VRX - Valeant Pharmaceuticals International Inc.

[Liberty]

Picasso, what you are not mentioning is that it's possible to buy other people's R&D. If you compare VRX to P&G, you have to compare the whole strategy, not just one aspect of it. Valeant is more acquisitive, especially when it's more efficient or there's a better risk-reward ratio than developing in house. That's what a lot of these bolt-ons and licensings are -- the R&D happened, just at some other company.

 

They also have a large branded generics/OTC portfolio that doesn't required much R&D at all, so the R&D that is left is mostly spent on a smaller portion of the portfolio, not spread across it evenly (I think Pearson once said that if you adjust for it, they are spending equivalent of 6-8% on R&D, but that's from memory so I could be wrong).

 

I also believe that there's a pretty wide range of levels of effectiveness on R&D spending. I'm sure we all know lots of examples of throwing money at a problem not always being a solution, and organizations that spend less but are way more productive than others. With pharma R&D, everybody seems so focused on dollar inputs, but what really matters is outputs. I'll take 3% of R&D that delivers X rather than 10% or R&D that delivers that same X. I think the 3G-like culture helps helps there (zero-based budgetting, outsourcing to external labs that have overcapacity so lower prices, focusing the efforts on more certain things rather than longshots, etc).

 

Management recently said that they are continuing almost all of Salix's R&D efforts. It's not like they blindly slash and burn everything. When stuff makes sense financially and meets their expected returns, they'll do it.

[Picasso]

I think what I meant was a required minimum amount of R&D to keep pace with your competitor.  Investors have seemingly put the "durable" segment as separated to impact from low R&D.  You can buy someone else's R&D but you still need to keep pace with your competition afterwards for different reasons.  Can you really expect the best scientists to choose from a short list of pharmas and decide Valeant is the best option?  Will Alcon develop better products than B+L over time?  There are intangibles that won't show up immediately on the financials but can easily appear over time.

 

Also I would love an explanation on how they get to pick and choose what R&D projects to take on.  That is kind of like going to someones stock portfolio and saying "we'll sell all these stocks and keep these ones and the returns will be better than 20%."  It seems implausible to me because many other pharma companies are trying to do this to a certain extent.  And yet industry wide returns on R&D are less than 5% or thereabout.  Do we have any evidence that Pearson has an "Ajit Jain" type individual able to pick out and sort what R&D to keep and scrap?  Do we have any numbers showing how much total R&D spend versus return on invested capital yet?  I guess the rebuttal is you won't get that level of disclosure from other pharma companies either (for a good reason).  Outside of Jublia, I think you can prove the bear thesis wrong by showing the returns Valeant is able to get on their R&D versus competitors.

 

So far we haven't had to worry much about the R&D or patent cliffs because only 15% or so goes off patent and it's being offset in other ways (acquisitions, some pricing, some volume, new drugs).  But maybe that's what makes investors despise or love this stock.  You might not see any issues develop for another five years and by then the bulls are hoping to make a lot of money.  I think if these issues are addressed or tracked better, investors can better value the situation.  And it's not like VRX is aggressively buying up their stock to want to make the story opaque.  A higher stock price helps them in many ways so they should be as forthright as possible if the extraordinary claims are true.

 

And again the big thing I was pointing to with low R&D was that even a durable category requires a certain amount of spending.  Non-durables require a higher level, like the 6-8% that Pearson brings up.

[hswoon]

I say this having just read a recent Procter and Gamble annual report.  Something as simple as Tide or Pampers still require a lot of R&D spend.  If P&G isn't spending it, they'll be sitting on relatively impaired assets over time no matter what.  Is 2% as a percentage of sales really enough for Valeant?  When I adjust for divestitures at P&G they spend around 3% of sales on R&D.  I'd like to think that Valeant would require something more than P&G just because of the difference in business qualities.  P&G has the shelve space, brand, decades of marketing spend.  Doctors or patients are going to use what is the most effective drug or treatment and there isn't the kind of marketing spend/brand attached to Valeant to make people pay up for an inferior product. 

 

Maybe I'm thinking about this wrong, but that thinking has sort of left me leery with the cash EPS.  All the intangibles they amortize may very well end up as some expense so giving their cash EPS a 30% discount might not be a bad thing to do.  And I'd assume that by the time (or if) we see deterioration, the market won't like the story and you won't get a P&G multiple on that either.

 

Does anyone have any evidence on the so called 'durability' of their products? By evidence I mean more than just management powerpoints. Sorta seems like a dream scenario where you find these wonder 'durable' drugs that can continuously pay out cash even after slashing RND + Sales/Marketing, whilst still maintaining some level of organic growth. And who's gonna sell you these for cheap??

 

Another issue which is puzzling is this focus on IRRs as a measure. If your IRRs are so great why not release figures of cash returns? The troubling thing I find is that IRRs are NOT indicative of your future cash return (although it does sound like that). Just because you get a 20% IRR does not mean you get 20% CAGR on your cash.

 

Also high IRR claims can easily mask declining growth, especially if you squeeze the cash up front by aggressively cutting costs....

 

 

[Liberty]

Also I would love an explanation on how they get to pick and choose what R&D projects to take on. 

 

Just had a quick look at my notes. This is from a presentation that Pearson gave:

 

We're a very pragmatic company. We do yearly review of our portfolio, as well as when we acquire a company. We invite outside scientists - not consultants - along with management, they go through each project, how risky is it, what label will be like, what commercial opportunity will be. But only scientists are allowed to vote, not management ("I'm not a scientist, what do I know about science?"). And we don't do it with raised hands, do it through anonymous tech. Pipeline items get red, yellow, or green vote. Most yellow we continue. We also don't have a pre-determined budget for r&d pipeline. We add it all up and that's our budget, we don't manage to a percentage.

 

People look at our R&D and say, that's a small percentage. But remember, big portions of our business like OTC/branded generics don't require much R&D. We probably spend 7-8% on R&D when you adjust it. It's low for some, but not as low as some.

 

As for keeping up with the competition, the proof's in the pudding. You can look at things they've owned for years and see how the organic growth and products did, as well as get an idea from the current organic growth does and what the trend there is (ie. they accelerated organic growth at B&L significantly after acquiring it).

 

But I still think it's a mistake to look at % of R&D and use that as some kind of perfect predictive proxy for future performance, especially across businesses that aren't the same (ie. Alcon doesn't have the same portfolio makeup as VRX and so its R&D needs are different, but they might also be less efficient per dollar of R&D invested vs output, but they also might not have much of a choice if they don't have the expertise in doing effective M&A at scale (VRX's decentralized model helps a lot with that -- people forget that not everybody can just turn around and decide to be good at M&A)).

[LongHaul]

This a quote from the 2013 annual letter to shareholders.

 

"However, what really makes it all work, is the high-quality

people with strong character and ethics that work throughout the company.

J. Michael Pearson"

[Picasso]

Also I would love an explanation on how they get to pick and choose what R&D projects to take on. 

 

Just had a quick look at my notes. This is from a presentation that Pearson gave:

 

We're a very pragmatic company. We do yearly review of our portfolio, as well as when we acquire a company. We invite outside scientists - not consultants - along with management, they go through each project, how risky is it, what label will be like, what commercial opportunity will be. But only scientists are allowed to vote, not management ("I'm not a scientist, what do I know about science?"). And we don't do it with raised hands, do it through anonymous tech. Pipeline items get red, yellow, or green vote. Most yellow we continue. We also don't have a pre-determined budget for r&d pipeline. We add it all up and that's our budget, we don't manage to a percentage.

 

People look at our R&D and say, that's a small percentage. But remember, big portions of our business like OTC/branded generics don't require much R&D. We probably spend 7-8% on R&D when you adjust it. It's low for some, but not as low as some.

 

As for keeping up with the competition, the proof's in the pudding. You can look at things they've owned for years and see how the organic growth and products did, as well as get an idea from the current organic growth does and what the trend there is (ie. they accelerated organic growth at B&L significantly after acquiring it).

 

But I still think it's a mistake to look at % of R&D and use that as some kind of perfect predictive proxy for future performance, especially across businesses that aren't the same (ie. Alcon doesn't have the same portfolio makeup as VRX and so its R&D needs are different, but they might also be less efficient per dollar of R&D invested vs output, but they also might not have much of a choice if they don't have the expertise in doing effective M&A at scale (VRX's decentralized model helps a lot with that -- people forget that not everybody can just turn around and decide to be good at M&A)).

 

When investors expect this to trade at 18-20 years worth of 2015/2016 profits plus another 4-5 turns of debt on EBITDA, I think you have to look very carefully at the lifetime cash flows.  Part of the 20% IRR targets involves some upfront improvement in the business they acquire.  In the case of B+L, it has only been two years since the deal closed so I have a hard time taking a ruler out 18-20 years.  If the proof is in the pudding, why don't they breakdown organic growth across every core acquisition over time?  I think we know the answer for this, it wouldn't look that great for deals pre-2013.  They do it for the recent performing acquisitions but everything else gets muddled together in ways that are difficult to judge long-term performance.  Valeant seems very good at pointing out the positives which I sometimes take as misdirection.

 

But then investors can easily point to the large acquisitions and say that's what matters the most anyway.  Sort of a fake it til you make it type thing.  At this point as long as Salix and B+L continues to deliver then I can see investors ignore the potential long-term effects of the strategy.  Or some other large acquisition with great potential. 

 

I also can't imagine the stress their employees must be under to meet their targets.  I think at a certain point you start creating incentives for people to make up numbers and lie about things because the pressure is so great.  There's a reason why they try and say their employees are ethical. 

 

The company is worth $100 billion today.  I have to ask myself if I had $100 billion whether I would go and buy up all the shares of VRX.  What is that likely to be worth in the future?  You really have to assume this is the next Berkshire Hathaway, because given the kind of return targets they mention with the market seemingly willing to pay 18x for it, it is going to rival Berkshire Hathaway in size. 

 

I think Ackman mentioned that Charlie Munger didn't really know a lot about VRX when he made his negative comments.  But I think Munger has read and seen so much over the years that he picks up on the unusual claims for why "this time is different."  He might not be right about VRX but I think his inclination is the result of having been there, done that.  So I think anyone investing in this company (especially all these 20%+ holdings at stellar fund managers) should have Munger's voice in the back of their heads at all times.  I'm fairly certain if Ackman explained the Valeant strategy to Berkshire, Buffett and Munger would laugh him out of the room.  It's a bit different when 3G does it with beer, ketchup, and burgers.  Doing it with pharma is a whole different ball game and a couple years of results doesn't make me a complete believer.

[Aberhound]

Although the terms of TPP and the other two misnamed trade agreements are secret they are expected to include rules to deter governments from intervening in the drug market by price fixing or perhaps rules preferring generics like BC uses and maybe even approved lists like BC also uses to exclude high cost drugs. A new arbitrator will enable drug companies to sue governments for such so called misconduct and then someone else pays, ie the taxpayer. As soon as TPP passes drug companies negotiating power improves so we will likely see massive drug price increases similar to how health insurance premiums skyrocketed after Obamacare passed.

 

Is anyone buying the dip based on TPP and it's effect on drug pricing? Right now drug prices are highest in US while afterwards we might expect all signatory countries to have drug prices much closer to the US adjusted for differences in wealth. Maybe the world post TPP increases the value of all pharmaceutical companies so the strategy of paying pre-TPP prices should work out well.

[Liberty]

You can't break out organic growth indefinitely because acquired businesses get integrated into the overall business, parts get divested, bolt-ons are added, etc. At some point the numbers become meaningless when compared to the original thing anyway (though they've broken down performance for all major acquisitions a few times for what that's worth). This is not a conglomerate that keeps businesses as is.

 

VRX market cap is 68bn, not 100bn (never was, at least not in USD).

 

Whether you believe in the durability of a big part of the portfolio or not is part of the analysis. You can look at the reasons they give for why they think it's durable and look at past performance and decide if that makes sense to you or not. But don't just assume that what they have is the same as just any random pharma out there, because the company was built from the ground up with a different strategy than most pharmas out there.

 

You are looking at depressed Salix performance right now because of the inventory issues. If you look at normalized performance, the multiple is much lower (they guided to a "conservative 7.5bn EBITDA" next year). I'd be surprised if cash EPS wasn't at least $18-19 in 2 years, and that doesn't take into account a big merger, which might be done on a friendly basis this time and be a deleveraging event (speaking of which, just with organic growth and Salix normalizing, the debt should go under 4X very rapidly in the next year).

 

But anyway, what you say has been said before, and what I'm saying has been said before, so better leave it here.

[Picasso]

In terms of the value of the company, I'm including the value of the debt. I don't think you can assume that the debt isn't part of the value when looking for a margin of safety. Whether you like it or not, that debt has to be paid back one day.

 

I think this is the biggest problem with these new growth at a good price stocks. It's almost impossible to get a traditional margin of safety. You rely on future cash flows that may or may not become impaired. The search for the next Outsider has pushed the limits on what an investor considers a reasonable risk/reward.

 

At this point we probably are talking circles which have been discussed before. I'm still not completely sold on the cash EPS or margin of safety. I'm more comfortable with some aspects of the bear argument but there are others I have a hard time handicapping.

[Liberty]

That's fine, everyone has a different approach. Only do what you're comfortable with.

[giofranchi]

Imo to compare what NVS or PG are spending in R&D with what VRX is spending offers little useful information.

Yesterday I was talking to a top-manager in a large international software company: he oversees the work of nearly 80 people, and he was complaining that he could be achieving the same results with his best 20 people...

And I guess this gets ever more meaningful as companies get larger and larger...

Therefore, it is much more important "how" you spend money than "how much" money you spend. And imo at the helm of neither NVS nor PG there is a person who could compare with Pearson.

This at least is the reason I am invested in VRX... Of course, I might be wrong!

 

Cheers,

 

Gio

[ccplz]

 

Therefore, it is much more important "how" you spend money than "how much" money you spend. And imo at the helm of neither NVS nor PG there is a person who could compare with Pearson.

 

 

Agreed with your first statement, but I guess the important thing is whether or not the second statement is true right?

 

I admit I am not a best judge of character, but Pearson doesn't seem like the most trustworthy character out there. If an investment thesis depends entirely on the character of one person, and that person is Pearson, the risk-reward just doesn't seem there. Of course I could be wrong, but why would anyone take the risk?

 

Munger and Buffett on spotting crooked management:

 

"Bernie Ebbers and Ken Lay were caricatures – they were easy to spot. They were almost psychopaths. But it’s much harder to spot problems at companies like Royal Dutch Shell.

 

[Throwing up his hands] Charlie and I would not have spotted the problems at Royal Dutch.

 

But we don’t learn because I’d still expect that Exxon’s figures are fair.

 

In the late 1990s, one business leader after another was cutting corners. They sink faster to a lower prevailing morality than rise to a higher prevailing morality, but they still generally follow the crowd.

 

[CM: I want to make an apology. Last night, referring to some of our modern business tycoons – specifically, Armand Hammer – I said that when they’re talking, they’re lying, and when they’re quiet, they’re stealing. This wasn’t my witticism; it was used [long ago] to describe the robber barons."

 

[giofranchi]

the risk-reward just doesn't seem there.

 

The reward:

As I have said, I believe this century is the century of biology and biotechnology. Pharma companies are making so much money, and are going to make even more. Waste can be easily afforded and is widespread. Just think what could be accomplished by an operator laser focused on ROIC, who operates in this sector and is great at what he/she is doing!

 

The risk:

Sometimes what Buffett and Munger say simply cannot be reconciled with what they are doing… They buy and truly NEVER sell… And they justly praise their managers as “all-stars”… Can you imagine a strategy that relies more on the quality and the reliability of management than theirs? Sincerely, I cannot.

When you invest in a business, you invest in people. Better accept it, because that’s a risk we all are going to run, whether we like it or not.

 

Cheers,

 

Gio

 

[giofranchi]

Letter to Valeant employees dated September 28, 2015

 

Cheers,

 

Gio

Letter_to_Valeant_employees_dated_September_28_2015.pdf

[mateo999]

Letter to Valeant employees dated September 28, 2015

 

Cheers,

 

Gio

 

I generally view a CEO defending his company's stock price as a kiss of death.  He's doing it out of desperation- he needs the market to believe.  And HY markets aren't going to be as comfortable lending to fuel M&A given VRX's business plan is now the political topic du jour.  Thank goodness- the mexico wall topic was annoying me.

[giofranchi]

I generally view a CEO defending his company's stock price as a kiss of death. 

 

Maybe... But I would never generalize… A 20%+ drop in 5 days is something extremely unusual… A comment might be justifiable… I don’t know… Anyway, I prefer to concentrate on the content of Pearson’s letter.

 

Cheers,

 

Gio

 

[tombgrt]

I generally view a CEO defending his company's stock price as a kiss of death. 

 

Maybe... But I would never generalize… A 20%+ drop in 5 days is something extremely unusual… A comment might be justifiable… I don’t know… Anyway, I prefer to concentrate on the content of Pearson’s letter.

 

Cheers,

 

Gio

 

 

No it's not, it just seems that way in bull markets.

[Liberty]

Letter to Valeant employees dated September 28, 2015

 

Cheers,

 

Gio

 

I generally view a CEO defending his company's stock price as a kiss of death.  He's doing it out of desperation- he needs the market to believe.  And HY markets aren't going to be as comfortable lending to fuel M&A given VRX's business plan is now the political topic du jour.  Thank goodness- the mexico wall topic was annoying me.

 

I saw it more as learning from the AGN media sh*tstorm (and many of the false accusations sticking to this day) and trying to get in front of the Hillary/price increases media cycle that tries to lump them with other very different companies by basically giving the facts about government reimbursement risk being low, price increases being a small part of the strategy, and organic growth being strong. The two things he addresses specially in the letter have to do with that news cycle; I'm sure he was getting questions about them because of the drop in share price, because that's how investors think ("the price dropped, you guys must be in trouble, right?"), but I think he's mostly trying to avoid having some new label (like the "doesn't believe in R&D") attached to the company forever...

 

The business is performing very well at this time and they are issuing relatively little equity for acquisitions, so I don't think a low stock price hurts them (a year ago it was much lower and that wasn't a problem).

[Picasso]

I'm sort of amazed by how investment savvy Pearson is.  He uses phrases like "bear thesis" that make me think he pays a ton of attention to the stock price and blog posts. 

 

This is a guy who is 100% motivated to get the stock price to go up.  That's probably what draws me to the stock, but figuring out the margin of safety is so hard for me to justify.  Ugh....

 

The market is a funny thing.  It doesn't care about something until it does, and it cares about something until it doesn't. 

 

By the way, it wouldn't surprise me if Ackman pushed Pearson to put out that letter.  It had a lot of Ackman style to it.

[Liberty]

I'm sort of amazed by how investment savvy Pearson is.  He uses phrases like "bear thesis" that make me think he pays a ton of attention to the stock price and blog posts. 

 

This is a guy who is 100% motivated to get the stock price to go up.  That's probably what draws me to the stock, but figuring out the margin of safety is so hard for me to justify.  Ugh....

 

The market is a funny thing.  It doesn't care about something until it does, and it cares about something until it doesn't. 

 

By the way, it wouldn't surprise me if Ackman pushed Pearson to put out that letter.  It had a lot of Ackman style to it.

 

He said "bear thesis" so you think he pays a lot of attention to blog posts and the stock price? That's pretty thin evidence. It's probably just how he talks, and he didn't filter the letter through 15 layers of PR people and lawyers to turn it into the blandest of legalese...

 

Have you ever actually listened to Pearson speak about the business? That's a good one:

 

https://www.dropbox.com/s/v903zgq32qnq7ki/VRX-presentation-sd4782fa%20-%20Copy.mp3?dl=0

 

The guy cut his salary to $1/year, owns over a billion of VRX stock that he can't sell until years after he retires. He's basically perfectly aligned with long-term shareholders.

 

A big part of his strategy is based on doing things that will look bad in the short term, but will create value in the long term (like buying businesses with hair on them, like Salix or Dendreon, buying tail products that nobody else wants, cutting low-ROI R&D, taking big restructuring charges that kill earnings but will save tons of money over time, etc). He almost had never done interviews until he tried to buy AGN, and when he does he's usually unpolished and looks like he doesn't want to be there. Opposite of the slick stock-promoter.

 

I think what probably happened is he was in his office and constantly got calls from panicking investors asking about how "Hillary's going to kill your business" and "what will you do if you can't do those massive price increases anymore?", and he was counting the days until some WSJ or NYT journalist riding the current wave of attention for this topic did a piece on Valeant (with quotes by Pyott and Melnyk, probably), or some populist politicians on the election trail targeted that "tax inverted foreign company that raised prices on drugs X, Y, and Z", and they they'd be stuck with that label forever, because soundbytes trump facts.

 

But since the facts are that they are only a little exposed to government reimbursement issues, that price increases are only important to a small and declining part of their business, and that organic growth is very strong, well, why not put the facts out there clearly before someone else picks the narrative.

 

One reason why they might want to protect the stock price at this point is that they could be far along in talks with a very big acquisition or merger target, and that would require a significant equity component... But we can't know that for sure.

[giofranchi]

Novartis AG (NVS) and Google (GOOG)’s Life Sciences to Test Smart Contact Lens in People in 2016

 

http://www.biospace.com/News/novartis-ag-and-googles-life-sciences-to-test/390300?source=sm&type=twitter_NovartisGoogleContacts090815

 

Cheers,

 

Gio

[giofranchi]

But since the facts are that they are only a little exposed to government reimbursement issues, that price increases are only important to a small and declining part of their business, and that organic growth is very strong, well, why not put the facts out there clearly before someone else picks the narrative.

 

When I said I would stick with the content of Pearson’s letter, that is what I had in mind.

 

Cheers,

 

Gio

 

[Picasso]

I think having over a billion dollars in the stock, referencing a bear thesis, and putting out this letter "to employees" classifies as caring very much about the stock price.  Other pharma stocks are getting hit in similar ways, is ENDP or AGN also putting out these letters?  Nope.  Also the acquisitive nature of the company (which admitted so far has been careful with stock issuance) makes him want the stock to go up.

 

I'm not saying he's a slick stock promoter, I kind of like that he understands the market.  It's refreshing in a way since some other stocks I follow have terrible capital allocators who don't understand the market well. 

 

I don't take the letter as a positive/negative other than his comments about continued levels of organic growth rates which ties into previous guidance.  For me it mostly highlights his motivation to make sure the stock performs well.

[Liberty]

I think having over a billion dollars in the stock, referencing a bear thesis, and putting out this letter "to employees" classifies as caring very much about the stock price.  Other pharma stocks are getting hit in similar ways, is ENDP or AGN also putting out these letters?  Nope.  Also the acquisitive nature of the company (which admitted so far has been careful with stock issuance) makes him want the stock to go up.

 

I'm not saying he's a slick stock promoter, I kind of like that he understands the market.  It's refreshing in a way since some other stocks I follow have terrible capital allocators who don't understand the market well. 

 

I don't take the letter as a positive/negative other than his comments about continued levels of organic growth rates which ties into previous guidance.  For me it mostly highlights his motivation to make sure the stock performs well.

 

Do you agree that the current news cycle (Hillary, price increases) could in itself be reason enough to put a letter out to try to correct some misconceptions?

[Picasso]

Do you agree that the current news cycle (Hillary, price increases) could in itself be reason enough to put a letter out to try to correct some misconceptions?

 

Sure.  Everything Pearson mentioned in that letter has been disseminated by the company before.  If he is getting a ton of calls from investors and the media then yes I agree he has a reason to get in front of it.  It probably also tells a savvy investor that the market is still not efficiently informed about the fundamentals of this company.  If you think the fundamentals are sound, you should be happy to hear that a ton of people are harassing Pearson over misinformation.  It would imply a long runway ahead of it.

 

I thought most of this stock price reaction stems from how badly VRX screens for investors.  A high P/E multiple when investors are looking to sell/short over valued biotech stocks, a ton of debt, and most investors couldn't name off 3 of their top products.  I don't completely agree that some tweet removed 20%+ of value from this large cap stock other than people needed a reason to sell.  The stock is still up 40% YTD for pete's sake.