Valeant Pharmaceuticals International
Once in a while, the investment community finds out that one of its darling companies touted as a star investment turns out to be a disaster. In 2015, Forbes Magazine sang the praises of Valeant, describing it as one of the world’s most innovative companies with a market capitalization of $67.5 billion. Even though it was ranked no. 1147 in terms of sales, it was ranked no.133 in market value. In the light of our assertion that corporate strategy is the major driver of market capitalization, the investment community clearly thought Valeant had a stellar and sustainable future. Fast forward nine months later and Valeant is the polecat of the very same investment community. Market capitalization plummeted to $9.5 billion – 14% of its 2015 value.
Much like Lehman Brothers, the massive amount of debt – some $31 billion on annual sales of $11 billion – was what spooked the investment community and brought the stock price crashing down from $257.00 per share in August 2015 to $28.10 in April 2016.
What was the strategy in play that brought the company down?
With significant hedge-fund investment, the strategy was to grow market capitalization as fast as possible, then exit with alacrity. The goal was to achieve the five-fold growth by buying companies, repricing their product range and re-launching the products under the Valeant banner.
In January 2014, Valeant’s now departed CEO, Michael Pearson, was quoted as saying “We did set an aspirational target of being a top five pharma company by the end of 2016… that would be a market cap of $150 billion roughly.” Since the top five pharma companies average $41.1 billion per year in prescription sales only, that would require a five-fold increase in sales in two years.
The problem with a highly leveraged growth strategy is that it requires larger and more profitable acquisitions to keep the momentum going, if the acquisitions in and of themselves are not massively profitable. When Valeant tried to buy Allergan, that company compared Valeant to Tyco, a company that deployed a similar growth through acquisition strategy that spectacularly crashed 2002. Allergan successfully resisted the takeover bid, and vindicated their position.
The question the board under the chairmanship of Robert Ingram needs to answer is this:
“What strategy will restore investor confidence in Valeant?”
The investor community bases its valuation on future earnings potential, and a new strategic direction would have to doubly reassure stockholders that Valeant could profitably do so. Clearly, the sophisticated buy-reprice-relaunch model won’t do, and given that 50% of the current directors list an affiliation with hedge funds, we would be surprised to see a robust long-term growth strategy.
Remarkably, management seems to be at a complete loss as to a new strategic direction. In the March 15, 2016 quarterly investor stockholder conference call, the company listed the following key activities:
- Restructuring smaller businesses: Solta, Sprout, Obagi, Commonwealth.
- Beginning to address SG&A cost reductions given revenue shortfalls: (but… partially offset by investment in key functions – Financial reporting, Public relations, Government affairs, Managed care and Compliance, which means the gain will be marginal.)
- Exploring targeted divestitures of non-core assets.
This lackluster list of managerial interventions should make the last investors head for the exits, especially in the light of the strategy outlined at the JP Morgan Healthcare Conference in January 2016. There the interim CEO stated that Valeant remains “committed to our strategy with a relentless focus on execution.” He highlighted the following (we assume) as strategy components:
- Collection of great healthcare franchises and brands around the world
- Deep bench of talented people
- Exciting pipeline of new products
- Relentless focus on providing easy and affordable access for physicians and patients
We contend that this is not a strategy, but simply the necessary conditions to survive – have product that the market wants, have competent people, new products in development and getting the products to the market at low cost to the consumer. Every pharmaceutical company needs to satisfy the same requirements.
In the long term, there is only one strategy that works – bring new blockbuster drugs and devices to market faster than the products become available as generics. Of the four strategy items, we consider the last two statements fit this model – exiting pipeline of new products and affordable access to products.
How well is Valeant positioned to turn these two strategy items into a sustainable long-term advantage?
At the same JP Morgan Healthcare conference, Dr. Ari Kellen EVP and Company Group Chairman shared this information on the state of the R&D pipeline:
Firstly, pharma companies tend to have more early stage developments than late stage developments. The low level of early stage developments may be the result of the minimal amount spent on R&D. Valeant spent some $260 million on R&D in 2014, which is 5% of its prescription income. The top ten companies spent on average 18% of its prescription income on R&D. Compared to its total sales, Valeant spends 2.8% on R&D. That is not what the top pharma companies do. Considering the R&D pipeline itself, the situation may be even less attractive.
Our research indicates that, in pharmaceutical R&D, the accepted rule of thumb is that:
- Stage 1 to 2 = 30% survival rate
- Stage 2 to 3 = 14% survival rate
- Stage 3 to NDA = 9% survival rate
- NDA to commercialization = 8% survival rate
Applying this to the Valeant late stage pipeline where its long-term growth must come from, only one drug or device out of the 72 products in development may make it to the commercialization stage. This is not a problem for blockbuster drugs like cox2 inhibitors that provided decades of massive cash inflow in the billions of dollars. However, looking at the performance of the existing Valeant top 30 bestseller products, the average annual sales is $48.23 million per product with the top earner contributing $210 million per year. That is less than the company’s total annual R&D expenditure.
It is reasonable to assume that the probability of that single successful product being in the billion dollar earning range in the near future is near zero. It seems there is nothing there to reassure investors of long-term growth.
We have also considered the second strategy element, of providing easy and affordable access to physicians and patients, to Valeant products. Will this bring long-term growth?
For Valeant, the top 30 products account for 52% of sales income. Since the company indicated in its 2014 filing that it has 1600 products it sells, the top earners represent 1.9% of its product portfolio. There must be a gigantic number of unprofitable products in the portfolio all requiring sales effort, supply chain and manufacturing cost and effort. It may also explain the anomaly that, in December 2014, there were 6,200 employees in sales and marketing and 1,600 in general and administrative positions out of 16,800 people.
That is 47% of the workforce.
Secondly, the biggest buyer of pharmaceutical products are the US and Canadian government procurement programs. These are supplied by the large wholesale pharma supply companies, which Valeant is actively pursuing. It describes the new Walgreens Booth Alliance agreement as a significant gain in order to “take cost out of the healthcare system.” We interpret that to mean lower prices on Valeant’s products. Add this to the existing contractual relationships with the wholesale providers:
- McKesson with $179 billion in 2015 sales. It accounts for 17% of Valeant sales.
- Amerisource Bergen with $ 135.9 billion in 2015 sales. It accounts for 10% of Valeant sales.
- Walgreen Booths Alliance with $103.4 billion in sales. Valeant now has a 20-year supply agreement with a 10% price reduction commitment. It is reasonable to assume that it would account for at least 10% of sales.
These three large entities alone represent 37% of Valeant’s sales, in turn however Valeant only makes up approximately 2.6% of McKesson, Amerisource and Walgreens Booth Alliance’s sales. Not a strong negotiation position. We interpret that to mean that Valeant prices and margins will continue to be under pressure.
To bring the observations together:
- Very low probability of significant new products coming from late-stage R&D.
- A huge product range requiring massive sales and admin support.
- A significant increase in exposure to price and margin erosion from large wholesale buyers.
There is not much left to reassure investors of a strong, profitable long-term growth strategy.
The last question then remains: “What can Valeant do to rebuild its market valuation?” The answer is not rosy. We would advise the board to:
- Dramatically reduce the product range down to profitable products. Sell off what can be sold.
- Retire debt by liquidating as many assets as possible.
- Take a hatchet to the R&D pipeline and focusing all effort on the candidate products with the highest probability of delivering significant sales volume. Implement high-velocity project management tools and skills.
- Upgrade supply chain management infrastructure to effectively manage inventory using 24-hr. replenishment optimization algorithms and tools.
- Dramatically reduce headcount and fixed expenses.
- Appoint a board that truly has the long-term interest of the company at heart.
- Be the best and most responsive service provider outside of the large wholesale chains using supply chain technology again.
However, bold and significant strategy changes like these may convince the investor community that Valeant has a future.