You probably haven’t heard of Valeant but you should, because it’s important. It’s a great example of how one person can really make a difference.
In this case an ex-McKinsey guy called Michael Pearson totally messed up the global pharmaceutical industry.
Mr Pearson became CEO of Valeant a few years ago. After careful analysis he figured that medical research was a waste of money. So he cancelled all programs and decided on a strategy of mergers and acquisitions instead.
As he must well have known, acquisitions almost invariably destroy economic value. They go ahead due to the incredible ’strategic’ advantages they have for the decision makers – the CEOs that run the company. Dealmaking is fantastic for executives but almost always horrible for shareholders and often enough for society at large.
As an example of how consistent this is, 90% of the deals made by major mining companies since 2007 have been written down to zero.*
Tens of thousands of mining executives, bankers and advisers have spent the past 8 years burning capital. If they did the opposite of what their thinking told them, they would have done better. Their entire approach was flawed, all their work was a waste of time, and they’ve demonstrated a total lack of understanding of their business.
Almost without exception.
If you were a mining executive or banker since 2007 you should have stayed in bed.
If only Michael Pearson made his mistakes in mining rather than Corporate Chemistry.
His strategy was to buy any pharmaceutical company he could get his hands on. He then immediately jacked the prices of the drugs as high as he could, while gutting research expenditure to as close to zero as possible. Thousands of highly skilled jobs were destroyed and fruitful avenues of inquiry abandoned because of his work.
To see why this is so appealing to the likes of Pearson, consider that if you cut $100 million of R&D costs it’s $100 million of earnings, which means you get it every year. This has a value of anywhere to $1 billion to $2 billion, or in the ridiculous valuation mathematics that still applies to Valeant, much, much more than that.
You can use this extra value in the debt or equity markets to buy another company, rinse, and repeat.**
When you gut a research lab all the institutional memory disappears. The equipment is sold at liquidation prices and the teams disbanded. It’s an entropy thing.. a house that took a year to build can burn to ash in under an hour. The same principle applies to labs full of bespectacled researchers, only we’re all depending on these labs to treat the diseases that will kill us.
There’s an argument that the presence of a player willing to pay top dollar for new drugs encourages that development and helps fund start-ups by giving them a clear exit route. I’m somewhat open to this view. Most drug development occurs in the US precisely because they’ve let a million business models flourish, creating a market large enough to literally pull these miracle treatments out of thin air.
I would take the US Facebook, Amazon, Google or Apple over any tech company Europe has produced over the same period, and Europe has more than twice as many people. Just because something emetic like Valeant turns up every now and then doesn’t mean that it should be killed because on the surface it seems to be up to no good.
In line with this thinking, Forbes argued that spending $16 billion on research or buying a research company for $16 billion is exactly the same.
Umm, no. They are completely different. Valeant is a truly repulsive beast that needs to be put down.
The cuts that justify the deals (‘synergies’) invariably involve the destruction of real networks, business links, knowledge and whatever that invisible stuff is that actually makes up a firm.
This kind of strategy needs an ever higher multiple on your shares and an endless supply of new prey.
The impact of this kind of strategy is far broader than it seems at first. Once one company starts this game all the others either follow suit or are bought themselves by that very company kicked things off.
The simple presence of a player like Valeant caused the entire US pharmaceutical sector to boot valuable researchers onto the streets, where they are unable to help you, me and our families beat the incurable cancers, heart conditions and other diseases that will kill us.
A notorious example of Valeant’s broader impact is that Martin Shkreli twat who cottoned on to Valeant’s idea that you could buy drugs, jack up their prices, then claim with a straight face that this was all a good thing. Fortunately he’s about to get his own punishment.
I’m also particularly irritated by Martin Shkreli as his interests (hedge funds and chemistry) overlap with mine, but that’s another story.***
Anyway Valeant gets worse. Aside from some of the most blatant tax structuring on the planet (it pays an effective tax rate of something like 3%) Valeant has been screwing pharmacies and insurance companies by manipulating them into buying their own overpriced and less effective drugs instead of cheap generics.
This looks illegal and mildly fraudulent, but probably not Enron-like.
From an investment perspective, however, the good news is that Michael Pearson will probably still lose the cheeky billion or so he paid himself recently.
The company’s market cap is $40 billion, with debt of $30 billion, for a total business value of $70 billion (excuse the rounding).
Valeant’s revenue is $10 billion – earnings are $0.6 billion and they’re now going to have to reduce the price gouging on their drugs. Due to the fall in share price and loss of confidence, the equity and debt capital markets will be closed to them. They will not achieve the growth required to justify a 7x sales multiple. M&A is now impossible.
Did I mention their research pipeline is empty?
I hate getting into anything late. Much better to build positions early and slowly in which case you invariably put in some capital at the top (or bottom when buying). This might be an exception.
My favourite part of this story is that Bill Ackman, one of my least favourite hedge fund managers, has around a third of his fund invested in this monster.
A couple of years ago Bill tried to get a company called Herbalife nailed for fraud and was proven conclusively wrong, after extensive and damaging investigations, after he spent a small fortune blown on private investigators and the like.
More recently he made a pile of coin by finding a way to legally insider trade.
He teamed up with Valeant and bought a huge stake in a company Valeant was about to bid for before the news became public. If a banker did this he would be jailed for years, but Ackman found a way and was the toast of the financial town.
In summary, if ever someone deserved to get burned in the markets, it’s this investor, on this stock, with this CEO. Both of these men are about to get Valeantly f*cked.
*To be clear, this isn’t 90% of mergers and acquisitions that made less than they hoped or destroyed ‘economic value’, it’s 90% of the total purchase price paid that subsequently vanished.
In these M&A roll-ups nothing of value is actually created. No matter where or over what time period you look at, M&A is a loss-making proposition.
**Ofcourse you need a high earnings multiple to make this work, and if there’s one carnivore doing this all the target companies tend to rise in price themselves.. which is all you need to know to realise this kind of strategy could never run forever.
There was an entire boom and bust in the 60s based on this kind of thing.
***At least I feel like less of a mercenary!
ps I think I went easy on these guys. According to the excellent work done by John Hempton of Bronte fame, Valeant sells vitamin A cream for $400 a tube. They sell another drug for $400 that’s available for ~$10. They sell a treatment for athlete’s foot with 20% success rate for $8,000 – a better one costs maybe $20. And it looks like they’ve done it by buying pharmacies, sending the drugs to people and getting insurance companies to pay the bill.
pss I trade this stock (advise you don’t) and change my mind all the time