Valeant: It's Not a Game of Chess- Part I

“I think there are times when you should be satisfied with less based on just the ideas of decency, and at Valeant they just looked at it as a game like chess. They didn’t think about any human consequence, they didn’t think about anything but getting what they wanted, which was money and glory, and they just stepped way over the line and, of course, in the end, they were cheating.”

“Interesting thing is how many high-grade people it took in (Valeant).”  - Charlie Munger (Trades, Portfolio) at the 2017 DJCO Meeting.

Â

I have always been interested in extreme successes and failures as case studies. No doubt, Valeant Pharmaceuticals (VRX, Financial) has been the most fascinating story I have followed in the investing world over the past few years. What started as a promising business model designed by an ambitious and goal-driven McKinsey consultant ended up being what Munger called a “sewer.” (Incidentally, Enron’s Jeff Skilling was also an ex-consultant of McKinsey. In fact, Skilling actually was one of the youngest partners in its history).

I am sure the Valeant story will be of great interest to a great many people, including journalists, business school professors and investors. What I am trying to do here is recount my own experiences, observations and analysis with Valeant as one of my case studies. Evidently, Valeant’s business is a bit complicated and the drama took a little while to unfold. I do not think it is easy to see what went wrong at Valeant (there were so many), even if one spends a significant amount of time and effort to read and learn about the business. But there are certainly a lot of red flags on the way. At the peril of acting arrogantly by stepping out of my circle of competency, I would like to share my case study of Valeant with readers of this forum. My hope is we can all learn something from this mind-boggling debacle.

Before we begin digging the dirt, a brief introduction to the industry Valeant operates in seems necessary. Therefore, let’s start with some basic information about the specialty pharmaceutical industry.

The pharmaceutical industry can be divided into a few subindustries. There are different ways to categorize each subindustry. I personally use the following categories:

1. Big pharma such as Merck (MRK, Financial) and Pfizer (PFE, Financial). These are traditional pharmaceutical companies that spent billions of dollars on research and development to come up with blockbuster small molecule drugs such as Lipitor and Crestor, although now almost all of them have made inroads into biological drugs.
2. Generic drug companies such as Teva (TEVA, Financial) and Mylan (MYL, Financial). These are the reverse engineers who try to either invalidate the patents of the big pharma companies or wait for the patents to expire so they can introduce the generic version of the branded drugs at a much lower price.
3. Biopharma such as Amgen (AMGN, Financial) and Celgene (CELG, Financial) produce large molecule biological drugs. In essence, they use the human cell’s chemistry to produce therapeutically useful proteins such as monoclonal antibodies.
4. Specialty drug companies such as Valeant and Allergan (AGN, Financial). This class of drug companies is very unique. The term specialty drug has a very broad definition, but generally speaking, it is described as prescription drugs that are difficult to manufacture, require special administration and often have limited distribution. Examples of specialty drugs include nasal sprays, sterile injectables, ophthalmics and topical drugs. Specialty pharmaceutical companies often operate in niche markets with limited competition. Specialty drugs often have a higher barrier to entry and are very often difficult to formulate. Therefore, unlike generic drugs which encounter enormous pricing pressure because of the amount of competition, specialty drugs usually face limited pricing pressure. When there is a shortage, specialty companies can raise the prices of specialty drugs (this is a very important part of Valeant’s playbook).

Prior to 2015, the specialty pharmaceutical business model gained popularity due to a confluence of reasons, to name a few:

1. The big pharma has been grappling with declining R&D productivity.
2. The patent cliff compounded big pharma’s trouble.
3. Cheap debt, limited competition, drug shortages, the ability to raise prices, tax inversion and the M&A opportunities all laid the foundation for the roll-up strategy in the specialty pharma space.
4. The Food and Drug Administration site inspections and the resultant warning letters, the slow pace of ANDA approval as well as manufacturer consolidation all contributed to a shortage, especially for injectable drugs, which created the opportunity to raise prices of those drugs.

Mike Pearson saw the opportunities. And he was determined to grab them aggressively. The result was the rise and fall of the company he took to heaven and then let crash to hell.

We will explore the Valeant blowup in detail in the next few articles.

Start a free 7-day trial of Premium Membership to GuruFocus.