Valeant Pharmaceuticals International

24 May 2016


Company Background – a tale of drugs, drugs, and more drugs

Valeant Pharmaceuticals International is a multinational pharmaceutical company based in Laval, Quebec, Canada. Valeant manufactures generic pharmaceuticals and over the counter products specialising in dermatology, eye care, aesthetics, consumer products, gastrointestinal products, oral health, neurology and other therapeutic areas.

In 2013 Valeant acquired Bausch & Lomb, one of the largest suppliers of contact lenses in the world.

Valeant grew at a rapid rate through a series of mergers and acquisitions under the leadership of former CEO J. Michael Pearson. By early 2015 Valeant was the most valuable company in Canada based on its market capitalisation.

Valeant prepares its accounts annually to 31st December and is quoted on the New York Stock Exchange.

Valeant’s Business Model –once very profitable

Valeant’s business model is based purely on acquisitions of medical and pharmaceutical companies and the subsequent increase in price for the products those companies supply. The company spends little on research and development with less than 3% of turnover being allocated to research and development activities. Placing this in context, large drugs companies (Pfizer, Merck & Co and GlaxoSmithKline) typically spend in the region of 15% to 20% of their sales value annually on research and development activities.

Something hits the fan

Since mid-2015 Valeant has been embroiled in a number of controversies that has resulted in the price of its stock falling by close to 90% in less than a year. In August 2015, prior to the events described below, the stock was trading at $263 per share. On the morning of 19th May 2016 (the time of writing) the stock was trading at $27.86.

Price Gouging – take them for what they have

In September 2015 the company came under the spotlight of politicians in Washington in respect of its pricing strategies. Valeant raised the price on all of its brand name drugs by 66% in 2015, five times more than its closest industry peer.

In late September 2015 members of the United States House Committee on Oversight and Government Reform urged the committee to subpoena Valeant in respect of sharp increases in the price of Nitropress and Isuprel, two drugs that are used to treat chronic heart conditions. Valeant had raised the price of Nitropress by 212%, and Isuprel by 525%.

In February 2015 Valeant acquired Salix Pharmaceuticals for $15.6 billion. After the acquisition Valeant raised the price of the diabetes pill made by Salix (marketed under the name Glumetza) by 800%.

The Philidor RX Distribution Scandal – boosting sales with the liberal use of Liquid Paper

On 21st October 2015 allegations were levelled against the company that called into question Valeant’s accounting practices with several reports highlighting the close ties between Valeant and the speciality mail order pharmacy Philidor RX. It is alleged that workers at Philidor RX were given written instructions to change codes on prescriptions so that it would appear as if the Doctor or the patient had specifically requested Valeant’s branded products rather than cheaper generic versions of the same or equivalent drug. 

An investigation by the Southern Investigative Reporting Foundation uncovered that Philidor RX had been consolidated into the group accounts of Valeant but not adequately disclosed in detail to investors in the company. Allegations from Pharmacy Benefit Managers accused Philidor RX of improperly filling scripts in a similar fashion to the process described above. Valeant has now severed ties with Philidor RX, but the process of severing those ties has caused a number of accounting restatements delaying the release of financial statements to the investing public.

The delay in the preparation of the financial statements is so acute that in accordance with covenants relating to loans given by Valeant to providers of debt financing, Valeant could potentially be in default.

On 30th October 2015, Valeant cut ties with Philidor Rx, and on the 15th December 2015 entered into an agreement with Walgreens to distribute Valeant’s products through Walgreens chain of 8,000 pharmacies.

Late filing of accounts

On 16th May 2016 Valeant announced that it expects to file accounts (10-Q statements) on or before the 10th June 2016. In addition, the company announced on the 11th May 2016 that it had applied for a Management Cease Trade Order (MCTO) restricting the ability of members of the Board of Directors of Valeant from trading in shares.

Reasons to consider buying the stock

  • The two executives most closely associated with the scandals, J. Michael Pearson (CEO) and Howard Schiller (CFO) have left the company.
  • The portfolio of brands that Valeant owns and controls has significant value that is not currently reflected in the stock price.
  • Valeant has appointed a new CEO, Joseph Papa. Papa is the former CEO of Perrigo and has a proven track record.
  • Joseph Papa has a strong incentive to succeed as he stands to make over $500m if Valeant’s stock price hits $270 by 31st December 2020.
  • The company plans to pay its senior executives multi-million dollar bonuses to stay with the company through the toxic period of accounting scandals, numerous regulatory investigations, and criticism from both the United States Senate, and the House of Representatives. Specifically, the company plans to pay $1 million retention bonuses to Robert L. Rosiello (CFO), Dr Ari Kellen (Group Chairman), and Anne C. Whittaker (Executive Vice President). In addition to these bonuses if they stay with Valeant they will be entitled to special equity awards of $2.8m, $3.8m and $1.25m respectively. These bonuses vest over a period of 18 months.
  • Two large funds (Pershing Square and ValueAct Capital) have retained shareholdings in the company and have publicly stated that they intend to hold onto the investments that they have made because they expect the company share price to rebound. Pershing Square has lost close to $1 billion on its investment in Valeant since taking a position in the company in March 2015.
  • The company has no large debt payments falling due until 2018.
  • Valeant has given assurances that its financial statements and statutory disclosures will be brought up to date on or before 10th June 2016.
  • Hospitals are to be given a 40% rebate on the amounts they were charged for Nitropress and Isuprel.
  • The termination of the proposed merger between Pfizer and Allergan could be beneficial and provide opportunities for Valeant to expand moving forward.

Reasons to consider passing on the stock

  • Valeant’s future sales growth is at risk given that 50% of its annual sales growth historically has come from drug price increases on new products acquired through its merger and acquisition strategy. For 2016 Bloomberg expects annual revenue to be in the vicinity of $11-$11.2 billion down from original expectations of $12.5 to $12.7 billion.
  • Valeant’s operating margins will come under increased pressure as a result of an increase in operating expenses arising from additional costs in respect of financial reporting, government affairs and managed care.
  • While Valeant’s margins have outperformed most of its peers including Endo and Allergan because the company spends little on research and development, future merger and acquisition activity is unlikely given the need to pay off debt accumulated as a result of past mergers and acquisitions.
  • Analysts expect that Valeant will continue to see lower growth in its US dermatology, gastrointestinal, and woman’s health units. This will pressure revenue and earnings gains in the near term. Valeant has also seen inventory destocking in its dermatology and gastrointestinal segments, as well as revenue declines for its prescription ophthalmology division in 2016. These factors are likely to act as a drag on revenue throughout 2016.
  • Although Valeant will pay down more than $1.7 billion in debt during 2016, dramatic growth remains questionable without future Merger and Acquisition activity.
  • While the new distribution agreement with Walgreens may offset some of Valeant’s sales volume loss following the termination of its activities with Philidor RX, Walgreens have the right under the distribution contract to cut the price of some of the key branded dermatology and ophthalmology products by up to 10%.
  • The delay in filing accounts and the possibility of additional adjustments to the financial statements being required makes it difficult to value the company.
  • The payment of bonuses to key members of management to entice them to stay with the company is evidence of a toxic environment within the company that could take many years to clear.

Is Valeant right for your portfolio?

The current share price of $27.86 may not reflect the underlying value of the brands and basket of products that the company controls. The process of recovering from the scandals that have plagued Valeant throughout 2015 and the early part of 2016 will be a lengthy process. With an estimated PE Ratio of 3.29 (Bloomberg) Valeant represents an investment opportunity for anyone with a tolerance for high risk investments and a penchant for investing over the long term.

Closing thoughts – time to consider your investing strategies

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.

 

Disclaimer:

Neither Firstline Securities nor Michael D Sims has received compensation for this blog publication or have any business relationship with any company whose stock is mentioned.

Nothing in this blog should be construed as investment advice. Please consult your financial advisor. This is not a solicitation to buy or sell any securities, neither is this tax advice.

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