Canadian pharmaceutical company Valeant (NYSE:VRX) has made a name for itself through acquisitions. On May 27 it announced that it was buying Bausch & Lomb for $8.7 billion making it a global leader in eye care. What does this deal mean for Valeant investors? I'll have a look.
In a May 25 article Forbes contributor David Shaywitz highlights--with much attribution to Sean Silcoff of the Globe and Mail--the ways in which Valeant CEO Michael Pearson has created a private equity model within a traditional healthcare company and making millions for himself and shareholders in the process. Hired by Valeant as a consultant in 2007, Pearson came to the conclusion that its business model was a complete mess and unworkable. He proposed that the company stop pursuing the development of blockbuster drugs like every other big pharmaceutical company and instead go after niche products selling between $10 million and $200 million per year. Valeant's board liked what they heard hiring Pearson as its CEO in February 2008.
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Valeant does so many acquisitions it highlights them on its homepage. In the five years since he's been CEO, Pearson's done 57 acquisitions totaling $10.6 billion, which includes the Biovail merger in 2010. That's $186 million per deal. The Bausch & Lomb purchase is clearly his biggest yet increasing the dollar value of acquisitions made by 82%. This is the deal that will make or break Valeant.
Warburg Pincus paid $4.5 billion or 18.4 times EBITDA for the eye-care company in October 2007. Chances are good that Warburg's investors put up no more than 33% of the purchase price or $1.5 billion, which means its investors can expect a 20% annualized return on their money before fees. I would classify that as a good, if not spectacular return on investment.
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What Bausch & Lomb Brings
When Warburg acquired Bausch & Lomb the company was coming off a bad year in 2006 settling more than 600 lawsuits over its MoistureLoc lens solution, which was linked to dangerous fungal infections. However, if you use its 2005 results, the private equity firm only paid 11 times EBITDA, a far more reasonable multiple. Since then it's been able to increase Bausch & Lomb's annual revenue from $2.3 billion in 2006 to $3.3 billion in 2013 with adjusted EBITDA of $720 million, almost six times its 2006 EBITDA. Combined with Valeant's existing eye-care business, the segment will have $3.5 billion in annual revenue and be immediately accretive to earnings per share (EPS). In addition, Pearson sees $800 million in annual cost savings it can achieve by the end of 2014. It's going to need every last dollar to repay the $7 billion in debt it will incur to make the deal happen. Once completed the company says its debt to pro forma adjusted EBITDA ratio will be approximately 4.6 times. While that might be true, $17 billion in debt is still a lot no matter the additional cash generated by Bausch & Lomb.
Valeant's stock is up 41% year-to-date and 693% since Pearson took over as CEO in early 2008. The market approves of his decision to become an acquirer of businesses rather than a developer of drugs. While it's working so far, there's no guarantee that his formula for success will carry on indefinitely. In many ways Valeant is like a conglomerate; if it's not too careful it might end up with a bunch of underperforming businesses.
The average price-to-sales ratio for Allergan (NYSE:AGN), Forest Laboratories (NYSE:FRX) and Mylan (Nasdaq:MYL) is 3.4 times, exactly half Valeant's sky-high number of 6.9. Granted, none of its competitors have grown revenue nearly as fast so I suppose it's only fair that Valeant receive an overly generous multiple given its position within the pharmaceutical industry. Bausch & Lomb only adds to its mystique. This is a momentum stock if I've ever seen one.
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While Pearson's plan makes a whole lot of sense in the low-rate environment we currently operate it's not always going to be this way. Shareholders better hope that earnings growth catches up with revenue growth or this could be one big house of cards should interest rates move higher.
For this reason and the fact it's already had a good run the last five years, I'd be real hesitant to own its stock at the moment.
At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.