Revisiting Valeant Pharmaceuticals
Three years ago I wrote about Valeant Pharmaceuticals International, Inc. (VRX) and why I believed it was an attractive investment opportunity. There were several things I liked about Valeant, including a focus on attractive market segments, a disciplined approach to capital allocation, and an efficient tax structure. But over the past 18 months the business deteriorated quickly as mistakes in one area of the company spilled over to others and led to a negative feedback loop that was magnified by the heavy use of debt. In this piece, I attempt to summarize what happened and the lessons I learned.
In February 2015, Valeant acquired several products from Marathon Pharmaceuticals including two cardiovascular drugs, Isuprel and Nitropress. These products are used by hospitals and had neither patent protection nor generic competition. Believing the drugs to be underpriced relative to the value they offered, Valeant raised the prices of these life-saving drugs by several hundred percent. The price increases put severe pressure on many hospitals’ budgets and sparked outrage among these hospitals, Congress, and the general public. While the effect of this outrage did not have an immediate impact on the business, the price increases later helped reinforce the public perception that Valeant was a bad actor in the health care system.
Later in 2015, it became known that Valeant was using a specialty pharmacy, Philidor, to fill prescriptions for its dermatology products. Philidor was quite aggressive in its role, allegedly gaming the system to garner higher reimbursement rates, refilling prescriptions without a patient’s request, and altering prescriptions to fulfill them with more expensive Valeant products instead of generics. It’s unclear if Valeant was involved or knew how Philidor was being managed; regardless, it angered both doctors and payers. Doctors started to write fewer prescriptions for Valeant products and payers used their newfound negotiating leverage to extract lower prices from Valeant. Valeant’s dermatology revenue would go on to decline nearly 50% in 2016, and its actions drew congressional investigations and government subpoenas regarding Philidor and the company’s pricing practices. The company’s board of directors also created an ad hoc committee to review Philidor. The review took a substantial amount of time and delayed the filing of the company’s 2015 Form 10-K, causing a technical default on its debt. To cure the default, the company had to negotiate expensive waivers with its creditors which put additional pressure on cash flow. Finally, the controversy caused Valeant to cancel planned 2016 price increases across its businesses, not just dermatology.
Once Valeant ceased doing business with Philidor in October 2015, it had to find another way to distribute its dermatology products. Management quickly formed a partnership with Walgreens, whereby Valeant would bypass drug distributors and ship its products directly to Walgreens. After the rollout, Valeant noted an unforeseen need to make the arrangement acceptable to payers, presumably meaning a need for additional compensation. For distributors and other retailers, some combination of confusion and anger caused them to reduce the inventory of Valeant products they held, causing an additional short-term impact on Valeant’s financial results. This was not only for dermatology products, but it also spilled over to other businesses like Salix, Valeant’s gastroenterology business. In addition to the de-stocking of Valeant’s largest product, Xifaxan for irritable bowel syndrome, management also realized patient access for Xifaxan wasn’t as broad as needed to continue to drive growth. In exchange for better formulary positioning, payers were able to extract additional rebates on the product but subsequent volume improvement has been modest. At this point, two of Valeant’s larger franchises were unexpectedly weaker and the company did not have the ability to raise prices in other areas to compensate as it had done historically. Repaying the significant amount of debt the company accumulated had become considerably harder.
Much has been made of Valeant’s “$30 billion of debt,” but the absolute amount of debt is less important than the amount of debt relative to cash flow. The chart below shows the change in management’s 2016 EBITDA guidance from October 2015 to late 2016, highlighting the magnitude of the decline in the business’ fundamentals. When management expected EBITDA — an admittedly crude measure of cash flow — to be $7.5 billion in 2016, Valeant’s leverage ratio was 4.0x ($30 billion ÷ $7.5 billion). Assuming the company could generate cash to pay down debt and reduce leverage, this was not an overly concerning number. But as 2016 progressed and the business deteriorated, leverage ballooned to nearly 7.0x as EBITDA declined much more quickly than Valeant was able to reduce debt. It is now in the difficult position of having to repay debt with a much smaller cash flow base than anticipated.
2016 EBITDA Guidance Midpoint
EBITDA= Earnings Before Interest, Tax, Depreciation, and Amortization
Source: Valeant press releases and commentary
*Not formal guidance, but an expectation referred to several times beginning in February 2015
As I reflect on the very poor outcome from our investment in Valeant, I was wrong because I underestimated the collective impact of the above issues on the fundamentals of the business. Part of our process is to update our estimate of intrinsic value at least quarterly, or more frequently if necessary, which I continued to do as issues developed. My conclusion continued to be that the share price had declined more than the change in the fundamentals warranted, and that the stock was still trading at a meaningful discount to my estimate of intrinsic value. I did not anticipate the magnitude of the decline in the dermatology business, or the degree of customer, payer, and government pushback. I assumed performance from Salix would be much better. I underestimated the contribution of Valeant’s historical price increases to its profits and the impact if it lost the ability to raise prices to the extent it had in the past. And just as high levels of debt boosted results when things were going well, all of these impacts were magnified when the fundamentals worsened, leading to a significant decline in the intrinsic value of the business.
In hindsight, the business was aggressively managed and the frequent acquisitions made it harder to understand its underlying performance. There were several red flags that individually did not cause much concern, including high debt levels, material price increases on some products, the rapid pace of acquisitions, political pressure, management turnover, and lofty financial targets. As results continued to exceed expectations, it was easier to overlook each concern individually, but I underestimated the snowball effect they could collectively create if management tripped up. This investment has also reinforced the impact that leverage can have on equity value when business results deteriorate. Debt is not bad in and of itself, but high amounts of leverage should not be coupled with aggressive business practices in other areas. Finally, I should have been more aggressive in selling the shares when they were peaking in the summer of 2015. At that point, much of the discount to my estimate of intrinsic value was based on the belief that management could create additional value through capital allocation. This was a less conservative way to think about margin of safety, and I relied on this belief too heavily.
I believe that Valeant has some good assets, such as Bausch & Lomb, and in a number of scenarios the value of these core franchises could justify a substantially higher stock price. However, with the fundamentals yet to stabilize, it is difficult to gain confidence in any particular outcome, and the elevated levels of financial leverage magnify the costs of being wrong for shareholders.
We continually try to improve our decision making and learn from both our successes and mistakes. While Valeant was a painful investment, we will have these lessons to apply to our process and decision making in the future.
As of April 30, 2017, Diamond Hill held shares of VRX in the Research Opportunities Fund representing 0.55% of net assets.
Originally published on May 22, 2017.
The views expressed are those of the research analyst as of May 2017, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.