Stock analysts put too much faith in Valeant’s guidance

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When you truly believe in a stock, setbacks that result in pullbacks in the share price are buying opportunities, not warning signs. After all, the markets overreact to news, both bad and good, all the time.

Sometimes markets underreact, too. Perhaps, we can say, in the case of Valeant Pharmaceuticals Inc. After a year of demonstrably bad news, and several years of red flags before it, a number of sell-side analysts finally have been jumping ship, abandoning "buy" ratings they rode down from the days when Valeant was a $250-plus (U.S.) stock.

What has prompted most of the analysts to do this is not the investigation into Valeant by the U.S. Securities and Exchange Commission, nor the company's now-ended murky relationship with a specialty pharmacy that hit the headlines in November, nor a host of other issues with its disclosure, or financial reporting. It is instead that management has been, in recent weeks, sharply reducing the financial guidance it provides to investors.

In short, many analysts have trusted Valeant, rather than its critics, to be the best source on Valeant.

And the investors who listened to those analysts have suffered.

A month ago, there was only one sell rating on Valeant out of 25 analysts covering the stock, according to Bloomberg data. Now, there are … four.

Shibani Malhotra, an analyst with Nomura Securities, wrote in a note Wednesday: "We have lost confidence in management's ability to understand its own business and to provide reliable guidance." She added: "We have been humbled by our stock call on Valeant, which we have defended despite the continuing spate of bad news." (Her new rating, however, is "neutral," not "sell.")

It is possible, however, that Valeant's management understood its business all along, yet made it difficult for analysts and investors to understand it.

At its simplest, Valeant's story was a compelling one: Eschew research and development; instead, buy developed or nearly developed drugs to sell. (Price increases were part of the mix, but in the current political climate, Valeant now de-emphasizes that part of the tale.)

To evaluate how well this was working, however, investors needed clear, broad disclosures on how these businesses were doing once Valeant acquired and began to manage them. And it is something they did not get.

As far back as 2012, I brought you the views of Dimitry Khmelnitsky, the Veritas Investment Research analyst (the analyst referred to above as the lone "sell"). He observed in February, 2012, that, during fiscal 2011, the company twice changed its methodology for calculating "organic revenue growth," which is supposed to measure sales gains in products it already owns, stripping out the revenue gains that come from acquiring new companies. Quarter after quarter, Mr. Khmelnitsky devoted space in reports to estimating what he felt Valeant's true organic growth was, versus what Valeant was reporting.

And, yet, it didn't take formal status as a Bloomberg-recognized analyst to make these points. In August of last year, an individual investor who blogs as "AZ Value" prepared a multipart series on Valeant that he called "A Detailed Look Inside a Dangerous Story Well Told."

Some of his key points:

• Valeant, starting in 2012, provided less detail than it had before about the revenues and profits of the major non-public companies it acquired, lumping them together rather than providing information about each.
• From 2011 to 2013, Valeant reduced the number of its operating segments about which it disclosed sales numbers and performance trends from five (“U.S. Dermatology,” for example) to two, “developed markets” and “emerging markets.”
• In 2013, Valeant’s investor presentation included a slide titled “Revenue Performance of Past Acquisitions” that said 17 previous deals were producing a “total” compound annual growth rate (CAGR) of 12 per cent. Except, however, this was the average growth number, unweighted by the size of the acquired companies. If you were to give the larger companies ($100-million to $800-million in sales) the appropriate weighting, the actual CAGR was 6 per cent, he said. “And just like that, in a matter of minutes we just cut the growth rate they were claiming in that 2013 table by half,” he wrote. “Pretty cool isn’t it?”

What is uncool is how this analysis, as well as that of others such as the Southern Investigative Reporting Foundation or Citron Research, was either ignored or shouted down, dismissed as driven by short sellers who stood to profit if Valeant shares fell. Some investors dismiss sell-side analysts as either dumb or corrupt; I do not think they are either. In this case, however, they embraced a story well told, to use AZ Value's phrase, and disregarded all the danger that was attached to it.