Bill Ackman, the activist investor who runs Pershing Square Capital Management, is confident that his money-losing bet in Canadian drug company Valeant Pharmaceuticals will eventually pay off.
Valeant’s turned into a disaster for Ackman this year — with Pershing Square losing around $1.5 billion on paper as the shares cratered.
The shares crumbled after it came under attack from short sellers who questioned its dependence on specialty pharmacies to sell its own dermatology products. Citron Research, which led the campaign, accused Valeant of using one such pharmacy to book “phantom sales.”
Valeant’s denied those allegations and severed its ties with Philidor. On Tuesday, the company announced a 20-year agreement with Walgreens Boots Alliance to distribute its dermatology products.
Still, the plunge has ensured that “2015 will be the worst performance year in Pershing Square’s history, even worse than 2008 during the financial crisis,” Ackman wrote in the fund’s third-quarter investor letter, released Wednesday.
For the first 11 months of the year, Pershing Square Holdings, the fund’s publicly traded vehicle, has declined 20.8% net of fees.
But no, he’s not giving up on Valeant. In fact Ackman’s sure that are rally in the drugmaker’s shares will leave his investors much better off.
Buy, sell, trim or hold?
When an investment is bleeding money, you’re faced with four decisions:
buy, sell, trim or hold.
The same day Citron’s attack on Valeant began, October 21, Ackman added 2 million shares to his position, bringing it to 21.5 million shares. Even still, the stock continued to fall precipitously.
A few days later, Ackman spent nearly four hoursdefending his Valeant investment on an investor call with more than 9,000 people listening.
“Life will go on for Valeant,” he said. “While this has been a very damaging moment for the company … we think the Valeant business is quite robust.”
He added that the stock at those levels was “tremendously undervalued”
A few weeks later, Ackman really doubled-down on the investment. On November 23, Pershing Square said it had massively boosted its stake in Valeant from 6.7% to 9.9%.
The new position includes stock options, and Ackman explained in the letter that this means there’s significant gains to be made.
Valeant’s shares are trading at just below $120 right now, after jumping sharply in the wake of news of the Walgreens Boots deal.
If the stock “rises to $165 or more by January 2017, we will make more than 10 times our net investment over this period,” Ackman wrote in the letter.
The options also mean Valeant would have to nearly halve before Pershing Square begins to lose money: “Our downside is equal to the net purchase price of each option plus the decline in the stock price, if any, below $60 per share as of January 2017.”
“Before we increased our position, we did substantial due diligence by re-underwriting our investment in the company. In particular, we reviewed all of the short sellers’ allegations, the potential political and regulatory risks, the impact of the shutdown of Philidor, and the company’s capital structure, debt covenants, and overall financial risk,” Ackman wrote.
He added that Pershing Square also updated its financial model to “better assess free cash flows, how quickly the company would be able to reduce leverage, the probability of financial distress, and to determine a conservative estimate of Valeant’s intrinsic value.”
“Ultimately, we concluded that the risk of bankruptcy or financial distress was de minimis in light of (1) the highly cash-flow-generative nature of the business, (2) the minimal debt maturities over the next several years, (3) the nature of Valeant’s financial covenants, and the highly diversified (both by therapeutic area and geography) product portfolio.”
Since Pershing increased its investment, Valeant’s stock has risen by more than one fifth.
Here’s more on the option-trades from Pershing Square’s letter:
Generally, we purchase stocks outright to get exposure to a particular investment. In this case, we took advantage of the high volatility of Valeant stock, its extremely low share price, and the high degree of market uncertainty in choosing to build a position that offered us a compelling reward for the potential risk. Rather than purchase common stock outright, we increased our investment through a contemporaneous series of over-the-counter option transactions. The bulk of the increase in our investment in Valeant was created through the sale of European-style put 6 options struck at a $60 stock price, the purchase of American-style call options at a $95 stock price, and the sale of European-style call options at $165 stock price, all of which expire in January 2017. This derivative position gives us the upside of the stock from $95 per share up to $165 per share until January 2017. The net purchase price of the options was $6.75.
In summary, if the stock rises to $165 or more by January 2017, we will make more than 10 times our net investment over this period. Our downside is equal to the net purchase price of each option plus the decline in the stock price, if any, below $60 per share as of January 2017. By selling European-style put options, the shares cannot be put to us until January of 2017. By then, we estimate that Valeant’s stock price will be substantially in excess of $60 per share, potentially several multiples of this price.
The upside of our derivative investment is approximately equal to that of owning the stock outright at $95 per share with 30% less downside, i.e., if the stock were to go zero, we would lose approximately $67 per share, (the put strike price plus the net option premium). By selling two options for every option that we have purchased, we have also minimized the effective cost of this investment and limited the impact of rapid time value decay which is characteristic of an outright option purchase on a highly volatile stock. In a worse-case scenario, which we believe is extremely unlikely to occur, we risked approximately 4% of additional capital on this investment while increasing our notional exposure to Valeant by about 6% of the portfolio.
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