Monday, October 15, 2018

A Value Opportunity in Bausch Health

Overview:

Bausch Health Cos., Inc. engages in the development, manufacture, and market of a range of branded, generic and branded generic pharmaceuticals, medical devices and over-the-counter products. It operates through the following segments: The Bausch + Lomb/International, Branded Rx, and U.S. Diversified Products.

The Bausch + Lomb/International segment consists of the sale of pharmaceutical products, over-the-counter products, and medical devices products. The Branded Rx segment comprises of pharmaceutical products related to the Salix product portfolio; dermatological product portfolio; branded pharmaceutical products, branded generic pharmaceutical products; over-the-counter products; medical device products; Bausch + Lomb products sold in Canada; and the oncology, dentistry, and health products for women. The U.S. Diversified Products segment refers to the sales in the U.S. of pharmaceutical products, over-the-counter products, and medical device products in the areas of neurology and certain other therapeutics classes, including aesthetics and generic products in the U.S.

Founded: 1994
Number of Employees: 20,700
Headquarters: Laval CA
CEO: Joseph C. Papa, MBA

History

Valeant, BHC's predecessor, is notorious in an industry rumoured to be one of the most cut-throat and crime-ridden.(1)

It lost over 70% of its market value in approximately 100 days in Q2/Q3 of 2015, eventually bottoming out at $11.20 from a high of $347.84.  Lawsuits, investigations, criminal charges followed.  It replaced CEO Michael Pearson and installed Joseph Papa.  Papa has divested some of the purchases made under his predecessor, reduced debt and changed the company's name to Bausch Health.




Analysis Hypothesis:

I believe that much of Valeant's problems stemmed from its culture.  When a company falls in such a spectacular fashion, more likely than not, there's a management component and in a situation like this, when a new company rises from the ashes of the old one, we need to know if there is still rot at the core.

Has BHC fundamentally changed from Valeant and does its future look promising?

Methodology

This analysis will review the board of directors and management team, the company's financial health, R&D investment, debt, growth potential, valuation and income outlook.

Board of Directors and Management Team

A Globe and Mail article, published on July 30, 2015 less than a week before the beginning of the Valeant crash, unintentionally and ironically wrote a treatise on what was probably at the core of Valeant's issues, a policy of aligning management rewards with share performance, to the determinant of building long-term value.

There are currently ten members on the board of directors, only one remains from its days as Valeant.  It is also a reasonably diversified group, drawing on people with different backgrounds and expertise.  It's also a largely independent.

The Management Team is likewise very diverse and probably has a good blend of new blood while still preserving the knowledge base of people from its Valeant days.

Both elements of leadership look strong.

Financial Health

We'll look at BHC's quality of earnings to determine company's financial health.

It is a fact that earnings can be manipulated and they can be improved by accounting-driven decisions.  We want earnings that are persistent, can be expected to repeat and aren't the result of one-off events or management tinkering.  I use an nine part quality of earnings framework based off the work of two academics, Lev & Thiagarajan.  You can read their original paper here.  You can read my adaptation here.

The framework looks at nine areas in the financial statements: inventories, receivables, capital expenditures, research & development, gross income, selling-general-administrative expenses, sales per employees, tax rate and audit opinion.  The first two, the fourth, fifth and six are compared to sales levels, capex and/or r&d are compared to industry averages (I use a peer group average as a proxy), the tax rate measures seeks to remove the effect of an earnings bump from a reduction in the tax rate and the a last one looks for a clean audit opinion.  When any of these measures give a favourable signal, I give it a score of one.  All the scores are summed to get a total out of nine, the higher the better.

BHC scored a three out of nine, an abysmal score.  The company has recently announced a return to profitability, and the graph below demonstrates it.  However given their quality of earnings score and a simple review of their declining gross margin and revenue (accelerating decline in revenue's case) it looks though they managed it with manipulation, but I need to be clear.  I don't mean they created fictitious sales or anything like that.  I just mean they made accounting choices that goosed their earnings.





I usually feel strongly about good quality of earnings, but should it be overlooked in this case?  I imagine righting a ship that capsized in a maelstrom is tough work.  Maybe Papa should be the given the benefit of the doubt, at least for a time.

Research and Development

One of the features of the company's Valeant days was little spending in R&D.  Let's look at BHC's R&D spend as a percentage to sales.

It's good to see R&D going up (although keep in mind that revenue has been declining for the past couple of years.  However even at it's peak of 4.35% of sales, it's a small number.  When I look at the R&D to Sales spend of some of BHC's competitors, we can see that they are below the average of 10%, but within the range.



Debt

The company has been lauded for reducing debt and streamlining its focus, undoing part of what boosted its price before August 2015.

Let's say we're from Missouri and want to see for ourselves.

Indeed the debt has come down relative to it's peek, however it's still well above it's 2013/2014 levels and what it's paying out in interest is concerning.  The pre-tax interest coverage ratio, EBIT/interest, is still declining. meaning its debt burden is getting worse (although at a slower pace).


Growth

I believe that if there's an investment opportunity, it'll be either a growth, income or value story.  You might even have two out of the three.  So, is BHC a potential growth company?

There's not a lot of data for Papa's tenure at BHC and the stock hasn't returned to the highs it experienced when Papa was first brought on.

However we'll look at how many times the company has increased its quarterly EPS over the past seven quarters.  Usually I would work with annual results, but there isn't enough information in this case.  These are the quarterly values:

Q (June 2018)
-3.215
Q-1
-9.7137
Q-2
1.8434
Q-3
4.625
Q-4
-0.1479
Q-5
2.369
Q-6
-1.9615
BHC has increased it's quarterly EPS three out of a possible six times.  This doesn't look like a growth story and coupled with the poor quality of earnings results I wouldn't buy the stock for growth.

Valuation

We're going to look at several valuation measures - the Ohlson Clean Surplus (OCS), Enterprise Value/Earnings before Interest, Taxes, Depreciation and Amortization (EV/EBITDA), the PE ratio, and the Discounted Cash Flow Model.

OCS

The OCS is an interesting valuation model that calculates a theoretical stock value.  While I don't hold it out to be an exact value, it can give a decent ball park or at least an indication whether the stock is over, under or fairly valued.  For a detailed explanation of the model, please review this article.   Academic testing demonstrates that the model has predictive results two to three years out.

Using the OCS, BHC does appear to be undervalued.  Using a discount rate of 15% (the calculated rate is strange owing to its negative beta) and the current return on equity of 43% gives a theoretical price of $94.  However that's a fairly high return on equity.  Reducing it by 55% bring the price of the stock into fair valuation territory.  So provided the future ROE is something greater than 24%, the stock is undervalued.

EV/EBITDA

The EV/EBITDA for the most recent year is 10.46, dropping from 18.16 in Y-3.    Looking at BHC's peers we can see an average EV/EBITDA of 14, another clue BHC might be undervalued.

PE Ratio

BHC's TTM PE ratio of 2.9 is quite low.

DCF 

I put together a quick and dirty DCF using the firm's rate of 15% used in the OCS, free cash flow per share and growth equal to zero.  The calculation of 7.41/.15 = $49.42, a premium of 45%.

Income

BHC is not currently offering a dividend so this is not an income story.

Conclusion

The analysis suggests BHC could be a value play.  Although I don't like a situation with a bad quality of earnings score, I would consider forgiving it for the reasons above.  However this company's predecessor was involved in activities that could have destroyed it.  The market may not be so forgiving and I don't just mean the stock market.  The company has a lot of work ahead of it to regain the trust it lost with its customers.

Disclaimer

Part of intelligent investing involves taking on risk levels appropriate to one's circumstances.  We don't know what your's are and this analysis should not be construed as investment advice.  INVRS, its parent company, its officers, directors and employees cannot be held responsible for any investment decisions you make.

Research Notes

(1) http://www.louisaonline.com/hwa/hw-louisaonline-august-2015.pdf
(1) https://www.taylorfrancis.com/books/9781135072902
(1) https://www.macleans.ca/news/canada/barry-honey-sherman-murders/

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