its business segments organically, but is especially focused on aesthetics and ophthalmology. Valeant is increasing its salesforce in the aesthetics market from 94 to 200, a rare move for the firm, which sees significant opportunity to boost the business with the additional products from the Solta Medical and Obagi acquisitions. The increase will put its salesforce in line with industry leader Allergan (AGN).
The big news that caught investors’ attention was management’s new goal for the company to become a top-five global pharmaceutical company based on market cap by the end of 2016. Management expects this to require about a $150 billion market cap, up significantly from Valeant’s current $40 billion market cap. While this goal isn’t too surprising to us--CEO J. Michael Pearson had already stated in a letter to employees that his goal is to become the biggest health-care company in the world--investors seemed pleased to see such an ambitious goal become one of the company’s official targets, and one to which management compensation is benchmarked. We wouldn’t read too much into the goal, since it will be driven largely by the amount of equity used in futures deals, and could actually act counter to investors’ best interests. We have an Exemplary stewardship rating on Valeant and believe the firm looks out for investors’ best interests, but it could in theory achieve its goal by consistently overpaying for deals with equity, which would harm investor returns.
Any hope of reaching the $150 billion market-cap goal will depend on Valeant completing its much-discussed merger of equals. While we were initially skeptical of Valeant’s ability to find a large partner willing to combine businesses and hand over leadership to Pearson and Valeant, management continues to discuss the possibility after more than a year, which we see as a sign that there is a high probability of a deal. Valeant has likely approached firms it is interested in, and if the deal had been definitively rejected, it would have moved on from the idea and returned to focusing on traditional acquisitions. It’s likely that the company has candidates that are at least interested in the possibility of a merger and are willing to negotiate.
Valeant’s Strength Is in Acquisition and Consolidation
Under the control of CEO J. Michael Pearson, Valeant's aggressive acquisition strategy has been executed nearly flawlessly. Since Pearson took over five years ago, the stock is up more than tenfold, as Pearson's highly accretive acquisitions have significantly reduced the firm's patent exposure, refocused the business on attractive pharmaceutical markets, and drastically improved margins. Although the stock has already had a terrific run since Pearson took over--and saw an 11.3% jump on Jan. 7, the date of the new guidance announcement--we believe significant opportunities still exist, and the firm's scale advantages will allow it to continue executing value-creating deals for years to come.
We expect Valeant to continue to consolidate competitors and leverage its existing infrastructure. The strategy has been successful across all of the firm's major markets, but performance has been the most impressive in the U.S. prescription dermatology market. In 2008, Valeant was the 11th-largest player, with less than 1% market share. Now, through nearly a dozen acquisitions, it has become the leading player, with market share of 15%-20% and sales 50% higher than the second-place competitor. More importantly, this rapid growth allowed Valeant to leverage its salesforce and back-office expenses to create an extremely efficient business with operating margins well above 50%. We don’t expect the same success in ophthalmology, since Valeant will face a much more concentrated market and larger competitors, such as Novartis (NVS), Abbott (ABT), and Johnson & Johnson (JNJ), but we believe there will still be attractive opportunities for Valeant. The market is growing at a midsingle-digit rate and the high cash-pay component means relatively little pricing pressure from managed-care and government payers. Valeant is unlikely to dethrone the market leader, Novartis, but we think it will be able to profitably consolidate smaller players and invest capital at returns significantly higher than its cost of capital over the next several years.
Fair Value Estimate Remains $125 per Share
Our fair value estimate of $125 per share remains intact following the company’s recent guidance. We expect additional earnings from Bausch & Lomb to more than offset the additional interest expense and share dilution that Valeant is taking on to fund the transaction. The deal boosted our 2014 earnings per share estimate by 25%.
We still expect the company to produce high-single-digit organic revenue growth during the next five years. Valeant has done an impressive job reducing selling, general, and administrative expenses over the past few years, but now boasts one of the lowest SG&A ratios in the pharmaceutical industry and probably has minimal room for additional improvement. Management has now focused on reducing manufacturing expenses and is consolidating from 17 plants to just eight. We expect the consolidation to significantly improve gross margins over the next two years.
Scale Advantages Secure Valeant’s Moat
Valeant's narrow economic moat, which remains intact following the recent guidance, benefits from patents, as all branded pharmaceutical companies do, but it is also derived from scale advantages, both efficient scale in small niche markets and absolute scale on a global basis. Valeant looks to exploit the efficient-scale advantage whenever possible. It seeks niche therapeutic areas (dermatology) or geographic regions (Canada, Australia, Eastern Europe) that are not large enough to attract attention from the largest and best-capitalized competitors (typically big pharma), yet are still large enough to provide a meaningful opportunity to Valeant. In these markets, Valeant is able to build scale through acquisitions and become the largest fish in a small pond, giving it cost-structure and distribution advantages over smaller competitors.
The firm has used wise capital-allocation decisions to mitigate the negative impact that changing industry dynamics would have had on its moat. It has stopped investing capital in the heavily genericized neurology segment and has focused on investing in areas where it has competitive advantages: Canada, dermatology, and emerging markets. The attractiveness of dermatology has slightly declined as a result of the increasing prevalence of generic options, but Valeant has adapted to the less lucrative environment by focusing on gaining scale and leveraging its salesforce to further extend its advantages over competitors.
Pearson’s Record of Success a Positive for Investors
J. Michael Pearson joined Valeant as CEO in February 2008. Before Valeant, he spent 23 years at McKinsey & Company, where he rose to head of global pharmaceuticals and gained significant experience in acquisitions, integration, and efficiency strategies. Because of the firm's aggressive acquisition strategy, Pearson has a much greater impact on his company than the average pharmaceutical CEO. Investor returns will be highly dependent on his ability to choose acquisitions carefully, avoid flops, and execute integrations successfully.
So far, we find Pearson's disciplined approach to acquisitions and his five-year-plus record of success to be encouraging. He has demonstrated a willingness and ability to walk away from a target and avoids bidding wars whenever possible. He lacks a scientific background or experience in research and development, but the firm has moved from an R&D-focused strategy to one focused on acquisitions and integration, which fits Pearson's expertise.
Pearson has been very successful allocating shareholder capital. His acquisitions to date have added tremendous value for shareholders, and he has shown that he is prepared to sell the firm's assets when they are worth more to another buyer than they are to Valeant shareholders. When he first took over, Valeant operated in dozens of countries but lacked the critical mass to operate efficiently. He quickly sold assets that lacked a competitive advantage so the firm could redeploy capital in areas where it had scale and strong growth prospects. He has also added significant value to shareholders by aggressively repurchasing the firm's stock over the past few years at prices well below the current share price.