Valeant Pharmaceuticals; Market Cap: $25.73bn (as of 13/11/2015)
Introduction
Valeant Pharmaceutical, a pharma behemoth renowned for its aggressive acquisition strategy, has been facing some hard times as its stellar performance has deteriorated considerably amid scrutiny over its monopoly pricing for its drugs as well as recent accusations for its relationship with Philidor, its specialty pharmacy, to inflate revenues. In fact, company’s stock plunged from $264 on August 5 to close below $74 on November 12.
About Valeant
Valeant Pharmaceuticals (NYSE:VRX) is a Canadian-based specialty pharmaceutical and medical device company that develops, manufactures and markets a wide range of products in more than 100 countries.
Valeant is actively involved in the following business segments:
– Pharmaceutical products, mainly prescription drugs, which may be sold only to consumers possessing a valid prescription. The segment covers a broad range of treatments, including antibiotics, treatments for cardiovascular and neurological diseases, dermatological products, diabetic therapies and eye health products. It accounts for 57% of company’s revenues, as of 2014.
– OTC drugs, which are medicines sold from a healthcare professional directly to a consumer without any prescription. The segment includes mainly products sold for eye health, such as solutions used to lubricate contact lenses and eye vitamins as well as aesthetics products designed to optimize beauty and address signs of aging. It accounts for 21% of company’s revenues, as of 2014.
– Medical device products, which include the production of contact lenses, ophthalmologist surgical equipment and medical device systems for aesthetic applications. It accounts for 20% of company’s revenues, as of 2014.
– Licensing of products & contract services, mainly in the area of dermatology, accounts for 2% of company’s revenues, as of 2014.
Valeant’s Business Model
As already noted in our previous article covering Valeant’s bid on Allergan (https://bsic.it/scramble-fend-takeover-allergan-vs-valeant/), the Canadian company’s business model differs from the ones implemented by many of its competitors. Pharmaceutical companies have always relied on R&D to invent new drugs, but Michael Pearson, Valeant’s CEO since 2008, believes that such an approach is antiquated and inefficient. Since 2010 he has been working on a turnaround of an R&D focused, specialty pharmaceutical company with a portfolio of a few drugs, into a business that resembles a private equity firm. Under his guidance, the company has performed more than 100 acquisitions and has reduced R&D spending to 3% of sales, increasing its market capitalization to almost $100bn, as of the end of July 2015. Moreover, Valeant has a similar plan for almost all of the newly acquired companies, consisting in the reduction of operating costs, R&D expenses and the increase of drug prices to generate bigger cash flows.
The company is ill-famed for raising the prices of “under-priced” drugs acquired through deals by several hundredfold without committing more resources to find alternative treatments. So far this year, it has raised the sticker price of 56 drugs or about 81% of its portfolio on average by 66%, while the steepest raise (550%) was on the price of the gastrointestinal drug Zegerid. It is worth mentioning the case of Isuprel and Nitropress, the two drugs Valeant bought in February 2015, and the prices of which have been raised respectively from $258 and $216 to $806 and $1347.
Valeant’s strategy also involves the acquisition of other companies for tax purposes. For instance, in 2010 it merged with Biovail, moving its corporate headquarters to Canada and a few years later it failed to acquire Salix to relocate in Italy and cut its tax payments to just above 20%.
Valeant’s Recent Downfall
Since August Valeant has lost roughly 70% of its market capitalization, which now stands at c.$26bn. The stock’s free-fall was caused by investors’ concern about company’s long-term growth prospects and the short-term sustainability of its strategy. Many have expressed doubts on Valeant’s ability to generate enough revenues in the future if it continues to disregard R&D in favour of acquisitions, amid a decreasing number of possible targets and company’s $30bn of debt. Its limited additional debt capacity and junk rating make further acquisitions less feasible but also a halt in deals would be problematic for Valeant, as after the expiration of its patents, the company would have only a few competing products in its portfolio unless it invests in R&D soon. Moreover, Valeant’s favourite acquisition model, the “buy and raise”, may become less profitable as Hillary Clinton has pledged to put a cap on US drug prices. This threat represents a further incentive for Valeant to revise its business model and increase R&D spending, which now accounts for only 3% of revenues.
What Is Valeant Being Accused Of?
Valeant is now undergoing an investigation by the US authority on its mysterious relationship with Philidor, its specialty pharmacy, which helped the company boost revenues by recording fake invoices.
What is a Specialty Pharmacy?
In order to understand the dynamics of the story, it is crucial to define the role of specialty pharmacies in the US healthcare system. They are mostly focused on the distribution of specialty drugs, which are usually high cost products used for the treatment of complex or chronic diseases. This type of drugs requires special handling, administering, shipping, storage and specialty pharmacies are in charge of coordinating all the activities concerning the distribution of these medicines and the treatment of diseases.
As a result, specialty pharmacies have a much closer relationship with the patients than normal pharmacies do, as they do not only provide the medicine, but also educate the patients and coordinate the treatment of the disease. Drug makers have started using specialty pharmacies as a way to encourage the use of higher-priced drugs for even less severe illnesses like joint pain and acne.
Relationship with Philidor
During the investigation, Valeant disclosed to have very close ties to Philidor, a specialty pharmacy which distributes almost Valeant’s drugs only: the drug-maker paid $100m for the option to acquire Philidor at no additional cost within a decade.
Some days later, a report by Citron Research, which is run by activist Andrew Left (who is now actively shorting Valeant), revealed more information on Philidor, accusing Valeant of exploiting the specialty pharmacy to boost its revenues. When a doctor prescribes a Valeant’s drug, the patient receives the contact of a specialty pharmacy such as Philidor, which delivers the drug regardless of whether the insurer will cover the cost of the drug or not. In fact, Philidor sold drugs to patients with medical prescriptions before the insurer’s confirmation. The risk of not being paid by the insurance was completely on Philidor. However, to recover the cost of the unpaid drugs, the pharmacy had to increase the price of Valeant’s products, thus partly explaining increasing prices in the past years. In some cases Philidor even decided to waive the patient’s co-pay (the part of the drug’s cost for which the patient is liable) for Valeant products, whose cost is in the end was borne by Valeant itself, in order to make the patients more willing to buy its products again.
Valeant’s strategy is very simple: the company records revenues even if the insurer will not eventually pay for its drugs, as Valeant’s policy is to book revenues when the medicine is delivered to the customer, not when it is paid. Therefore, Valeant’s profits are inflated by using Philidor’s relationship with customers, offsetting the future write-downs coming from uncollectible revenues with high drug prices. Given the similarities, some people accused Valeant to be the new Enron.
Valeant’s Main Investors
The interest in the company began to rise when in 2010 the original Valeant, based in the US, merged with Biovail, a Canadian pharmaceutical company. The new entity took Valeant’s name and the CEO, J. Michael Pearson, established its headquarters in Canada. It was after this acquisition that Valeant started its aggressive strategy based on takeovers and price raises.
Between 2010 and 2014 the performance of Valeant was stellar. In 2013 the stock enjoyed an astonishing +108% and by the moment it reached its peak of 348, on August 6 2015, it was up 262% starting from 2010. Given its aggressive and complex strategy, Valeant mostly attracted institutional investors: Ruane, Cunniff&Goldfarb, an investment firm, which has a 10% stake in the company through its Sequoia Fund, followed by T. Rowe Price and Pershing Square Capital Management, which hold a 6% stake each in the company. John Paulson’s Paulson & Co., Jeff Ubben’sValueAct and BlackRock are among the other shareholders. According to Goldman Sachs, Valeant used to be among the top 10 holdings of the 32 hedge funds as of the end of the second quarter of 2015, with the stock accounting on average for 10% of the portfolios of those funds. Therefore, it is not a surprise that Valeant’s breakdown created such a turmoil on the markets.
ValueAct, the fund run by Jeff Ubben, is appointing its president, G. Mason Morfit, to an ad hoc committee inside the company, which will look into Valeant’s relationship with specialty pharmacy Philidor. Moreover, Mr. Morfit previously served as a director at Valeant from May 2007 to May 2014. This suggests that the fund is seeking to help Valeant regain the trust from investors.
Bill Ackman is probably the most active of Valeant’s investors. In 2014 he was on the forefront of the $50bn battle for the takeover of Allergan. Eventually, Allergan was acquired by Actavis for $66bn (https://bsic.it/get-66bn-smile-actavis-buy-botox-maker-allergan/) but still Valeant’s performance allowed Bill Ackman to become one of the most successful investors over the past years and was the main reason behind the skyrocketed fame of Pershing Square Capital Management. Fund’s performance allowed it to be compared to Berkshire Hathaway and some people on the markets started calling Bill Ackman “Baby Buffet”. Not surprisingly, the reaction of Pershing Square to Valeant’s problems was to increase its stake by another 2m shares, paying roughly $230m, for a total of c.21m shares. Bill Ackman stated his support for J.Michael Pearson, CEO of Valeant, on numerous occasions and still believes that the Canadian company is undervalued and will eventually regain all the market capitalization it lost. Pershing Square Capital Management is now 28% down from the start of the year.
Valeant caused significant turmoil in Sequoia Capital Management as well. The Canadian company represented 29% of the fund’s holdings as of June 30, according to data compiled by Bloomberg. The Sequoia Capital Management outperformed 99% of its rivals as of the end of August 2015 and 97% over the past five years thanks to its stake in Valeant. However it suffered a paper loss of about $1.2bn after shares of the company plunged. At the end of October, two out of Sequoia’s five independent directors, Vinod Ahooja and Sharon Osberg, abruptly resigned following the decision of the board to buy additional Valeant’s stock at what is considered a depressed price. Following this announcement Sequoia Capital Management decided to stop the purchase of stock in the Canadian company.
Conclusion
None of the major investors in Valeant Pharmaceuticals have sold their stake for now, which appears to be a sign of strong confidence in company’s strategy, notwithstanding the current difficulties. However, it is also possible that the big players are simply not willing to accept a loss coming from one of the best stocks for the past years. It is hard to predict what will come next, but given the mounting concern over the drugs’ price and the nearing presidential election in the US, it will not be an easy time for Valeant and its business model.
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