Kirk Paulus: Valeant Pharmaceuticals has a very interesting business model. It's different from a lot of their peers in the industry, though there has been some movement to actually adopt some of their practices by some competitors. What they are currently doing is not so much reliant on creating new drugs; it's more reliant upon acquisitions and synergies and cost cutting and the value that they can achieve for shareholders through these things.
So, an average company in pharmaceuticals will spend between 15% and 20% of their sales, which is the metric we often use, on research and development of new drugs. For Valeant, it's closer to about 2%. So they are not so much looking to make money through the development of new drugs but rather through aggressive acquisitions of companies, and once they are successful in the acquisition, they implement cost-cutting measures – for example, reducing the employment numbers and increasing the price of the drugs in the portfolio. Obviously, this is going to create value for shareholders, especially when they use a fair amount of leverage to accomplish this as well.
Now, the strategy was very successful. They had a very meteoric rise in their share price and really it was due to these aggressive acquisitions and the question becomes eventually whether or not that this model is sustainable.
Why have investors suddenly become skeptical of Valeant’s business model?
The problems that Valeant is really starting to see right now somewhat started to appear back in 2014 when they were attempting to acquire a firm called Allergan. During this time, they hadn't really run up against any kind of significant pushback, not this significant from such a major acquisition. And what Allergan said, it wasn't necessarily the share price or the offer price, I should say, that was their cause for concern. It was the actual business model that Valeant is employing where they are instead of using R&D and organic sales growth to grow their earnings and to return value to shareholders. Again, they were doing aggressive acquisitions. And the question is, there has to be a limit to this. This is what several people have put forward.
In the short to mid-term there is no question that buying a drug, increasing its price, lowering your costs will clearly create value for shareholders. You're going to get more earnings. But in the long term, you do have to create drugs. And as long as there are targets out there, it's a great strategy. But once the targets start to dry out, well, now you have a problem because you're not really structured as a firm that's built to create new drugs; you're just one that basically create efficiencies when you buy or increase the price when you purchase other companies.
How is the regulatory environment impacting Valeant and the pharma industry?
In addition to the issues with regards to some pushback from a major acquisition, there was an issue that was raised with Turing Capital by Martin Shkreli, who purchased a drug called Daraprim and attempted to increase the price from $13.50 to $750. And that actually got a lot of notice of the public and of regulators and made its way all the way to the Democratic primary race, with Bernie Sanders and Hillary Clinton both calling for greater regulation of the pharma industry.
Now, there was a back off on that. I don't know how much it's going to be the final price of Daraprim. But the fact of the matter is, it brought this issue right into the limelight and while Valeant is not a firm that is going to increase the price of life-saving drugs 5000%, in 2015 they did increase it 66%, which is still a very substantial amount, and a large part of their business model is to increase prices. So there is a threat now that there may be increased regulation, which may decrease the amount by which a drug price can be increased each year, which obviously will affect their aggressive acquisition strategies and really put a crimp in what up until this time has been a very positive model for their shareholders.
What precipitated the recent massive decline in Valeant’s share price?
More recently, what shareholders and a lot of investors have noticed is the real fall-off in the share price Valeant has experienced. Now, the reasons I listed earlier were more long-term and aren't necessarily responsible for this sell-off. It's more from a report from Andrew Left who is from Citron Research, and he has raised some very serious allegations regarding sales practices of Valeant with regards to a firm which they economically own, essentially, called Philidor. And the allegation, there is a lot to it, there are many shell corporations and all sorts of legal stuff going on there. But the long and short is that he is alleging that they are doing phantom sales through fictitious emails to basically book revenue that actually wasn't sold, that the product isn't necessarily being sold to clients, but is just sitting on shelves.
What should individual investors do with their Valeant shares in light of this news?
Valeant has actually been a fantastic stock for us. We've had great gains in many strategies. Over the course of the last four or five years since they have adopted this really aggressive model, they have really returned valued to shareholders. However, with the share price falling the way it has, obviously, they have fallen on momentum metrics, still are ranking all right on price to earning metrics. But again, that's based on the veracity of the earnings numbers.
Overall though, I would say the majority of our strategies are currently rating it as a sell. There's a couple in which it still is a hold, as I said before, but really it's not showing up quantitatively as a strong buy anymore for all the reasons listed and the falling of the share price. So, right now, a wait-and-see approach may be best just to see how these fraud allegations shake out and what happens in the regulation of the pharma industry in general.
Valeant may still be a legitimate part of a portfolio, but especially for the individual investor I wouldn't recommend going out and just buying tons of shares of Valeant in hopes that everything is going to be fine. It may work, but that's not the way we invest. Talk to your advisor, talk about in a portfolio context and decide if it's right for you.
