Last Monday – Labor Day, Valeant Pharmaceuticals International Inc. (VRX) announced that VRX agreed to buy Medicis Pharmaceutical Corp. for $2.6 billion. The share price of VRX jumped 15%, Tuesday, September 4, 2012 when the markets opened. This is very rare, that an acquiring company’s stock price gets this share price pop after an acquisition announcement. Usually shares of an acquiring company fall dramatically after such an announcement. Ever wonder why? It’s all in the merger math and the markets seem to know it instantly even though the CEO’s and CFO’s don’t.
I like positive stories, and seeing VRX increase dramatically on this news signaled to me there had to be some sort of story here behind the numbers. So I took some time to do my research.
Financial markets are about math. The current financial universe focuses on discounted cash flow, enterprise value and valuation tools, which don’t really explain a good acquisition (Good in terms of an acquiring company shares appreciating on a deal announcement) from a bad one, (Bad in terms the acquiring company shares trading down – sometimes dramatically – while the acquired company shareholders get a substantial premium) at least to me.
Have you wondered why the difference?
Remember Harvard MBA’s and CFA’s don’t have model price math. So let’s see what is going on here and I will explain why Valeant had such a good day, through the math of model price.
Theoretical Earnings (TE)
As a review, our calculation of theoretical earnings represents a specific earnings number that a company needs in order for its’ balance sheet to maintain “state” or stay constant in the future. Every balance sheet is different, just as a fingerprint, so every calculation of theoretical earnings is unique to the company’s balance sheet. No finance book I have seen has this concept of TE. However give this concept some thought and I believe TE makes sense on two levels. The first level is comparing TE to the current level of earnings. The company may have some patent or industrial process that produces additional earnings over the company’s benchmark. We believe the differential between the two, earnings and TE, represents the market value the equity market is giving the company as a whole. It is the “x” factor in the market value of the company. We calculate TE on every balance sheet for every company, and keep a database of this number with the financial history of the company.
[Current financial industry practice use rather simplistic ratios like price/earnings, and compare ratios to similar companies in their own industry. I have never found this particularly relevant compared to theoretical earnings concept.]
The second level is the dynamic between TE and actual earnings per share. If the spread between TE and actual earnings is increasing the market will reward this company with market value – share price appreciates. To us this is the most important driver of security prices going forward. Tell me whether this dynamic is expanding, contracting and I can predict with certainty whether a company’s stock is increasing or decreasing.
So let’s have a look at Valeant and see what the market liked so much.
First let’s look at our long-term chart of Valeant (VRX) since 2005, using monthly price bars.
Valaent Pharma with monthly price bars, EBV Lines (colored lines) and model price (dashed line)
For those interested, a daily updated chart of VRX subsequent to this post will be maintained on Facebook, here.
Along with the above price chart, let’s review what was going on with theoretical earnings and estimated earnings since 2005.
Let’s also do a ratio chart of the above.
Discussion of the above charts
As observers can see before the selection of the current CEO, J. Michael Pearson, the spread between earnings per share and theoretical earnings was decreasing. As the ratio was decreasing VRX was losing valuation or market value. With Mr. Pearson as CEO, one can observe stability between this above noted ratio. We highlight the merger with a Canadian Pharmaceutical Company – Biovail – because the balance sheet increased in size dramatically thereby increasing theoretical earnings. Since the Biovail merger VRX has been acquiring companies, WSJ notes 50 acquisitions since Pearson was rewarded the CEO position, with the above noted ratio of TE and estimated earnings expanding greatly, as one can observe
So let’s take this one step further. Let’s look at the personality behind Valeant in one CEO named J. Michael Pearson.
Mr. Pearson earned his MBA from the University of Virginia, then went to work for McKinsey & Company. Having worked at McKinsey for 23 years, rising to Director advising companies in the healthcare field including Valeant. Mr. Pearson left McKinsey for Valeant Pharmaceuticals (VRX) in February 2008. In other words, he spent his 10,000 hours learning and advising individuals in the healthcare industry and found a vehicle in Valeant to try a business strategy that “went against the grain” of current industry practice, as, noted in publicly available articles.
As reported in the Wall Street Journal, Valeant directors began seeking a new CEO in December 2007. The Chair of the Board, at the time, told Mr. Pearson and two other finalists that he liked the private-equity model for executive pay “because it aligns management’s incentives with those of the investor,” he recalls. The Directors required the winning candidate to buy at least $3 million in stock, and forgo routine annual equity grants and hold many shares for years before selling. Mr. Pearson already was advising Valeant as head of the global pharmaceutical practice at McKinsey at the time and had the cash to meet the stock purchase requirement. He ended up buying $5 million dollars worth of shares at the time.
Skipping to the present according to the latest proxy material Mr. Pearson has beneficial ownership of 5.6 million shares. Plus with other restricted stock units and performance restricted stock units bring the total shares to 7.6 million shares. So at the close on September 11, 2012 Mr. Pearson has $430 million in Valeant shares. Mr. Pearson also will be getting $1,750,000 annual salary in 2012 for his efforts.
Remember this all happened since he joined the company in February 2008. As we all know not exactly a friendly economic environment to garner this type of wealth.
Valeant fits the definition of a “Rollup”
What Mr. Pearson is doing is not unique in finance. Google the word “rollup”, and you will find in Wikipedia a “rollup” is a technique used by investors where multiple small companies in the same market are acquired and merged by a consolidator (VRX). No mystery here. As I mentioned earlier and reported by the Wall Street Journal, Mr. Pearson has overseen 50 transactions since becoming CEO in 2008, expanding the company’s annual revenue from $600 million to around $3.5 billion. If the Medicis acquisition is completed, Mr. Pearson said, Valeant will have revenue of roughly $4.5 billion.
My takeaways from the above
1. The model price math, in particular the management of theoretical earnings, from when J. Michael Pearson took over in 2008 to present has been masterful. The market has recognized this by increasing the valuation for Valeant rewarding shareholders and in particular the CEO.
2. When VRX announced the acquisition of Medicis Pharmaceutical on Labor Day, VRX jumped 15% because 1) the growth of VRX by acquisition is continuing after the company shares were consolidating over the last quarter or so. 2) Management has demonstrated it can manage TE and more importantly the spread between TE and estimated earnings – in other words I believe the market gave management and market participants the “thumbs up”.
3. Rollups as a financing technique usually have a lifespan. Either the acquirer (consolidator) runs out of company’s to buy, to fuel future growth or through ego and/or hubris the acquirer’s management acquires companies that are too big thereby substantially increasing theoretical earnings and crushing theoretical earnings versus the forward looking earnings per share spread or ratio. Financial history tells us shareholders at the end of the acquirer’s strategy or a large management “ego buy” bears the ultimate financial losses.
4. Since Valeant’s management team doesn’t have model price math it is interesting to speculate, at least on my part, is Mr. Pearson doing this instinctively after his 23-year experience at McKinsey or do they some working financial model of their own.
5. I have spent a lot of time and effort on this blog for a number of reasons.
a) Great real life example of model price cause and the effect on a company’s valuation.
b) There have been thousands of rollups in the history of finance and to me it’s fun to analyze one in action.
c) History tells me I will be writing about this company sometime in the future. Call this piece a primer for future blog posts. d) Mr. Pearson went from mere millionaire to multimillionaire status being at the right time and the right company – is he lucky? Model price math currently says no, however does he know this?
e) Finance is an interesting spectator sport when you know what to look for, hopefully I’m telling you what to look for.
f) Every public company has the ability of managing this ratio, resulting in much higher valuations. The market pays for efficiency in a company’s use of capital. Unfortunately in the world of finance today, a Mr. Pearson is rare.
g) As I have stated previously this blog site is about illuminating new financial concepts, which are not in any textbook. Hope you agree I am doing exactly this.