VRX - Valeant Pharmaceuticals International Inc.

[dorsiacapital]

Since VRX is cutting out the middle man, MP mentioned margins will be 75% so much higher then Teva.

 

 

Who is the middle man exactly? Is it McKesson and the other wholesalers? Presumably, those companies actually added value to the chain or else pharmaceutical companies would have tried to cut them out a long time ago - especially if their existence was eating up 10-20% of the pharmaceutical company's margins.  Valeant will have to recreate various infrastructural operations that McKesson et. al. provided, which will add significant costs.  Valeant will also have to presumably increase its working capital significantly because it no longer has McKesson or Walgreen's purchasing the drugs in advance of the finalized sale.

 

Perhaps the middle man is the PBMs (and I suppose there is some middle in the difference between the brand name and the generic, which is where the PBMs get their profit margins) but, up until now, pharmaceutical companies were happier to take the higher sales on the brand name even at the cost of volume. And even then, I'm still not sure how PBMs are the "middle man" rather than the negotiating agent for the big-money payors (unless Valeant thinks that they can do so much volume that $75 cash pays become profitable).

 

If this is such a great deal, why hasn't anyone done it before and why did Pearson only do it when his Plan A fell apart? Do you think Pearson and Valeant were in a good negotiating position when they cut the deal with Walgreen's? Do you think their need to cut a big deal quickly may have lead them to make long term concessions that may hurt the company? 

[giofranchi]

Gio,

 

Are you still long VRX, or have you sold out [at a loss?, perhaps to tax wise offset other gains?] of this, or are you standing right now on sideline? I have gone through sixty-some pages in this topic without getting to a clear and straight conclusion.

 

Hi John,

I am no longer a shareholder of VRX.

I have sold around $105 for a 50% loss on an investment that was 15% of my firm’s portfolio. In the past I had doubled my money in VRX, therefore my experience with VRX is not so punishing as it looks like at first glance… still, to tell you the truth, it hurts a lot!!

 

I hope, though, that I have learnt some good lessons:

1) VRX has been the very first company I have owned that ended up being accused of fraud, and I really didn’t know how to react promptly. Now I know: no matter how much I like a company, if it gets accused of fraud, I will sell and wait to see what happens from the sidelines;

2) A bit more diversification helps: not much… from 5-10 companies to 10-15 companies;

3) Most of all REPUTATION: in the public markets I have finally come to realize that reputation is paramount! And from now on I’ll limit my investment universe to those companies led by managers who have been successful in building an almost unassailable reputation for themselves. Because probably they won't be accused of fraud, and should they get under attack for some other reasons, I must have the conviction to keep trusting what they do and say.

 

What I think I still don’t understand is why people seemed almost to rejoice about the fact VRX got into trouble… I will be extremely happy if Pearson proves to be honest and successful as he seemed to be just a few months ago, even if I am no longer a shareholder of VRX! I am happy when I find a great company, and disappointed when a company that looked great runs into trouble. I can only guess the opposite is true for short sellers!

 

Cheers,

 

Gio

 

[Happy]

I hope, though, that I have learnt some good lessons:

1) VRX has been the very first company I have owned that ended up being accused of fraud, and I really didn’t know how to react promptly. Now I know: no matter how much I like a company, if it gets accused of fraud, I will sell and wait to see what happens from the sidelines;

2) A bit more diversification helps: not much… from 5-10 companies to 10-15 companies;

3) Most of all REPUTATION: in the public markets I have finally come to realize that reputation is paramount! And from now on I’ll limit my investment universe to those companies led by managers who have been successful in building an almost unassailable reputation for themselves. Because probably they won't be accused of fraud, and should they get under attack for some other reasons, I must have the conviction to keep trusting what they do and say.

 

1) seems to me to ensure that you occasionally get forced to sell out of great businesses at precisely the wrong time. Once the business gets accused of fraud so that even you get scared away, you will always be looking at a big big loss from the peak.

Your solution seems to be that 3) helps you from staying away from these situations as much as possible. But from the 3 managers you mentioned in one of your last posts (Buffett, Malone, Watsa), Watsa was accused by short-sellers in the same way as Pearson and I'm sure how Malone did business with his hundreds of acquisitions, huge costcutting, many tax-motivated deals and basically taking advantage of shareholders with the structuring of the famous spin-off he must have been perceived as a highly questionable character by the media for decades and only looks great now because there was never a huge scandal. So with 1) you probably would have sold at some point out of 2 of the 3 managers that you provided as examples in which you only want to invest.

 

I'm not trying to be mean, but I like your posts and you seem to be receptive to constructive feedback.

[giofranchi]

1) seems to me to ensure that you occasionally get forced to sell out of great businesses at precisely the wrong time. Once the business gets accused of fraud so that even you get scared away, you will always be looking at a big big loss from the peak.

 

I do not think this should be exaggerated! It is the first time it has happened.

 

But from the 3 managers you mentioned in one of your last posts (Buffett, Malone, Watsa), Watsa was accused by short-sellers in the same way as Pearson and I'm sure how Malone did business with his hundreds of acquisitions, huge costcutting, many tax-motivated deals and basically taking advantage of shareholders with the structuring of the famous spin-off he must have been perceived as a highly questionable character by the media for decades and only looks great now because there was never a huge scandal. So with 1) you probably would have sold at some point out of 2 of the 3 managers that you provided as examples in which you only want to invest.

 

I agree. Except there is a huge difference from Watsa’s reputation 10-15 years ago and his reputation today. The same is true for Malone at TCI and today. The same I hope will be true for Pearson a few years from now. I guess it is a matter of track record: if a manager has already proven he/she can withstand accusations and has already proven those accusations wrong in the past, it is much easier to have confidence in what he is doing and saying.

Tell me: do you really see Malone getting accused of fraud... now? Do you see Watsa getting accused of fraud... now? Do you see MKL getting accused of fraud? Do you see GOOG getting accused of fraud? Do you see ABT getting accused of fraud? Etc.

I don't. Or at least thanks to their strong reputation the probability of such accusation is much lower. But we can never be sure, right? That’s why I think 1) and 2) will be useful to cut my losses short next time!

 

Cheers,

 

Gio

 

[Happy]

Yeah I don't really see them getting accused of fraud NOW either.

But I also had (and still have) a lot of faith in Pearson and thought that something like this was very unlikely to happen... and it still happened. And quite possibly Pearson had nothing to do with it so not doing anything wrong doesn't save you from temporarily getting accused of something.

[John Hjorth]

Hi Gio,

 

Thank you for your nice write up of your experience and perception of this investment!

[drzola]

Part of the reason I dumped my dependents shares was once Ericopoly triggered my denial bias, and yestrday I believe I was extremely lucky to rid of my larger personal position at a tad over breakeven. The same message that Gio conveyed came to me whilst discussing value investing principles with our latest prize grad student under our current nurturing care in the lab early yesterday am.

 

cheers.

[ourkid8]

Why hasn't anyone else done it?  Well, there always has to be a pioneer and hopefully this will wake-up others to look at circumventing the PBM route to reduce costs to the customer while at the same time increasing margins. 

 

http://fortune.com/2015/12/16/cvs-valeant-walgreens/?xid=yahoo_fortune

 

“This is another example of Valeant attempting to circumvent what PBMs do for payers,” Merlo told Wall Street analysts at the CVS investor day in New York. “These actions ultimately drive up costs for payers when you think about the use of prescription co-payment programs.”

 

Since VRX is cutting out the middle man, MP mentioned margins will be 75% so much higher then Teva.

 

 

Who is the middle man exactly? Is it McKesson and the other wholesalers? Presumably, those companies actually added value to the chain or else pharmaceutical companies would have tried to cut them out a long time ago - especially if their existence was eating up 10-20% of the pharmaceutical company's margins.  Valeant will have to recreate various infrastructural operations that McKesson et. al. provided, which will add significant costs.  Valeant will also have to presumably increase its working capital significantly because it no longer has McKesson or Walgreen's purchasing the drugs in advance of the finalized sale.

 

Perhaps the middle man is the PBMs (and I suppose there is some middle in the difference between the brand name and the generic, which is where the PBMs get their profit margins) but, up until now, pharmaceutical companies were happier to take the higher sales on the brand name even at the cost of volume. And even then, I'm still not sure how PBMs are the "middle man" rather than the negotiating agent for the big-money payors (unless Valeant thinks that they can do so much volume that $75 cash pays become profitable).

 

If this is such a great deal, why hasn't anyone done it before and why did Pearson only do it when his Plan A fell apart? Do you think Pearson and Valeant were in a good negotiating position when they cut the deal with Walgreen's? Do you think their need to cut a big deal quickly may have lead them to make long term concessions that may hurt the company?

[giofranchi]

But I also had (and still have) a lot of faith in Pearson and thought that something like this was very unlikely to happen... and it still happened. And quite possibly Pearson had nothing to do with it so not doing anything wrong doesn't save you from temporarily getting accused of something.

 

How do you suggest to deal with an accusation of fraud then?

We never really know with great depth the management of a public company, right? And that’s one of the differences between owning a private business and owning a fraction of a public company. Am I wrong?

Therefore, I have come to two possible solutions:

a) Invest only in those companies which have a very low probability of being accused of fraud,

b) If an accusation of fraud should be brought up anyway, I’ll cut my losses short.

Do you have any other idea?

 

Thank you,

 

Gio

 

[Picasso]

I don't think anyone here got hurt because of fraud claims. They got hurt because this was outside their circle of competence.

 

It was like the price hikes, Philidor, etc was news to the bulls.

[Happy]

I would expect you to do better over time if you analyzed each situation separately and trust in whatever your judgment tells you (obviously taking the much lower price into account). It's fine if you sell then, I just wouldn't want to sell automatically because of a threat of fraud.

I think fear of bankruptcy is something similar as the biggest fear of fraud is that the stock might go to zero as well (instead of declining a more moderate amount because of a disappointing year etc). But those situations where a stock could conceivably go to zero are the best investment opportunities when you are confident that that has at most a low probability (as it is likely to cause Mr. Market to panic). When Buffett first bought Wells Fargo people thought it could easily go under. Same for American Express. When he bought GEICO in the 70s even he saw some probability that it might not survive the next year. I'm just saying that if you can't allow for even the slightest possibility of anyone of your stocks going to zero (if you turn out to be very wrong), then the best deals are automatically off the table and even a Sell if you happen to find yourself in them.

 

I don't think there can be an easy solution for how to deal with this problem. It all depends on the individual case and your conviction. In these cases the upside and the downside are both much higher than normal so it seems more important to do the best analysis that you can and then stick to your gut.

[giofranchi]

I don't think anyone here got hurt because of fraud claims. They got hurt because this was outside their circle of competence.

 

It was like the price hikes, Philidor, etc was news to the bulls.

 

With fraud I mean most of all a management that lets shareholders believe A when instead there is B going on behind the scenes… We were told organic growth was achieved 50% trough volume and 50% through price. And Philidor was never mentioned to shareholders. That’s why I started the poll when VRX stock price was still trading well above $200.

 

Cheers,

 

Gio

 

[Liberty]

CVS on the VRX-Walreens deal:

 

http://fortune.com/2015/12/16/cvs-valeant-walgreens/

[Picasso]

If someone did enough due diligence, you would have easily found out about the stuff behind the scenes.  That's not really fraud.

 

When the Philidor news hit, those investors didn't know if it was real fraud or not. Even Ackman fell into that camp according the to a WSJ article. If you spend the time to understand the business you'll know what you're dealing with versus trusting management.  I think there are other reasons why one would not feel comfortable with this investment as well.

 

Anyway I think there is a lot more to learn here than just trying to invest with good management but that's just me.

[giofranchi]

I don't think there can be an easy solution for how to deal with this problem. It all depends on the individual case and your conviction. In these cases the upside and the downside are both much higher than normal so it seems more important to do the best analysis that you can and then stick to your gut.

 

Ok, thank you!

Although this sounds much easier to do when you are lucky / savvy enough to buy at an already very depressed price. Some people on this board have done so: some have decided to hold on their shares, others have decided to sell.

I guess it is much more difficult to do, when you have suffered all through a very steep decline in share price…

 

Cheers,

 

Gio

 

[undervalued]

I don't think there can be an easy solution for how to deal with this problem. It all depends on the individual case and your conviction. In these cases the upside and the downside are both much higher than normal so it seems more important to do the best analysis that you can and then stick to your gut.

 

Ok, thank you!

Although this sounds much easier to do when you are lucky / savvy enough to buy at an already very depressed price. Some people on this board have done so: some have decided to hold on their shares, others have decided to sell.

I guess it is much more difficult to do, when you have suffered all through a very steep decline in share price…

 

Cheers,

 

Gio

 

I bought at around 117 for 5% of portfolio.. bought more around 70ish (want to double down but don't have the conviction) so only added 10%.. sold out yesterday at 118. Even with so many smart money in the company, I just can't get past the way they do accounting. MP bonus is tied to his own cash matrix which doesn't expense any acquisition cost and he kept changing his matrix every year. If that doesn't sound fishy, I don't know what is.

[dorsiacapital]

Why hasn't anyone else done it?  Well, there always has to be a pioneer and hopefully this will wake-up others to look at circumventing the PBM route to reduce costs to the customer while at the same time increasing margins. 

 

 

I guess I'm struggling with how you can circumvent the PBM route and reduce costs to the customer and increase margins. I think you can get one to two of the three but not all three.

 

For example:

 

Right now, Glumetza is priced on GoodRx at $3,340 dollars (http://www.goodrx.com/glumetza)

Glucophage XR, which is the same basic thing of Metformin in an extended release formulation, is priced on GoodRX at between $5-50 (http://www.goodrx.com/metformin-er-glucophage-xr) 

 

Previously, Valeant gave patients coupons to waive the copay for Glumetza and then tried to obtain reimbursement from the PBM/insurance companies at some variant of the $3,340 list price.  Even if Valeant was able to only get 10% of the list price - about $340 - it's still a very profitable business even after you subtract the copay coupon price of $75.  (Glumetza generated 53 million in revenue last quarter).

 

Now, apparently, Valeant is pricing Glumetza at about the same price as the generic - let's say $35. They have to increase their volume of Glumetza by 1000% just to roughly match the amount that they would be making at a 10% reimbursement rate. (And that volume increase comes with various costs of manufacture, distribution, etc., that will eat away at margins). If Valeant was getting a 50% reimbursement rate (not inconceivable) then they would have to increase their volume of Glumetza by 5000% - and they, not McKesson, will have to bear all the costs that come with that increase in volume.

 

So yes, priced at $35, Valeant can circumvent the PBMs, because they can't argue that generic substitution should occur, and Valeant's action will be good for the consumer (and society as a whole), but it certainly won't be helpful to margins. That's why I think the $600 million in savings figure that Valeant touted in the Walgreen's deal comes primarily from their own pockets.

 

More generally, the PBMs, as far as I can tell, are the gate keeper for the real deep pockets - the insurance companies. They benefit either from encouraging competition (as in the Hep C wars) or generic substitution. The PBMs can play a little rough, but as far as I can tell, they generally benefit when they reduce costs to the system as a whole - and I like that there a private actor with an incentive to keep costs down.

 

In order to increase margins, I think you need to find a way to make the PBMs reimburse, because they're the ones who can pay the list prices that generate wonderful margins. Philidor, I think, was designed to increase margins by making it more likely that PBMs would pay list prices. (And, if you notice, the 4Q 2015 revisions has a very big hit to cash flow of 40% that far exceeds the quote of 7% revenue. And yes, I know, Valeant has explanations for why the percentage change is so much bigger than their previous percentage revenue quote for Philidor.)

 

 

[Guest Schwab711]

Why hasn't anyone else done it?  Well, there always has to be a pioneer and hopefully this will wake-up others to look at circumventing the PBM route to reduce costs to the customer while at the same time increasing margins. 

 

 

I guess I'm struggling with how you can circumvent the PBM route and reduce costs to the customer and increase margins. I think you can get one to two of the three but not all three.

 

For example:

 

Right now, Glumetza is priced on GoodRx at $3,340 dollars (http://www.goodrx.com/glumetza)

Glucophage XR, which is the same basic thing of Metformin in an extended release formulation, is priced on GoodRX at between $5-50 (http://www.goodrx.com/metformin-er-glucophage-xr) 

 

Previously, Valeant gave patients coupons to waive the copay for Glumetza and then tried to obtain reimbursement from the PBM/insurance companies at some variant of the $3,340 list price.  Even if Valeant was able to only get 10% of the list price - about $340 - it's still a very profitable business even after you subtract the copay coupon price of $75.  (Glumetza generated 53 million in revenue last quarter).

 

Now, apparently, Valeant is pricing Glumetza at about the same price as the generic - let's say $35. They have to increase their volume of Glumetza by 1000% just to roughly match the amount that they would be making at a 10% reimbursement rate. (And that volume increase comes with various costs of manufacture, distribution, etc., that will eat away at margins). If Valeant was getting a 50% reimbursement rate (not inconceivable) then they would have to increase their volume of Glumetza by 5000% - and they, not McKesson, will have to bear all the costs that come with that increase in volume.

 

So yes, priced at $35, Valeant can circumvent the PBMs, because they can't argue that generic substitution should occur, and Valeant's action will be good for the consumer (and society as a whole), but it certainly won't be helpful to margins. That's why I think the $600 million in savings figure that Valeant touted in the Walgreen's deal comes primarily from their own pockets.

 

More generally, the PBMs, as far as I can tell, are the gate keeper for the real deep pockets - the insurance companies. They benefit either from encouraging competition (as in the Hep C wars) or generic substitution. The PBMs can play a little rough, but as far as I can tell, they generally benefit when they reduce costs to the system as a whole - and I like that there a private actor with an incentive to keep costs down.

 

In order to increase margins, I think you need to find a way to make the PBMs reimburse, because they're the ones who can pay the list prices that generate wonderful margins. Philidor, I think, was designed to increase margins by making it more likely that PBMs would pay list prices. (And, if you notice, the 4Q 2015 revisions has a very big hit to cash flow of 40% that far exceeds the quote of 7% revenue. And yes, I know, Valeant has explanations for why the percentage change is so much bigger than their previous percentage revenue quote for Philidor.)

 

Bingo! I just don't understand how the get to $7b EBITDA. How are they going to increase EBITDA margins with everything but GI and US B&L struggling? Is Xifaxan really going to represent ~100% of 2016 revenue growth?

[Guest Grey512]

The FCF for next year will be below $3b. Miles below my original estimate.

I'm thinking of shorting this again.

 

[dorsiacapital]

The FCF for next year will be below $3b. Miles below my original estimate.

I'm thinking of shorting this again.

 

This. My wish for the new year is that all Valeant discussions use GAAP OCF or FCF rather than EBITDA to discuss cash generative abilities. Especially for a debt laden company like Valeant, EBITDA is a pale stand in for these metrics. 

 

On that note - Valeant expects 600 million of adjusted OCF next quarter. It also estimates about 2.25 billion in debt repayment next year. If debt repayment is basically a rough proxy for cash flow (and I think it basically is although I know others disagree) then Valeant is not particularly confident in its ability to grow cash flow much beyond what it's expecting next quarter. (I understand there may be a $500 million payment to Sprout next year, although I wonder if they'll find a way to renegotiate that.)

 

If you go back to mid October, you can find Valeant proponents talking about how Valeant could repay 4-5 billion in debt if it put its mind to it....times seem to have changed a bit.

[cmlber]

The FCF for next year will be below $3b. Miles below my original estimate.

I'm thinking of shorting this again.

 

This. My wish for the new year is that all Valeant discussions use GAAP OCF or FCF rather than EBITDA to discuss cash generative abilities. Especially for a debt laden company like Valeant, EBITDA is a pale stand in for these metrics. 

 

On that note - Valeant expects 600 million of adjusted OCF next quarter. It also estimates about 2.25 billion in debt repayment next year. If debt repayment is basically a rough proxy for cash flow (and I think it basically is although I know others disagree) then Valeant is not particularly confident in its ability to grow cash flow much beyond what it's expecting next quarter. (I understand there may be a $500 million payment to Sprout next year, although I wonder if they'll find a way to renegotiate that.)

 

If you go back to mid October, you can find Valeant proponents talking about how Valeant could repay 4-5 billion in debt if it put its mind to it....times seem to have changed a bit.

 

They said multiple times on the call that they have a cushion in their debt pay down guidance.  They'll be growing revenues 21%, that requires a good amount of working capital.  Add to that the fact that the new Walgreens deal will mean a material step up in working capital since all of Walgreens inventory will switch over from purchased to consignment.  They also said multiple times on the call that the remainder of the gap is related to one time milestone payments on previously acquired products.  They also called out $200 million in restructuring charges.  It's very easy to make reasonable assumptions based on the info we have and step that $2.5 billion up to $4 billion in real owner earnings.  In 2017, I fully expect that with no other acquisitions they will be able to pay down $4-5 billion in debt.

[jay21]

Dont they only need to pay down ~2b if they are moving to a 4x target? So that is the minimum? Still need to look into the call.

[Guest Grey512]

In 2017, I fully expect that with no other acquisitions they will be able to pay down $4-5 billion in debt.

 

OK. Let's say it's $4-5b in 2017.

Is that really worth $70b of EV and $50b of market cap, today? Given all the integrity issues?

[cmlber]

In 2017, I fully expect that with no other acquisitions they will be able to pay down $4-5 billion in debt.

 

OK. Let's say it's $4-5b in 2017.

Is that really worth $70b of EV and $50b of market cap, today? Given all the integrity issues?

 

$5b is a 13% fcf yield at todays market cap, assuming they don't grow at all in 2017.  Yes it's levered, but it's still a 9%+ yield unlevered, on a business that can be safely levered with a capital allocator that, despite recent controversy, has created significant value in a short period of time.  What's the short thesis?

 

[ScottHall]

In 2017, I fully expect that with no other acquisitions they will be able to pay down $4-5 billion in debt.

 

OK. Let's say it's $4-5b in 2017.

Is that really worth $70b of EV and $50b of market cap, today? Given all the integrity issues?

 

$5b is a 13% fcf yield at todays market cap, assuming they don't grow at all in 2017.  Yes it's levered, but it's still a 9%+ yield unlevered, on a business that can be safely levered with a capital allocator that, despite recent controversy, has created significant value in a short period of time.  What's the short thesis?

 

Martin Shkreli.