Specialty Drug Industry, the Alchemy of Finance?

[WhoIsWarren]

Certainly, the specialty drug sector is in vogue. 

 

And the 'roll up' trail-blazers Valeant and Endo Health Solutions are keenly followed by a number of people on this board.  So I think this article, by a seasoned healthcare analyst, urging a healthy level of investor skepticism, should be of interest.

 

Feedback welcome.

 

http://www.valueinstitute.org/viewarticle.asp?idIssue=1&idStory=134

 

"It seems that acquisitions are ‘in' these days, nowhere more so than in the specialty drug sector. With each deal, excited investors and analysts salivate at the prospect of the next. Mr. Market approves unequivocally, but we advise caution."

[ScottHall]

Decent article, but it focused too much on generalities for my taste without going deep enough in the specifics for the industry or the companies in it. Still worthwhile, just not one of my favorites.

 

I think one of the biggest troubles Valeant bears have is not understanding that their acquisition spending essentially is their "organic" (though obviously not in the literal definition of the term) growth, which is understandable on account of Valeant strips the associated expenses away when reporting adjusted EPS.

 

I would ignore Valeant's reported organic growth rates since they strip out a lot of stuff, so I would probably assume some runoff over time as has been the case recently.

 

You'd have to make some adjustments to Valeant's adjustments in order to get an idea of what the "maintenance" vs. "growth" portion of those acquisitions is, and use that to also get some idea of how much of the acquisition "restructuring" expenses will be required essentially indefinitely, if you accept my previous statement to be true. I would suggest that Valeant's "cash EPS" on the basis of my suggested adjustments above probably isn't quite as high as Valeant says it is.

 

That's just how I'd approach the situation with my process, if I was valuing Valeant and trying to get a better understanding of the business model. I think the idea makes a lot of sense intuitively and they obviously have some pretty bright people on board, but of course only time will tell how sustainable the model is.

 

If you put a gun to my head right now I'd say they'll probably do well over time (I liked the stock a lot about $50 ago, though never bought it for professional reasons), but I can definitely understand where the skeptics are coming from, having read Billion Dollar Lessons.

 

Just my back-of-the-envelope thoughts...

[Liberty]

Thanks for posting, WhoIsWarren. It does indeed raise many of the questions that have been raised here in the VRX thread, though I don't think it really answers them or provide a smoking gun.

 

About rising interest rates and the impact on acquisitions; I'd be curious to look at other businesses that have been successful at building value via acquisitions, and what they did when interest rates were higher (teledyne? capital cities?). I'm not sure exactly sure how their tactics changed (just lower leverage, higher hurdle rate, more equity raised?), but it seems like it didn't affect their overall strategy too much.

 

I think smart management should be able to adapt. The question is more, are you sure management is as smart as you think? When they come out with stats like "70% of acquisitions destroy value",  it reminds me of when people talk about overall market valuations. It's interesting, but if you're not buying an index, it might not tell you too much about the specific businesses you're looking at. Likewise, that 70% figure for the whole market doesn't matter if you invest in a specific business that can create value via acquisitions 75% of the time or whatever.

[Makisig]

Hello ScottHall,

 

First an admission: I actually wrote this article for the Value Institute.  Also thank you for your comments – I love to get feedback.  Yes, this article does not get into the specifics of the industry/companies.  I can absolutely understand that this is not what you are looking for.  It was designed to discuss the generalities of the phenomenon in question.  Getting into the detail is something that we sometimes do (for example we recently wrote in detail about the dental implant business).  We find that many readers actually prefer a broad summary of the issues unless they have a keen personal interest in the topic at hand.

 

Also, whilst I have a good grasp of the salient features of the industry, I admit that I haven’t done detailed work on the companies mentioned.  This is because I know, after initial analysis, that these companies are not of interest to me on the long or short side.  This is why I am not making any definitive statements about the companies in question.  I am also intrigued to see some very smart money on the long side (e.g. Valeant: Ruanne Cunniff, Brave Warrior).  However I am also intrigued and even stunned at the dramatic change in sentiment and strategy in this sector and, for choice, I see some warning signs that I don’t really hear many others talking about. In this sense, think of the article as an overview of reasons to think a little about what might go wrong here.

 

In regards to your comments about how to think about the structure of earnings (maintenance and growth component), I agree.  The problem is, I believe, that this is beyond analysis – I don’t believe this can be done with any degree of accuracy as there are simply too many unknowns in the analysis (too many markets, too many deals, too much restructuring, too many ‘adjusted’ numbers), but conceptually this is exactly the way to think about the issue at hand.  By extension, another problem is that people seem to be valuing these stocks by applying a multiple to the adjusted earnings/cash flows.  It is my belief that these earnings probably do not incorporate the cost of replenishing the capital stock (though, as alluded to, I don’t think this number can be quantified) – so while many of these deals might add value on a IRR basis, perpetual valuation tools like PEs are probably not suitable here.

 

In relation to the comments from Liberty, I don’t think there is a smoking gun (no reason to assume any fraud or any cataclysmic collapse of the strategy).  I also fully accept that there may be managers with acquisition skills comparable to Buffett or Stiritz but how will you know in advance?  In general, most acquirers won’t possess the skills required to add value through acquisitions – the investor must be very confident that he has the skills to spot the Buffett from the “Bluff-it” (and most will fail in this respect). 

 

Thanks again to you both for your comments.

 

Makisig

[Makisig]

Fever still rising in specialty drug sector.  Mylan +10% today as it says it it "poised" for a substantial transaction this year.  Before today the stock was already +70% in the prior 12 months.  I have been managing money professionally for 16 years and I have never seen anything like this before.

 

http://www.theflyonthewall.com/permalinks/entry.php/MYL;ACT;FRX;TEVA;LCIid1971033/MYL;ACT;FRX;TEVA;LCI-Mylan-soars-to-week-high-after-saying-poised-for-transaction

 

 

[Liberty]

Thanks for the additional details, Makisig. I appreciate it.

[Liberty]

More about biotech, but interesting:

 

http://compoundingmyinterests.com/compounding-the-blog/2014/2/21/biotech-popping-the-allegations-of-a-bubble.html

[Makisig]

Please see above an article that was sent to me.  Written by Mckinsey, it tries to explain why pharma megamergers add value.  In substance, many of the relevant issues also relate to the specialty drug group, discussed in the article at the top.  Both articles disagree but I think are well worth a read for anyone interested in the m&a splurge in the specialty drug sector.  I am always trying to keep an open mind and use these posts to stimulate debate so that those interested (including me) can learn.

 

As those who have read the valueinstitute article will appreciate, I have a generally negative disposition on these strategies at this point (given how much the stocks have run).  After reading the Mckinsey article, my negativity has moderated a little but I still remain concerned for the following reasons:

 

1. The data is arguably insufficient and I don't think it is fair to measure success/failure over a 2 year period (we need a longer period, maybe 10-15 years).  Also there are only 17 deals examined so caution is warranted on reading too much into the conclusions.

 

2.  "ROIC" excludes Goodwill - I presume on the denominator.  Well, it is very easy to add value if you ignore much of the acquisition cost!!!

 

3.  Economic profit rises significantly two years after consolidation deals.  But this will fall after 5-10 years if r&d/replacement spending is insufficient and Mckinsey provides no window into this.  This is something I am concerned may be happening at Valeant, Actavis, Endo.

 

4. The data produces somewhat  inconsistent results (though this is "real life" so this should not surprise us).  "Consolidations" seem to add the most value (leaner cost base, etc.), yet we then read this:

"... (TRS): for consolidation deals, excess returns are positive three years after the merger but turn negative after five years; for growth-platform deals, TRS is consistently positive through the five-year mark."

 

I would argue most of the specialty drug deals recently seen are "consolidations" (very cost-synergy-heavy).

 

5. The median excess TSR for acquirers two years after the deal is just 5%.  Yet the specialty drug stocks are generally +100% in the past 12 months as more deals are anticipated.  Maybe this has run too far?

 

6.  Luckily throughout the period under examination (1995-2011) interest rates kept falling.  Surely there is a higher chance of rising interest rates of the next 15 years?

 

Not trying to rain on anyone's parade here.  I have no long/short interest here - just a fascinated sideline observer, and a natural, though certainly not always correct, sceptic.

 

Makisig

[Makisig]

Apologies, here is the link I mentioned:

 

http://www.mckinsey.com/insights/health_systems_and_services/why_pharma_megamergers_work

[Liberty]

Thanks Makisig, that's very interesting.

 

One thing I would add, though, is that to me this is a bit like talking about general market valuation. It's useful if you're going to invest in an index, but if you're going to invest in a single company, it probably doesn't tell the whole story.

 

I think Valeant is very interesting. If all they did differently from others was make more acquisitions, then I'd be worried. But what interests me is a combination of how management thinks and operates and the business model as a whole, of which acquisitions are only a part (an important one, though).

 

In other words, I think they have a good chance of success because they do many things differently (and better) from most of their peers. I could be wrong, though. I have been in the past  :)

[Makisig]

Liberty, you make a good point on Valeant, which I acknowledge I don't know extremely well.  Thanks.

 

Makisig