Bausch & Lomb Purchase Highlights Value-Creation Ability of Valeant's Moat

With the acquisition of Bausch & Lomb,  Valeant Pharmaceuticals (VRX) is jumping headfirst into ophthalmology. Although the firm is issuing equity to pay for a portion of the $8.7 billion deal, the acquisition looks highly accretive to shareholders and gives Valeant another major growth platform. However, given the high concentration of the industry and the presence of larger players like Novartis (NVS) and Johnson & Johnson (JNJ), we do not expect Valeant to be as successful as it was in dermatology. Although investors shouldn't expect a repeat of Valeant's success in dermatology with this deal, we still believe the ophthalmology market provides opportunities for expansion that will generate returns significantly higher than Valeant's cost of capital over the next several years.

Valeant's relentless focus on efficiency is likely to yield some improvements at Bausch & Lomb, but the acquired firm holds low share in highly concentrated markets, so Valeant is unlikely to continue strengthening the ophthalmology segment's competitive advantages as it currently is in its dermatology, emerging-markets, and Canadian segments. With Bausch & Lomb making up 40% of the combined entity's estimated 2014 sales, we believe it is large enough to keep the companywide moat from expanding.

Valeant has historically sought opportunities where it could be the biggest player in fragmented markets, like dermatology or its Canadian business, giving it significant advantages over competitors and the ability to continue consolidating smaller players to extend its lead. We think Valeant may be able to carve out a niche acquiring some smaller products in the pharmaceutical segment, but it will face challenges in the contact lens and surgical device segments. In these two segments, Bausch & Lomb is a second-tier player, and the highly concentrated markets make improving its position difficult. In contact lenses, Bausch is in fourth place with 10% share, well behind market leader Johnson & Johnson and its 40% share. The four top firms control approximately 95% of the market, so there is minimal opportunity for Valeant to move up. In the surgical device segment, Bausch is in third place with 10% share, but leader Novartis has approximately 60% market share.

Valeant's Narrow Moat Will Create Significant Value for Shareholders
At Morningstar, we award a wide moat rating to firms that we believe with near certainty will be earning excess returns in 10 years and more than likely in 20 years. With Valeant, there is a lot of uncertainty about what the business will be in 20 years, so we do not award the firm a wide moat, but that has no bearing on the amount of value we expect the firm to create over the next few years. We don't see any near-term threats that could bring Valeant's strategy to a halt, but over the long term there are a number of concerns, including bigger competitors pursuing Valeant's strategy and shifting the economics, a more level tax playing field, or Valeant just getting too big.

So far we have not seen any other big players fully embrace Valeant's successful strategy, but we have seen an increased interest in mergers and acquisitions in specialty pharma, potentially eliminating acquisition targets and driving up prices. If Valeant continues its wild success over the next few years, it is likely to catch the attention of more competitors. If other firms similarly drop internal research and development and seek new products primarily through acquisitions, over time it will drive up asset prices and significantly diminish the attractiveness of the strategy. If the tide shifts too far, it could become a disadvantage to rely on acquisitions for new products, and Valeant is unlikely to lead in a market that rewards internal development.

We would also not be surprised to see some developments to level the tax playing field. The firm's low 5% tax rate does not factor into our moat rating, since we do not believe it is a sustainable competitive advantage, but it has been a very valuable asset. The company benefits from significant tax arbitrage and value creation every time it acquires a higher-tax asset. Over the long term, it is quite possible that the landscape could change in one of three ways. Canada could adopt stricter tax policies, or other countries like the United States could enact more-favorable tax policies. And if tax policy remains unchanged, we would expect competitors to react to Valeant's tax advantage by moving their businesses to more favorable regions of the world.

However, the amount of value a moat can create and the duration of a moat are two distinct issues. Our moat rating assesses how long an advantage can last, it does not take into account the amount of capital a firm is able to reinvest at excess returns. A narrow-moat firm that can reinvest 100% of its earnings at a high rate of return for 5-10 years could create more value than a wide-moat firm that can reinvest only a small fraction of its annual earnings at a high rate for 20 years.

Based on management's guidance for EBITDA and operating cost synergies (selling, general, and administrative and R&D only), the Bausch & Lomb acquisition should give Valeant a pretax EBITDA yield of around 17% on the $8.7 billion purchase, and that gives no credit for manufacturing synergies or new revenue opportunities. With minimal capital expenditure requirements, we think the deal will provide a pretax yield around 16%, more than double what we expect Valeant to pay on the debt it will use to fund the majority of the acquisition.

Is Ophthalmology the Next Dermatology for Valeant?
In dermatology, Valeant went from essentially no position to being the clear market leader in less than five years. In 2008, Valeant was the 11th-largest player in the U.S. prescription dermatology market, with less than $100 million in sales (less than 1% share). In the five years since, Valeant consolidated players large and small to become the largest market participant, 50% larger than the next competitor, Galderma. More important, the rapid consolidation gave Valeant scale and the opportunity to leverage its salesforce and back office to create a very efficient $1.5 billion-plus business unit with operating margins well above 50%.

Dermatology was essentially the perfect therapeutic area for Valeant, which probably explains why it was CEO Mike Pearson's first pursuit. The therapeutic area had many attractive characteristics, including high fragmentation, high cash pay, strong barriers for generic entry, and minimal big pharma presence. That same success is not going to happen in ophthalmology. Valeant is now stepping into a concentrated market and will face off against Novartis, Allergan , Abbott (ABT), and Johnson & Johnson, rather than the fragmented group of small companies that it competes with in dermatology.

Despite the tougher competition, it's not all bad for Valeant. The ophthalmology segment still has many attractive characteristics: It's growing at a solid pace, it has a high cash pay component, and generic products face strict barriers to entry. Ophthalmology is much more attractive than other specialty pharma segments like women's health and central nervous system drugs. In ophthalmology, Valeant isn't going to continue hitting home runs, and it isn't likely to be the top player, but that doesn't mean the therapeutic area isn't worth being in. The company doesn't need to be the number-one player to earn attractive returns for shareholders. Bausch & Lomb is at least a top four player in all three segments of the ophthalmology market-- pharmaceuticals, vision care/consumer, and surgical products--and the $36 billion market has plenty of room for Valeant to get its piece. There are product categories under the broad umbrella of ophthalmology where Bausch & Lomb is going to be better positioned than competitors, and we believe Valeant will focus its effort and capital on those areas.

Once Again, Valeant Has Found a Highly Accretive Acquisition
Although we were surprised by the massive amount of synergies management expects to realize in the acquisition, it is not unprecedented. In its last three major acquisitions (Biovail, Medicis, Ortho/Dermik), Valeant was able to cut between 64% and 73% of the target's prior-year operating expenses. However, given that Valeant had only a minimal presence in ophthalmology, we would not expect it to reach such massive synergies on this deal. Management's initial guidance calls for a 49% reduction from Bausch & Lomb's 2012 operating expenses.

Management is conservative in all guidance it gives, frequenting leaving room for overdelivering, so we have no reason to believe that it is now being overly aggressive with its synergy expectations. On the last two deals where management issued synergy targets, it meaningfully beat expectations and realized them much quicker than originally forecast. Management has been similarly conservative with its EPS guidance, beating expectations every single year since J. Michael Pearson took over as CEO in mid-2008.

With the integration of Bausch & Lomb into our model and a reduction in Valeant's cost of equity, we raised our fair value estimates to $125 and CAD 129. Our 2014 EPS estimate increased 25%, to $8.04 from $6.45. The Bausch & Lomb transaction has minimal impact on our long-term growth assumptions, as we believe the ophthalmology business will produce mid-single-digit long-term organic growth rates, in line with our previous assumptions for the company as a whole.

We also lowered our uncertainty rating to medium from high. Valeant's underlying business was already very diversified with minimal volatility, but this acquisition increases its diversification. The acquisition strategy and debt load do add some degree of increased risk to our uncertainty rating, but we believe it is more than offset by the stability of the underlying business. Like many health-care companies, Valeant faces less cyclicality than the average business because health-care products are not traditionally discretionary expenses. Valeant is even better positioned than most, as it has an enormous portfolio of diversified products. The firm sells hundreds of products, with none making up more than 5% of sales, so it is largely isolated from product-specific risk and the impact from any individual patent expiration is minimal. The firm is also geographically diverse, with half of sales coming from a broad group of international markets, including Eastern Europe, Canada, Latin America, and Southeast Asia.

Possible Issues
A healthy dose of skepticism is fair anytime a firm is making acquisitions at such a rapid rate, but we have yet to see any issues that should trigger concern. Now more than five years into the rollup strategy, we would expect to see signs of poor integration or failing sales if the firm's cost-cutting was too extreme. Nevertheless, we address some common concerns:

Valeant lacks experience in ophthalmology. Pearson and Valeant had only minimal experience in the dermatology industry, but that didn't hold them back on their path to billions of dollars' worth of value creation and a dominant position in the industry. When Valeant began expanding its dermatology business, it had just 1% share, essentially the same share it had in ophthalmology before this transaction. In addition, Pearson has said he spent a significant amount of his time at McKinsey working with the ophthalmology industry, so he is confident he knows what he is getting into.

Valeant is now too big, and it is running out of investment opportunities. Valeant's earnings for 2014 are expected to be just $2.5 billion. Valeant can still easily put $2.5 billion a year to work; it has done two individual deals above that amount in just the past six months. Even ignoring additional borrowings, if Valeant can just continue to invest its $2 billion-$3 billion a year in profits at 15%-plus returns over the next few years, shareholders are going to see very attractive returns in the stock.

Rollups and acquisition sprees always end badly. While Tyco-like blowups are etched into investors' memories, successful rollups like Danaher and John Malone's Tele-Communications Inc. are often forgotten. Both firms implemented a growth-through-acquisition strategy with huge success. Similar to Pearson, John Malone took over as CEO of cable provider Tele-Communications Inc. after working as a consultant at McKinsey. During Malone's tenure from 1973 to 1999, the firm successfully used numerous acquisitions to rapidly gain scale and bargaining power over content providers and earn shareholders an annual return of more than 30%. Similarly, Danaher has used acquisitions as its primary source of growth. Since 1984, the firm has completed more than 400 acquisitions (about 14 per year on average, even slightly faster than Valeant's pace in recent years) and shares have appreciated at more than a 23% compound annual rate over the past 29 years.