Buying the Worst Business in U.S. History
Editor's note: Our special Digest holiday series continues today with the first of two valuable essays from our colleague Dr. David "Doc" Eifrig...
Next Monday, you'll get a glimpse into Doc's thoughts from his income-focused advisory, Income Intelligence, on the next great logistics trend that almost no one is watching. And today, we're featuring an opportunity from his Retirement Millionaire newsletter...
In this essay – adapted from the March issue of Retirement Millionaire – Doc details a business that's one of the most hated companies in the market. But as good contrarian investors know, you find the best values among the market's most unloved stocks...
Buying the Worst Business in U.S. History
Mike Pearson was following his billion-dollar playbook... but this time, it blew up in his face.
Back in 2015, Pearson's firm had just acquired another company, and on the very same day, hiked the price of its two products 525% and 212%.
Now, all businesses want "pricing power" – the ability to raise prices without losing customers. And Pearson knew his new company had near-absolute pricing power. Despite the severe price hike... he hardly lost a single customer.
But that's because these weren't just any customers. These were patients. And the two products were life-saving heart drugs, Nitropress and Isuprel.
Pearson had done this dozens of times before. And despite the ruthlessness of this business model, he had succeeded. He was worth about $2.5 billion on paper.
But he didn't realize that the climate for drug pricing was changing...
Just a few months later, a young, brash, and thoroughly detestable pharmaceutical executive named Martin Shkreli did the same thing. He bought the rights to a drug named Daraprim that helped HIV patients treat parasitic infections. He raised the price from $13.50 a tablet to $750.
This time, news of Shkreli's move sparked a storm of controversy. The New York Times and others reported on the price hike. Shkreli went viral. He earned the nickname the "Pharma Bro," was called "the most hated man in the world," and was deemed to have the world's "most punchable face."
The Times story included a note that Pearson had been doing the same thing on a much larger scale. Within a couple months, Pearson's company was under investigation by Congress and several attorneys general.
By March 2016, Hillary Clinton's presidential campaign started airing an ad that specifically addressed Pearson's company: "The company is called Valeant Pharmaceuticals. I'm going after them. This is predatory pricing, and we're going to make sure it's stopped."
Believe it or not, having the then-presumed next president of the United States put a target directly on Pearson's Valeant was the least of its problems.
Valeant was one of the most immoral companies in American history. Though it appeared profitable, it was terribly managed. It put the appearance of short-term gains ahead of creating real value. It borrowed billions it could never repay. On top of it all, Valeant engaged in fraudulent accounting practices.
And today... I want you to buy it.
An Incredible Run
It's almost impossible to tell the story of Valeant's misdeeds in order, because it did so many things wrong at the same time in a web of deceit and greed. It's been called "a pairing of the worst of Big Pharma and the worst of Wall Street."
Let's start with the drug prices...
Valeant's growth kicked into higher gear when the company hired a consultant, Mike Pearson, as its CEO more than a decade ago. Pearson had studied the pharmaceutical industry and decided that spending millions on research and development didn't offer enough of a return. He figured he could earn a higher return by buying up drugs that had already been developed.
That in itself could be a reasonable business model. In its run upward, Valeant bought hundreds of pharmaceutical businesses, booked astounding growth, and saw an incredible rise in its stock price.
But Pearson's approach to the model was too aggressive. For one, he bought a company and then slashed all the research costs. That made the acquisition more profitable today. But what drugs would you sell tomorrow?
To pay for acquisitions, Pearson loaded up the company with debt. Total borrowings grew from $3.5 billion in 2010 to $31 billion in 2015. Debt-to-equity grew from 14% (meaning for every $1 in shareholder equity, the company borrowed $0.14) to more than 900%.
Those acquisitions fueled rising sales. Wall Street expected Valeant's growth to continue, so Pearson had to keep making bigger acquisitions to buy drugs with enough sales to move the needle. The whole thing became, in effect, a Ponzi scheme that needed new drugs to make good on the stock price.
Valeant also jacked up the price of life-saving drugs. Part of its playbook was to find old, forgotten, easy-to-produce drugs that were only made by one pharmaceutical company.
One such drug is called Syprine. For people with Wilson's disease – an inability to properly process copper – it keeps them alive and symptom-free. Merck (MRK) made the drug for years, and it cost about $1 a pill, or around $1,500 per year. Valeant acquired the rights to the pill and jacked up the price to $300,000 per year.
This worked for a few reasons. First, patients need the drug to live and had no alternative to get it. Second, insurance pays for most of it. After all, it's still cheaper than treating a patient for liver failure.
Since insurance pays for it, that means everybody pays for it. Of course, if a patient didn't have insurance, he'd better hope he is independently wealthy.
Valeant ran this scheme for years until public opinion and the regulators caught on. What Valeant had done was perfectly legal, but a single act from Congress could end the whole thing.
And if that weren't enough...
Right at the peak of the pricing scandals in 2015, some investigative short sellers uncovered what looked like fraud at Valeant.
Part of Valeant's sprawling empire was a "specialty pharmacy" called Philidor Rx Services. It was essentially a mail-order pharmacy that shipped Valeant drugs to customers and billed their insurance.
Nothing is wrong with that, but Philidor was hidden underneath multiple layers of corporate structure, seemingly to conceal Valeant's ownership. And when insurance companies would start rejecting Philidor's requests – noting this pharmacy was dispensing a lot of high-cost drugs – the company would resubmit applications under dozens of other pharmacy names to conceal its identity.
Some investors suspected Philidor of engaging in other shady practices. Although that turned out to not be the case, it still sent shares tumbling even further.
The Best and Brightest Were Brought Low
Through this saga, Valeant destroyed billions of investors' dollars... some of which belonged to the smartest and most successful investors.
Valeant's financial-engineering, shareholder-value-focused approach appealed to Wall Street. The company was one of the first to use a "tax inversion" by moving its home to a foreign country with lower taxes. It was also accused of "earnings stripping" by loading U.S. subsidiaries with debt to reduce taxable income.
All that growth meant that a lot of investors fell in love with Valeant's financials. The list of notable investors burned by Valeant include Jeff Ubben of ValueAct Capital, Bob Goldfarb of Sequoia, and John Paulson.
And none of the company's investors was more renowned than Bill Ackman.
Years ago, Fortune magazine put him on its cover with the headline "Baby Buffett." Ackman's hedge fund, Pershing Square Capital Management, had grown from $54 million in assets in 2004 to around $20 billion in 2015.
Ackman was known as a fastidious and involved investor. We saw him give a presentation in which he recommended shorting a bond-insurance company called MBIA (MBI) just before the financial crisis. Shares fell roughly 95%. But we most remember how he mentioned that during his research, the firm had spent $250,000 just on printing documents alone.
Ackman doesn't usually miss a thing.
Even so, he got deeply involved in Valeant. He paired up with Pearson to help Valeant buy a massive pharmaceutical company called Allergan (AGN) in 2014. The deal fell through, but Ackman made a tidy profit.
When news of Shkreli and Philidor broke, Ackman came out publicly to support the company and announced he was investing another $1 billion.
But Valeant's success story was over...
In the end, Ackman lost $4 billion of his and his investors' money on his Valeant bet.
The point is that Valeant had such an inscrutable business model and such a persuasive CEO that even the best and most diligent investors got pulled into its orbit.
If Valeant's history makes you leery of investing in it today... you're not alone. It remains one of the most hated companies on the market.
But of course, as good contrarian investors, we know that you find the best values among the market's most unloved stocks. And as we'll show you, that's exactly the opportunity we have today...
This Is Not the Same Company
To rebrand, Valeant changed its name to Bausch Health (NYSE: BHC) in July 2018.
It's more than a name change. The company had to undergo a major overhaul after its 95% decline. It sold off businesses, fired executives, and paid off debt.
Basically, the company needed to build itself back up around a tiny kernel of true value that sat at its core.
Bausch is not the same company that Valeant was, but it's the legacy of Valeant that allows us to earn a better return. For one, many investors still don't want to touch Valeant. And fewer investors means a lower price for us.
Second, Bausch still needs to pay off $23.8 billion in debt. Now, debt is generally not a good thing... but paying down debt and deleveraging can be a source of returns for shareholders, which we'll explain later on.
The plan to resurrect the company is straightforward in its broad strokes: Replace Pearson, sell off assets, pay down debt, and focus on profitable businesses. The particulars of doing that can be very difficult... but Bausch appears to be taking the right path.
First, Pearson got axed in May 2016. During Pearson's bull run, investors loved him and considered him central to the company. According to an investigation from Vanity Fair...
"You can't bet against Mike" became a Wall Street refrain. "Anytime you ask someone their investment thesis and in the first sentence they call the CEO by the first name, that's not an investment," observes one investor, who was skeptical of Valeant. "That's a cult."
Pearson was Valeant. And getting him out makes this a different company.
Better yet, they replaced him with Joe Papa. As the CEO of the pharmaceutical company Perrigo (PRGO), Papa delivered outstanding performance for 10 years.
This was also a period of deleveraging for Perrigo. Debt climbed but leverage ratios did not. In other words, Papa didn't manufacture growth through debt at Perrigo. He did it the right way.
To lure him away from Perrigo, Bausch offered him a major pay package... but it'll only pay off if Bausch's share price performs.
Papa was given options for 682,652 shares with an exercise price of $23.92. That means if he keeps the share price above $23.92 through 2026, he'll collect an extra $16 million. And he'll profit handsomely as the price rises above that. (Shares currently trade around $30.)
He's also incentivized to hit other measures. Roughly 60% of Bausch's executive compensation is attached to specific revenue and earnings targets.
The next step was to sell off assets so that it could focus and pay down some debt. Bausch went full blast, raising billions of dollars by selling off assets. That included...
- A collection of skin care brands for $1.3 billion,
- Dendreon Pharmaceuticals for $820 million,
- iNova Pharmaceuticals for $930 million,
- TBD-OMP for $190 million,
- The rights to a drug called Ruconest for $60 million,
- And Probiótica Laboratórios, Synergetics, Valeant Groupe Cosméderme, and Sprout Pharmaceuticals, all for undisclosed amounts.
Already, Bausch has paid its debt down from a peak of $31 billion to $23.8 billion. It has cut $200 million off its annual interest expenses.
And its bonds all trade above or near par. Investors often say the bond market is smarter than the stock market, so this would imply bond investors feel comfortable with Bausch's ability to pay its debt.
Now we can finally talk about what business Bausch is in, and why it looks good going forward.
Focusing on Two Main Businesses
When it started shrinking, everything was up for grabs. But in the end, Bausch wisely held on to what we consider its crown jewel: Bausch + Lomb.
You likely know Bausch + Lomb's eye care business. It's such a well-known and respected brand that Valeant chose it to inspire its name change.
The company makes contact lenses, eye medications, surgical supplies, and nearly anything that has to do with eye health.
As a trained ophthalmologist, I've always considered Bausch + Lomb to be the brand in eye care. I felt that way in business school even before my medical training. As a professional frugalist, I take care to know when brands signal true quality and when they are merely a guise to charge higher prices. I always reach for Bausch + Lomb products.
Bausch + Lomb accounts for $4.3 billion in revenue, just over half of the company's total of $8.5 billion.
Bausch is a great business. It's growing at about 4% to 5% per year and maintains consistent profit margins.
The market for contact lenses grew about 5% in 2018, but Bausch + Lomb's contact business grew 13%, suggesting it's capturing market share.
Looking forward, eye care has a clear opportunity. Globally, the population is aging. Individuals older than 65 years old spend eight times as much on eye care products than those younger than 65. That's a trend that has been helping all health care companies.
Additionally, young people have bad eyes these days...
Myopia – or near-sightedness – is related to staying inside and focusing on screens. You're going to see a lot of glasses in the future. One study out of Hong Kong shows that 70% of people born between 1950 and 1980 suffer from nearsightedness, while 87% of those born after 1997 have it, despite their young age.
For the most part, we can consider Bausch + Lomb a steady-as-she-goes, profitable business we'd like to own.
The next important segment comes from Valeant's 2015 acquisition of Salix Pharmaceuticals. The Salix business has drugs that focus on digestive health. With more than $1.3 billion in sales, Xifaxan offers a two-week treatment to relieve irritable bowel syndrome for up to six months of relief.
After that, it's got smaller drugs (in terms of sales). Relistor, which treats opioid-related constipation, sold $104 million in the last 12 months. Apriso, which treats ulcerative colitis, sold $163 million over the past 12 months.
In a shift for Bausch, Salix also has drugs in development. Bausch now spends more than $470 million in research and development. At about 5.6% of sales, it's still less than the average pharmaceutical company, but it's picking up. The Salix franchise has four treatments in Phase II and III trials.
After years of playing defense and fixing the company, Bausch management now claims it's on a "pivot to offense" and that growth from the Salix franchise will be the driver behind that.
Bausch has some other dermatological products and about 10 other "diversified" drugs it still sells. Some are quite expensive, but the days of jacking up prices are over.
How to Earn Returns From Debt
Thanks to all its debt, Bausch earned $3.4 billion on only $7.6 billion in shareholder equity, for a remarkable 44% return on equity.
But debt also adds risk. Bausch needs to pay about $1.6 billion a year in interest before it can earn a true profit. If sales or margins fall, that adds risk.
The main thesis here though, is that Bausch is paying down debt. That's a direct return to shareholders.
Here's how that works...
The market values Bausch at $30.6 billion. That's its market cap of $7.6 billion, plus its debt of $23.8 billion, minus its cash of $825 million. We add the debt, because if you were to try to buy all of Bausch, you wouldn't just pay $7.6 billion for the market cap, you'd also assume $23.8 billion in debt, so that's part of the cost. That figure is called its "enterprise value," or EV.
Right now, Bausch is making about $3.4 billion a year in EBITDA. It uses $1.6 billion for interest.
Now, if the market keeps the valuation on Bausch's business and it uses earnings to pay off $1 billion of debt, then that value will accrue to the market cap of the company and increase it by $1 billion.
In other words, this paying down of debt should provide a return of about 13% a year to shareholders. Add in the organic sales growth of around 2% and the underlying value of Bausch shares should be rising 15% a year.
That's just the baseline, and it's a great start. Of course, we see opportunities for the Bausch + Lomb and Salix businesses.
Also, the company is remarkably cheap. On a price-to-earnings basis, you can buy Bausch for just 6.7 times next year's earnings. But as we've noted before, high debt levels can skew the ratio.
The EV/EBITDA ratio includes the effects of debt. On this measure, Bausch trades for about 10 times earnings. The median for the S&P 500 is 14 times.
The key to finding a great investment is to find a profitable business that is unloved and forgotten by the market.
Bausch isn't just unloved, it's hated thanks to its reputation – even though it has shed those businesses. And a cursory review of Bausch shows a company with negative earnings and a lot of debt.
But that's exactly where the opportunity lies...
Folks loved Valeant – when they shouldn't have. Now, they're dismissing Bausch – when they shouldn't. If sentiment improves around the company, we could easily see valuations improve and shares rise 30% or 40% in short order.
Bausch Health (NYSE: BHC) remains a "Strong Buy" in the Retirement Millionaire portfolio. Use a 25% hard stop to protect your capital. And follow our position-size rule of limiting individual stock holdings to 4%-5% of your investing portfolio.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: We hope you're enjoying our 2019 Digest holiday series... As part of the series, we're allowing interested readers to access some of our most popular research at a substantial discount. Right now, you can try Doc's Retirement Millionaire advisory for the next 12 months at 75% off the normal cost. Get all the details right here.