Valeant Pharmaceuticals: a Momentum not Value Company

December 4, 2015.

Investors in Valeant Pharmaceuticals accepted characteristics remote from value investing: rapid revenue and margin growth driven by costly acquisitions which ballooned debt, massive price increases which risked payer backlash and new competitors and a high technology business with low R&D spend. And now, after its stock price collapse, its future is largely dependent on legal and legislative battles.

(Neither the author or Banyan Tree Capital Management has a position in any Valeant securities.)

Valeant Pharmaceuticals was indeed a very hot company and stock. Its revenues grew over ten-fold to $8.3 billion, in the six years to 2014, while operating income soared 17 fold to $2 billion. An investment of $100 in the stock in December 2009 was worth $1083 in December 2014, over five times greater than an investment in the S&P 500 Index. The stock gained an additional 126% when it reached an all-time peak price of $264 in August 2015.

A company based in Quebec, Canada, Valeant develops, manufactures and markets drugs in areas of dermatology, gastrointestinal disorder, eye health, neurology and branded generics. Earlier, from 2006 to 2008, increased competition and reduced payments from third party payers had halved its operating income. It then shifted from oral drug delivery technologies to developing drugs for central nervous system disorders such as epilepsy, Parkinson’s disease and multiple sclerosis.

Valeant’s strategy shifted again in 2010 when J. Michael Pearson became CEO following an acquisition. Pearson had been CEO of the acquired company since 2008. Earlier he was at McKinsey, which he joined in 1984, heading its global pharmaceutical practice and serving on the board of directors.

The strategy under Pearson, the company’s 2014 10K SEC filing states is rapid acquisitions of companies with drugs which ”.. are largely cash pay, or are reimbursed through private insurance, and, as a result, are less dependent on increasing government reimbursement pressures…” It bought over 50 companies, using cash and debt and paying steep prices. They include dermatological drugs provider Medicis Pharmaceuticals, bought in 2012 for $2.7 billion, nearly four times its 2011 revenues, eyecare company Bausch & Lomb in 2013 for $8.7 billion, roughly three times 2012 revenues and in April 2015 gastroenterology drugs maker Salix Pharmaceuticals for $15.8 billion, fourteen times Salix’ 2014 sales.

Typically companies list risks in their annual 10K filings more for legal protection than to state likely risks. But in Valeant’s case its mention of “Debt-related Risks”, in its 2014 filing, is a real one: “We have incurred significant indebtedness, which may restrict the manner in which we conduct business and limit our ability to implement elements of our growth strategy.” At year end 2008 Valeant had a good balance sheet with no long term debt, cash of $340 million and equity of $1.2 billion. But at September end 2015 it’s debt was $30.2 billion, nearly five times its equity.

A drug company with patents and other intellectual property typically has a fair amount of intangible assets. But Valeant’s intangibles at September 2015 were $22.5 billion, over three times its equity. It also had $17.4 billion in goodwill, resulting from acquisitions. Overall it thus had a negative tangible equity of $33.4 billion.

Salix, before its purchase by Valeant, spent 15 % of its $1,133 revenue in 2014 on research & development. Drug major Merck too spent 15% of its $42.2 billion 2014 revenue on R&D, excluding restructuring and merger related expenses. In contrast, Valeant slashes R&D costs at companies it acquires enabling it to grow operating margins. In 2014, for instance, it spent only 3% of its revenue on R&D. While this low spend helped increase profits short term, strong R&D expense is key to future revenue and profit growth for drug and other companies with patents, intellectual property and competitors.

Under Ethics, in its 2014 10K filing, Valeant states that its “.. most important objective is to serve our stakeholders, including the patients and consumers who use our products, the physicians who prescribe/recommend them, and the customers who provide retail outlets for these products.”

Yet Valeant’s drugs had the highest price increases amongst the 19 commonly prescribed dermatologic drugs tracked in a research study published in the Journal of the American Medical Association in November 2015. The study was conducted by Miranda Rosenberg and Steven Rosenberg, a daughter and father team with the daughter a student at The Perelman Medical School at the University of Pennsylvania. Valeant raised the price for 30 grams of its Carac cream, for treating pre-cancerous skin lesions, from $159 in 2009 to $2865 in 2015. The price for its Targretin gel 60 g tube to treat skin cancer was raised from $1687 to $30,320 over the same period — both about a 1700% increase.

The mean price increase, by Valeant and other drug companies, for the 19 drugs was 401% over the six year period, while the consumer price index rose 11%, the study found. “We’re not talking about new drugs,” Steven Rosenberg, a dermatologist in West Palm Beach, Fla., who led the research told The New York Times, November 26, 2015 “We’re not talking about exotic drugs. We’re not talking about drugs that are listed as being in shortage.”

In October 2015, Valeant’s stock price was cut in half to $94, after news reports that it instructed workers of Philidor, a pharmacy with ties to Valeant, to use a variety of questionable methods to try to get insurance companies to pay for its drugs. Also that month a company news release said it received subpoenas from U.S. Attorneys in Massachusetts and New York seeking documents “..relating to financial support provided by the company for patients, distribution of the company’s products, information provided to the Centers for Medicare and Medicaid Services, and pricing decisions.” A couple of weeks later Valeant appointed Mark Filip, a former Deputy Attorney General of the United States of the law firm Kirkland & Ellis, as an adviser.

Charles Munger, partner of Warren Buffett in running Berkshire Hathaway and a very successful value investor, told Bloomberg November 1, 2015 that in his role as chairman of the Good Samaritan Hospital in Los Angeles, he “could see the price gouging.” Valeant’s practice of acquiring rights to treatments and boosting prices, Munger added, was legal but “deeply immoral”, deeply wrong and unsustainable.

In early December 2015 Valeant’s stock traded at $96, down from $117 at year end 2014. Its strategy of buying companies to get more products requires increasingly bigger purchases to boost profit margin growth, since the denominator gets larger with each purchase. Also its huge debt load, higher interest costs due to a cut in its debt ratings and a fallen stock price will make large future acquisitions difficult. Valeant’s survival hence depends, not on its business economics, but on whether Pearson and major investors can save it from punitive actions from politicians and regulators and if it can manage its huge debt load.