Summary

• Three of Valeant’s top 5 products are ancient, tail products that reported a combined 144% annualized growth rate due to price hikes (25% growth in Q3 over Q2).
• My ballpark calculations show that Valeant’s 2016 EPS claims for Allergan shareholders are not realistic.
• Valeant again did not reveal revenue from recent acquisitions or how much of organic growth came from day 1 price hikes on recently acquired products.
• Fidelity endorses Allergan and questions value of Valeant’s stock.

Introduction

Valeant Pharmaceuticals (NYSE:VRX ) made its Q3 earnings presentation today. In response to the soaring numbers and the exhilarating press release, the stock soared. Valeant’s organic growth had averaged in the 0-2% range over the past six quarters, the sudden spike to 16% in Q3 sent the stock soaring.

Of course, Allergan (NYSE:AGN ) gave its rebuttal. Allergan’s rebuttal is based on Valeant’s trailer previewed last month, therefore Allergan’s rebuttal doesn’t address some of the items in today’s movie. Maybe Allergan will issue an updated rebuttal in coming days or weeks.

Eye-popping quarter-over-quarter growth in tail products

When Allergan first started out educating investors about Valeant’s opaque financial disclosures, one of the key thrusts was that Valeant wouldn’t break out its revenue data on a per-product basis. In response to this, Valeant revealed the revenue from its top 20 products for the first time in Q2 2014. This has proven to be quite useful.

Just compare Q3’s numbers with the numbers in Valeant’s Q2 earnings presentation. On the earnings call. Michael Pearson, Valeant’s CEO said that tail products are where he has maximum pricing power. Three such products are Wellbutrin, Solodyn and Targetrin. These three are among the top 5 Valeant products. Wellbutrin and Solodyn patents have expired and Targetrin patents expire in 2016. When we compare Q2 2014 revenue from these three products with Q3 2014, we see a combined revenue increase of $34 million. Strangely, though in Q2 Valeant said that the primary growth driver for Wellbutrin and Solodyn was price, in Q3 Valeant said that volume was the primary growth driver for both those products. In both Q2 and Q3, price + volume was the primary growth driver for Targetrin.

These numbers are really significant because the contribution of Valeant’s nail fungus product, Jublia, was just $12 million in Q3. Pearson has said that Jublia will be Valeant’s largest product ever and can reach up to $1 billion in sales. Note that Jublia cured nail fungus in just one out of six patients in clinical trials.

The $34 million increase in these three tail products is really large. Combined these three pulled in $170 million of revenue in Q3 compared to $136 million in Q2 2014. So these ancient products grew by 25% in Q3 compared to Q2 2014. If we annualize this 25% quarter-over-quarter rate, that is a 144% annualized growth rate in revenue! Allergan’s claims about Valeant’s price hikes must be true. I believe these ancient products are reporting huge growth thanks to price hikes. But how long can this go on? Won’t the PBMs put a stop to this anytime now?

I can now see why Valeant likes Allergan so much. Valeant has nothing like Botox. Being a biologic product at a low price-point, Allergan has a lot of pricing power left in Botox. Botox is a biologic, it is a toxin produced by a biological process. It is not a chemical that can be cloned by a generics company.

Other items

Valeant does not identify revenue from recent acquisitions. Therefore we don’t know how much Precision Dermatology contributed in Q3 and what the price hikes were. All we know is that Pearson said Precision Dermatology products had significant pricing opportunity on day 1. Surely, investors would be interested in how much pricing opportunity Precision Dermatology products have on day 366. We don’t know what the organic growth contribution of Precision Dermatology products was in Q3. Precision was supposed to have $130 million in 2014 revenue.

Valeant says that Acanya had strong growth and has 88% market share. However its revenue in Q2 was $18 million and it did not make it into the top 20 in Q3. That means Acanya revenue has declined to $16 million or less. Therefore, I am not sure why Valeant spent a slide in its earnings presentation on the great market share of Acanya. This is another out-of-patent product that got generic competition last year. Similarly, Elidel took up a slide showcasing its 52% market share even though its revenue declined from $25 million in Q2 2014 to $22 million in Q3 2014.

Valeant’s total revenue in Q2 was $2041 million and in Q3 it was $2056 million. If we ignore the royalties and other revenue, the product sales revenue was $1994 million in Q2 and $2022 million in Q3. Slide 36 tells us that divested businesses contributed $81.7 million in Q3. If we assume the divested businesses contributed the same amount in Q2 2013, we see an organic revenue increase of $2022 — $1994 — $81.7 = $110 million in Q3 ($34 million of that came from the three products discussed above). We don’t know how much of this came from price hikes on recent acquisitions. Apart from Precision Dermatology, Valeant seems to have made a number of other acquisitions in the last 12 months such as Solta Medical. Croma, Visudyne, Bescon, Macugen are four more names that popped up as Valeant acquisitions in Allergan’s rebuttal. It would be nice to know how much price hikes on recently acquired products contributed to Q3 organic growth and how sustainable they are (i.e. are they repeatable say a year from now).

Valeant says it will get more synergies than other acquirers because it participates in dermatology and ophthalmology (the two areas where Allergan dominates). At the same time, Pearson says that he received expensive on-the-job-training when he meddled with Medicis’ salesforce and that he won’t repeat it again. So if he doesn’t meddle with the salesforce, where is he going to find synergies? Valeant’s participation in dermatology and ophthalmology wouldn’t matter if he leaves the salesforce intact. How does Valeant have any synergy advantage over a non-participant such as Actavis (NYSE:ACT )?

Fidelity endorses Allergan and questions value of Valeant stock

In my previous article. I said that Actavis and Allergan had a surprising number of top shareholders in common, and that this would give Actavis an advantage over Valeant. I had also said that:

I believe that. Fidelity’s poor opinion of Valeant and their huge stake in Actavis will cause Fidelity to favor Actavis.

Two days after that article was published, Reuters reported that the largest Actavis shareholder, mutual fund giant Fidelity, has added to its Allergan holdings in Q3 and supports a merger between Allergan and Actavis. Fidelity says it supports a standalone Allergan, too. Fidelity has also said that it is ready to buy even more Actavis stock if Actavis wants to make a stock offering to raise cash for an Allergan bid. The Reuters article added:

Some Fidelity fund managers are reluctant to support Valeant’s cash and stock proposal in part because they have questions about the value of Valeant’s stock, according to the people familiar with the matter.

This is significant because Fidelity was the third-largest shareholder of Valeant until Q2. Fidelity sold most of its Valeant holdings when Valeant revealed its Allergan intentions. Fidelity might have sold even more Valeant since the end of Q2. Interestingly, Fidelity also said it supports Allergan’s standalone business plan. Apart from Fidelity and T. Rowe Price, no other top Allergan shareholder appears as a top Valeant shareholder.

Valeant’s top two investors are Goldfarb Investments and ValueAct Capital. These two are very tiny compared to the size of Allergan/Actavis investors. Shareholders who appear in the top shareholders lists of both Allergan and Actavis on MSN Money are: Blackrock, Fidelity, State Street, Alliance Bernstein, Northern Trust, Vanguard, Oppenheimer, Northern Trust. Allergan/Actavis investors have a hundred times greater buying power than the top Valeant investors. Any stock offering by Actavis for raising cash would be easily digested.

Ballpark calculations

Valeant says it will give $20 EPS in 2016 to Allergan investors. If we assume 600 million shares outstanding in a Valeant-Allergan combination with a zero tax rate and $40 billion in debt with an interest rate of 6%, that is EBITDA of $14.4 billion. Valeant’s 2014 EBITDA would be around $3.5 billion.

If we assume Valeant is run as a tight ship and synergies have been squeezed dry there, all the remaining EBITDA increase would have to come from Allergan. Let us assume $8.3 billion in 2016 revenue at Allergan (15% CAGR from 2014). If we subtract say $1 billion for cost of goods sold, we are left with $7.3 billion. Thus, even with very generous assumptions, I don’t see how Valeant can get to the EPS numbers it is promising investors. Note that after Allergan’s July 21 cost cuts, Allergan has 10,000 employees compared to Valeant’s 17,000 employees.

More importantly, the $10 EPS that Allergan promises in 2016 is debt-free, i.e. it will increase if shareholders let Allergan make an acquisition. Valeant’s $20 EPS (if feasible) comes with debt of $67 per share. The P/E ratio does not capture the debt disparity.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.