Valeant’s (NYSE:VRX) business model is predictated upon three key areas:
- Use of innovative and complicated offshore tax structure to reduce cash taxes to the largest extent possible.
- Avoidance of high value R&D. To quote former CEO Mike Pearson, "Valeant doesn’t invest in science. We invest in management."
- Leverage up using cheap debt to acquire other specialty pharmaceutical companies and raise the prices of the drugs Valeant acquires immediately.
Valeant tax advantage
While most investors talk about Valeant’s high leverage, very few understand Valeant’s tax structure as its most significant competitive advantage in the pharmaceutical business. As we all know, the U.S has a high corporate tax rate (35% at the federal level). Therefore, it is not unusual to see companies utilize tax strategies to lower the tax rate, the most famous of which is tax inversion. Specialty pharmaceutical companies have utilized this tax inversion strategy to reduce the tax rate to say 12% as is the case if they relocate to Ireland.
You would think a 35% to 12% reduction is good enough. Not for Valeant. As part of the merger deal with Biovail, Valeant took on Biovail’s tax structure and moved its headquarters to Canada, which operates on a territorial tax system in which companies are taxed on domestic but not foreign income. Biovail at that time held most of its patent IP in Barbados. Valeant would domicile the product related intellectual property in Barbados and repatriate income earned in Barbados to Canada, reinvest all earnings from U.S operations and would not repatriate the U.S earnings to Canada. In doing so, Valeant lowered its tax rate to mid-single digits. This is important because this extremely low tax rate allows Valeant to improve the cash flow of the acquired entity immediately.
Valeant’s high profile acquisition of Medicis illustrated this superior tax structure. Medicis at the time of acquisition was a U.S company with an effective tax rate of 41.5% whereas Valeant’s tax rate was about 5%. After the acquisition, Valeant was able to treat Medicis as a subsidiary and immediately shaved off $150 million in tax bills.
Don’t invest in science; invest in management
Pearson has been famously quoted as saying that Valeant “doesn’t invest in science. We invest in management.”
He wasn’t joking. In 2015, Valeant generated $7 billion of revenue and only spent $330 million, or 4.7% of the sales, on R&D. Daiichi Sankyo (TSE:4568) and Otsuka Holdings (TSE:4578), both of which had roughly $7 billion revenue in 2015, spent five times as much as Valeant on R&D. Allergan (NYSE:AGN), with more than $18 billion in sales, spent almost $2.8 billion on R&D, or roughly 15% of sales.
If Valeant spends much less than its competitors on R&D, how does Valeant maintain its competitiveness?
The answer ties to Valeant’s two other strategies – Valeant would utilize its low tax rate and take advantage of cheap debts to acquire other companies and raise the drugs of the acquired companies by an ungodly amount. One famous example was the Targretin gel, which treats lesions caused by lymphoma. A tube of Targretin gel rose from $1,687 in 2009 to about $30,320 in 2015. In another example, the list price for Calcium EDTA was raised from $950 to more than $26,900 at the end of 2014 after Valeant bought the drug in 2013.
Of course there are other factors such as rebate and chargebacks, etc., that reduce the price of the drug, but there is no doubt Valeant was raising the price of drugs it acquired aggressively even though some of the drugs save lives.
The story below in an article published by Los Angeles Times illustrates how evil Valeant was:
"The company’s programs to help patients afford the drugs weren’t charities, but a way to increase profits on their monopolies.
"The committee said that Valeant offered a program that covered the cost of co-pays for privately insured patients because executives knew it would reduce patients’ 'incentive to complain to the press about Valeant’s outrageous price increases.'
"By increasing prices rapidly, but covering patients’ co-pays, the companies could still make big profits, the committee said.
"They used the example of a drug priced at $100,000 that cost $10,000 to manufacture and distribute, leaving a potential profit of $90,000. If the company covered the patient’s $20,000 co-pay, the insurance company still paid $80,000 for the drug, resulting in a $70,000 profit for the company.
"The patient assistance programs were a key method that Valeant used in raising the price of Cuprimine, used since 1956, and Syprine, developed in 1969, the committee said. Both drugs are used to treat Wilson disease, a rare condition in which the body cannot process copper.
"Valeant raised the prices of Cuprimine and Syprine from about $500 to about $24,000 for a 30-day supply, the report said.
"'The committee believes that these programs were driven not by altruism, but by Valeant’s desire to extract monopoly profits and then conceal that fact from the public,' the report said.
"Valeant issued a statement saying it has established a 'patient access pricing committee' and has 'improved transparency' under a new executive team."
Charlie Munger summed it up nicely during the 2017 DJCO meeting:
"It was too good to be true. There was a lot wrong with Valeant. It was so aggressive and it was drugs people needed. Take the difference between Valeant and the Daily Journal Company (NASDAQ:DJCO). When the foreclosure boom came, we had 80% of the foreclosure business in our area. That’s a big area, Southern California and Northern California. It would have been very easy for us to raise the prices and make, I don’t know, 50 million more or something like that.
"All these people were losing their houses; a lot of them were perfectly decent people. The idea that right in the middle of that we’d just make all the money we could, which some of our competitors did, by the way, we just didn’t do it. I don’t think capitalism requires you to make all the money that you can. 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."
The investment committee, however, looked at Valeant as a game of chess, too. Valeant’s stock price went from a little more than $10 at the beginning of 2009 to $264 per share at the peak in 2015.
I am deeply disturbed by what I have found so far.
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