Compelling Financial Benefit in Valeant's Latest Buy

The $14.5 billion acquisition of Salix Pharmaceuticals SLXP brings

Salix--as well as the overall gastrointestinal market--carries some of the attributes Valeant has historically been attracted to, such as an undertreated market, minimal generic competition, and low Big Pharma presence, but it lacks many of important attributes that have been a key component of Valeant's strategy. The deal takes a step backward on the firm's shift toward durable and cash pay products. Salix's portfolio is entirely insurance- or government-reimbursed products, and although GI products tend to be tougher for generic manufacturers to replicate, the branded products are ultimately reliant on limited-duration patents for protection. In addition, Salix's lead product Xifaxan has a May PDUFA for the irritable bowel syndrome diarrhea indication, which would require significant primary-care physician marketing, an area Valeant has in the past avoided because of the inefficiencies of trying to address such a broad market.

Management expects Salix to be at least 20% accretive to earnings in 2016. The $500 million synergy target (before tax benefits) represents approximately a 65% reduction in Salix's operating expenses. While this is clearly an aggressive goal, it is in line with what Valeant targeted (and ultimately exceeded) for its prior large acquisitions of Biovail, Medicis, and Bausch & Lomb. Valeant expects to achieve these synergies within six months and does not plan any reductions to Salix's salesforce.

The all-cash deal will significantly increase Valeant's leverage to 5.6 times debt/pro forma EBITDA. However, given Valeant's 20% internal rate of return hurdle for transactions, it seems prudent to take on additional debt at management's expected 5.5%-6.0% interest rates. Given the wide margin of safety between the firm's investment return and borrowing costs, as well as Valeant's acquisition experience and record, we have confidence that this increased leverage is in shareholders' best interest.

In November, management issued initial guidance for 2016 adjusted earnings per share of $12.05. With the business' recent outperformance, plus the acquisitions of Dendreon and Marathon Pharmaceuticals, we believe Valeant was already poised to significantly exceed this guidance. Now with the addition of greater than 20% accretion from this Salix acquisition, we believe Valeant is positioned for $15.50-$16.00 of EPS in 2016. Even at $200, Valeant's shares are trading at just 12.5 times 2016 earnings, which seems low to us.

No Reason to Expect Acquisition Strategy to Slow Under the control of CEO J. Michael Pearson, Valeant's aggressive acquisition strategy has been executed nearly flawlessly. 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, 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 important, 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 still believe there will still be attractive opportunities for Valeant. The market is growing at a mid-single-digit rate and the high cash pay component means relatively little pricing pressure from managed-care and government payers. Valeant is unlikely to dethrone 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

Patents and Scale Are Advantages Valeant's narrow economic moat 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.

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. However, in ophthalmology, Valeant is entering a highly concentrated market with fewer opportunities for acquisitions. We think Valeant may be able to carve out a niche acquiring some smaller products in the eye-care 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 it difficult to improve its position. In contact lenses, Bausch is in fourth place with 10% share, but 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. Similarly, in the surgical device segment, Bausch is in third place with 10% market share, but leader Novartis has approximately 60% share.

Acquisitions Bring Risk as Well as Reward Valeant's most obvious risks are the financial and operational risks inherent in the firm's aggressive acquisition strategy. We believe the firm has proved its ability to quickly and successfully integrate deals, especially small bolt-on acquisitions; however, the Bausch & Lomb acquisition was Valeant's largest deal to date, until the Salix offer, and takes the company into segments of ophthalmology where it lacks experience.

If Valeant's acquisition of Salix does not close, we would lower our fair value estimate to $195.

High-Impact CEO We award Valeant an Exemplary Stewardship Rating. Because of the firm's aggressive acquisition strategy, CEO 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 six-year-plus record of success to be encouraging. He has demonstrated a willingness and ability to walk away from a target (Allergan, Cephalon, and so on) 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.