Use of Debt and the Importance of Terminal Value

Warren Buffett says "debt is a four letter word." Despite that, I have seen numerous examples of where debt can be useful and where it is dangerous. A recent review of pharmaceutical companies raised that distinction.

In the case of durable consumer products (think Crest or Colgate toothpaste), the brand is well-known and the changes are measurable (e.g., by identifying the market share changes annually, it is possible to identify the durability of a brand). In these situations, debt is appropriate and manageable because the terminal value of the asset is knowable.

For this reason, debt on a home in a decent neighborhood is a reasonable bet for a bank. The bank logically assumes that the home owner is interested in maintaining the home by investing time and money into its upkeep. Thus, given a reasonable location, the home should hold its relative value. In this same reasoning, government regulations forcing lending against homes in poor neighborhoods is a challenge as a home truly depreciates without constant attention.

In this same line of reasoning, pharmaceutical companies did not typically have debt. Initially, I believed that low debt levels were simple a function of having tons of money. Wrong. Instead, these companies identified that patent expiring products tended to have low or unknowable terminal value. When this dynamic is present, debt is extremely dangers. Mallinckrodt (MNK) ignored this dynamic and grew quickly. But since 2015, the stock price has gone from over $100/share to low single digits.

This issue is also relevant to Bausch Health Care (BHC). BHC has a durable consumer line in its Bausch + Lomb product line of eyecare products and borrowed money to purchase it. That is appropriate. However, BHC purchased Salix - a set of GI focused, patent expiring drugs. Those drugs are paying handsomely, but it is important that debt paydown occurs at the same rate as the expiration of its patents rate. As a good friend of mine said about financing cars, "the car gotta outrun the note."