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What We Can Learn From Valeant’s Wreckage

The Valeant wreckage continues to smolder, and it will remain a tourist attraction for students of forensic accounting techniques for some time to come. For an informative look at the accounts of the people who have been holding its stock, check in with Matt Levine at Bloomberg. He’s gone through the public filings of Bill Ackman’s Pershing Square fund and has reasonable estimates of their stock and option positions in Valeant, and hoo boy. He believes that their break-even point is at about $161/share, and if that’s accurate then the traditional “underwater” adjective does not begin to describe where they are on this company. You need a robot submersible to explore these depths. Levine further estimates another inflection point, at just under $18/share, which is where Pershing Square will likely have lost their entire four billion dollar investment. I have no idea if they hedged this position somehow, as a. . .hedge fund might do, but Ackman himself delivered a four-hour exhortation back in October, complete with a massive slide deck that covered in detail just how incredibly right he was about investing in the company, so maybe not. He was only down a billion dollars at that point, though – good times, good times.

Last summer no one would have believed just how bad it could get, or (in the case of Ackman himself) that it was capable of getting bad at all. No, Valeant was great, and it was just getting better and better, the same way it had for years. The problem is that some people may still not take the right lessons away from this one. Valeant became such a popular investment because of their low-cost high-prices business model, which you’d think would have been discredited by this little stretch of difficulty, but there will surely be some who will say “Well, but this was fraud. No way to know that a company’s cooking its books when it just flat-out lies to everyone”. But that misses a key point: you can’t deliver the kinds of numbers that Valeant was delivering without trickery. The company kept selling itself as a growth play, when it was nothing of the kind. Despite their statements, most of the revenue growth came from raising prices on its stable of old drugs, which it obtained by taking on mounds of debt, which only had a prayer of being serviced if those prices were jacked beyond belief and sales stayed strong. But a lot of the sales at those raised prices came through a shady hidden network of specialty pharmacies that they didn’t tell anyone about. No, Valeant wasn’t a good idea executed fraudulently – it was a fraudulent idea to start with.

As pointed out by Ronald Barusch in the Wall Street Journal, this debacle also vindicates Allergan’s attempts to avoid being absorbed by Valeant a couple of years ago. That was a smarmy affair, with plenty of misrepresentations, and if you didn’t dislike Valeant’s management before that, you certainly had reason to afterwards. Well, unless you were running a multibillion dollar hedge fund, that is – several of those folks (and not just Ackman) didn’t let that slow them down at all. (What’s even more painful for them is that many of these managers have shown themselves willing to invest in a good short thesis, but they sure didn’t recognize that this was another one).

Matthew Herper has some other lessons in his column here, and he has some good points. I would add this one, which bears on some of his points about doing research: don’t confuse generic drug companies with research drug companies. Recent events have shown that many members of the public, and many legislators and journalists as well, are rather hazy on this concept. But the key is whether a company does research on new drugs to patent or not. That’s a very expensive proposition – too expensive, said Valeant and their CEO Michael Pearson. Better to buy up the things other people have found and raise their prices. So just calling Valeant a “drug company” isn’t that useful, because that term doesn’t distinguish a marketer of other people’s known drugs from a company that tries to invent new ones.

Now, you can buy up things that are still under patent and make a portfolio of those, but that’s also not a cheap model. Patents are worth quite a bit because of the market exclusivity they provide, and if a company already has a drug under patent that’s selling, than what is it that you’re bringing to the deal? (Usually, it’s marketing – “go with us and we’ll sell a lot more than you would on your own”) Or you can buy older drugs that are off-patent, which would normally be a lot cheaper, but also would normally bring in a lot less revenue. Those are the generic drugs, off-patent, now competing on price because the market exclusivity is gone. Or is it? That, of course, is the set of regulatory loopholes that the Valeants and T*rings of the world are exploiting, finding ways to get people to pay huge prices for decades-old drugs.

With any luck, that business model has been discredited. As Herper puts it:

Part of the appeal of Valeant and other specialty pharma companies has been the idea that you could avoid having to deal with all the kooky science and 90%+ failure rates of real drug discovery. This sales pitch has always been irresistible to investors. . .(But do you) want the financial benefits of curing disease? You have to take the risk.

Me, I cast my lot with the kooky science. I wouldn’t mind getting that 90% failure rate down a bit, but that’s going to take even more science than we have at present. Onward!

32 comments on “What We Can Learn From Valeant’s Wreckage”

  1. Hap

    Isn’t that how scams work, though? People promise lots of money, or a moderate amount of money with no risk, or something else that lots of people want and can’t get, when no such opportunities exist, and people whose greed wins out over their rationality take them up on it.

    “If something sounds too good to be true, it probably is.”

  2. Anon

    “What We Can Learn From Valeant’s Wreckage?”

    Well, if the model looks like a ponzi scheme, sounds like a ponzi scheme, and smells like a ponzi scheme…

  3. Mike Andrews

    Pretty soon, the auditors will walk through the battlefield, shooting any survivors.

  4. Anon

    And the slow sell-off continues as investors try to exit without creating a sudden panic – down another 4% in the first 2 hours.

  5. Me

    …and the management team will be in charge of another company pulling in pseudo-7-figure salaries while the workers whose pension funds just got fried cry in their beer….

  6. Helical Investor

    Derek,

    I think it is a leap to presume that ‘the business model has been discredited’. Of course it depends on how that model is defined. Growth by acquisition can work, but requires extreme value price discipline and patience, which does not seem to have been practiced by Valeant. Aggressive acquisition always seems to end badly. Also, an R&D light business focused more on marketing existing rather than new products may be practical. One could argue that the old Allergan already had leanings well in that direction well before Valeant came knocking.

    A more interesting situation that may further ‘test the model’ is the 2013 split by Theravance into 2 firms. Theravance Biopharma will continue as a development stage R&D operation, and Innoviva is operating akin to a resource trust where the resource is the previously approved therapies and the revenues / royalties form them.
    http://www.fiercebiotech.com/story/theravance-split-two-companies/2013-04-25 (the Innoviva name came later)
    Will Innoviva try to ‘grow’ or just persist with patient disciplined future acquisitions? Will they go on a buying spree like Valeant? Will they simply run the course for some years while distributing income to shareholders (PDL Biopharma analogy)?

    Or are we looking at the question from the wrong side? What best benefits R&D? In this interview (starting ~ 25 minutes in) senior VP of Theravance Biopharma (R&D side of the split) Mathai Mammen makes a great quote about why the firm split from an R&D perspective. “”It is difficult to be innovative when you are in the shadows. It is much easier to be innovative when you need to be innovative; when you are out in the sunlight”. Of course top managements attention becomes disproportionately directed to revenues once you have them. Is this a way for R&D to stay focused and motivated, and not suffer the insinuation that they have become complacent (**cough** Pfizer)? I think that makes a lot of sense, but is honestly scary as well?

    My opinion is that Valeant is just a failed example of what pharma might become, largely due to internal hubris. Just another Tyco, or ITT Corp. but in a different industry.

    Ralph
    @helicalinvestor

  7. Helical Investor

    Derek,
    [link added to prior submission]

    I think it is a leap to presume that ‘the business model has been discredited’. Of course it depends on how that model is defined. Growth by acquisition can work, but requires extreme value price discipline and patience, which does not seem to have been practiced by Valeant. Aggressive acquisition always seems to end badly. Also, an R&D light business focused more on marketing existing rather than new products may be practical. One could argue that the old Allergan already had leanings well in that direction well before Valeant came knocking.

    A more interesting situation that may further ‘test the model’ is the 2013 split by Theravance into 2 firms. Theravance Biopharma will continue as a development stage R&D operation, and Innoviva is operating akin to a resource trust where the resource is the previously approved therapies and the revenues / royalties form them.
    http://www.fiercebiotech.com/story/theravance-split-two-companies/2013-04-25 (the Innoviva name came later)
    Will Innoviva try to ‘grow’ or just persist with patient disciplined future acquisitions? Will they go on a buying spree like Valeant? Will they simply run the course for some years while distributing income to shareholders (PDL Biopharma analogy)?

    Or are we looking at the question from the wrong side? What best benefits R&D? In this interview (starting ~ 25 minutes in) senior VP of Theravance Biopharma (R&D side of the split) Mathai Mammen makes a great quote about why the firm split from an R&D perspective. “”It is difficult to be innovative when you are in the shadows. It is much easier to be innovative when you need to be innovative; when you are out in the sunlight”. Of course top managements attention becomes disproportionately directed to revenues once you have them. Is this a way for R&D to stay focused and motivated, and not suffer the insinuation that they have become complacent (**cough** Pfizer)? I think that makes a lot of sense, but is honestly scary as well?
    http://humanpoc.com/mathai-mammen/

    My opinion is that Valeant is just a failed example of what pharma might become, largely due to internal hubris. Just another Tyco, or ITT Corp. but in a different industry.

    Ralph
    @helicalinvestor

  8. Anon

    @Helical Investor:

    “I think it is a leap to presume that ‘the business model has been discredited’.”

    Err, no. Valeant’s “business model” creates no net value, period. It relies on *taking* value from others (patients, tax payers, other pharma companies and their employees, investors, etc.). Which is fine, until people say “enough!”

    1. Old Timer in reply to Anon

      But this is a common model. Think about the car industry. Car companies can only sell to dealers, and dealers sell to consumers. People think that there is some magical reason their car depreciates 10-30% when they drive it off the lot! It’s not magic, it is the car dealer taking your car’s value!

    2. Daniel in reply to Anon

      Valeant turned out not to be taking money from patients or taxpayers, and fell because they were lying about that, not because the public said, “Enough!” There’s still the possibility that T*ring will successfully extract money with the scheme, and might be allowed to keep doing so, if regulators do a bad job. Derek’s point is that if your business model is to do something really evil, and nobody seems particularly upset, it’s probably because you’re not actually executing the evil business model. I think we’ll have to see what happens to T*ring before we can say whether that business model has been stamped out, though.

  9. lazybratsche

    “Or you can buy older drugs that are off-patent, which would normally be a lot cheaper, but also would normally bring in a lot less revenue. Those are the generic drugs, off-patent, now competing on price because the market exclusivity is gone. Or is it? That, of course, is the set of regulatory loopholes that the Valeants and T*rings of the world are exploiting, finding ways to get people to pay huge prices for decades-old drugs.”

    Fortunately, one of those loopholes was recently made smaller, if not exactly closed. The FDA can now choose prioritize generic drug approvals whenever there’s a monopoly being exploited for a particular drug (like we saw with Daraprim). That doesn’t make Shkreli’s shennanigans completley impossible, but it does greatly reduce the incentives since it cuts out much of the years-long queue for FDA approval of a competing generic.

    The new rule is #8 in this policy document: http://www.fda.gov/downloads/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDER/ManualofPoliciesProcedures/UCM407849.pdf%20fda%20anda%20approval%20priority

  10. Only things we learn from the debacle is that none of these so called experts are worth listening to, and investigative journalism is dead. Neither WSJ nor Matt Harper reported about potential problems with Valeant, when the stock was > 200.

    1. Edgar in reply to homolog.us

      Theranos (WSJ, Carreyrou) was good investigation. Also, short selling investors do good investigations.

    2. Slurpy in reply to homolog.us

      Homolog, part of that is because Valeant was only above $200 for about four months. Herper, at least, did write about it several times before that window, however, before it plateaued (once about two months before it hit $200, when it was about $170):
      http://www.forbes.com/sites/matthewherper/2014/06/12/valeant-pharmas-arguments-about-drug-research-are-misleading-and-wrong/

      http://www.forbes.com/sites/matthewherper/2015/01/21/wall-streets-drug-dealer-how-brent-saunderss-ma-binge-is-building-the-pharma-of-the-future/

    3. fajensen in reply to homolog.us

      If those “experts” and “oracles” were actually any good, it would be even harder to” make money”* in the stock market.
      Fraud is not really a subject discussed in neo-classical economics, “Markets” is supposed to take care of this automagically with the help of the con-fidence fairy. When left to self-regulation, Fraud is absolutely the most efficient business model. Thus, when the number are very too impressive, there is usually fraud involved. Its a good idea to buy the puts on every quarterly report after the normal 4 years of “beating analysts expectations”. They will miss / be discovered eventually – usually – in accounting period 5 or 6.

      *) Make Money -> Take someones money away from them.

  11. oldnuke

    Burn baby, burn.

  12. Anonymous Researcher snaw

    For their CEO, I shall play a nanotech violin. But remember the patients and employees who have been harmed by these shenanigans. When billions of fictional dollars evaporate like this, real people who had little say in the budinr decisions will surely suffer.

  13. Magrinho

    One of the greatly undervalued aspects of a strong R&D group is helping the broader organization know the difference between chicken shit and chicken salad.

  14. Helical Investor

    In my earlier reply I noted:

    In this interview (starting ~ 25 minutes in) senior VP of Theravance Biopharma (R&D side of the split) Mathai Mammen makes a great quote about why the firm split from an R&D perspective. “”It is difficult to be innovative when you are in the shadows. It is much easier to be innovative when you need to be innovative; when you are out in the sunlight”.

    And failed to link the interview. It is here: http://humanpoc.com/mathai-mammen/

    Ralph
    @helicalinvestor

  15. Anon

    Down another 9% on the day, at this rate Valeant won’t last another 2 weeks.

  16. grammar police

    What did you expect from people who can’t even spell “Valiant” right?

  17. hypnos

    Well, there is room for a legitimate research-driven business model based upon existing drugs: repurposing. This is something that can be attractive for smaller companies since it comes with a different price tag and also a different risk / benefit ratio.

  18. Anon

    I find the excuses by Sequoia, who lost even more than Ackman, quite pathetic:

    “We’ve been criticized for allowing the holding to grow so large, but our feeling before the crisis erupted was that Valeant was executing well on its business model,” Goldfarb wrote in the fund’s annual report last month. “As the largest shareholder of Valeant, our own credibility as investors has been damaged by this saga.”

    Perhaps they should have asked first whether the business model was viable and sustainable by creating actual value for anyone?

  19. Nick K

    The Valeant website shows a lady who looks as though she is screaming in terror. She must be an investor.

    1. oldnuke in reply to Nick K

      Or an auditor!

  20. petros

    Who are Valeant’s auditors?

    Could the debacle cause them major issues pace Enron & Arthur Andersen?

  21. Kent G. Budge

    “People think that there is some magical reason their car depreciates 10-30% when they drive it off the lot! It’s not magic, it is the car dealer taking your car’s value!”

    No, it’s selection effect. Most of the people trying to resell a car they just drove off the lot are people who discovered their new car is a lemon.

  22. Anon

    Pearson has just been fired.

  23. march madness

    With Ackman calling the shots now (if he wasn’t already doing so under the table) it’s only going to get uglier. They might as well add Shkreli to the circus – he certainly appreciates their business model.

    http://www.nytimes.com/2016/03/22/business/valeant-ackman-pearson-earnings.html?_r=0

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