Ackman, Sequoia Stock Valeant Changes Course

A pharmaceutical company fueling most of its rapid growth through acquisitions, Valeant (VRX, Financial) responded to a short-seller’s accusations this week by announcing a change of business model at its 2015 Investor Day.

Valeant, which resides in large quantities in the portfolios of major investors like Bill Ackman (Trades, Portfolio) and Sequoia Fund, endured criticism for its unconventional partnership with a specialty pharmacy distribution channel, Philidor, in November. The report, done by Citron Research, had crushed about half of the company’s market value by the end of October. Now, the company says it has cut ties with Philidor, started a relationship with Walgreens (WBA, Financial) and significantly reduced its 2015 earnings forecast.

“But the real objective is not to make money,” J. Michael Pearson, Valeant chairman and CEO, said of the company’s new plan with Walgreens. “It’s to help patients and help consumers and take money out of the system and return it to people who are paying.”

“And if we do this in an intelligent way, we can make more money,” he said.

Pearson said the company had “moved on” from Philidor to Walgreens, which he called “as reputable a company as you can get,” to distribute its drugs. Under the new plan, Walgreens would act as service provider, for which Valeant would pay it a service fee. Valeant would deliver drugs to Walgreens, like it does to its wholesalers, which will then distribute its drugs to stores every day. When a patient fills a prescription, Walgreens would also get a fulfillment fee.

“The key innovation here is now we can control pricing. We can now control pricing that’s not an average wholesale price; it’s our price,” Pearson said. The company also aimed to lower prices rather than increase them, passing on their savings to customers.

“More important, the opportunity for volume growth is huge,” Pearson said.

He expected that because of Walgreens 15% market share for prescriptions, Valeant’s market share would increase from 1% to 15% “overnight,” with growth likely to continue.

This and several other moves would come at a cost, though. Valeant lowered its fourth quarter 2015 guidance from a range of $3.25 billion to $3.45 billion to a range of $2.7 billion to $2.88 billion. It also lowered “adjusted EPS” from between $4.00 to $4.20 per share to between $2.55 to $2.65 per share, and adjusted cash flow from operations from more than $1.08 billion to more than $600 million.

Valeant attributed the decrease to three drivers, starting with costs associated with the separation from Philidor and an estimated one-time revenue impact of the Walgreens transition.

The third cause was price and volume-related changes for some of its drugs. Valeant has canceled some of its planned price increases, in addition to seeing reductions in its hospital products due primarily to contract negotiations.

For 2016, Valeant forecast $12.5 billion to $12.7 billion in revenue and adjusted EPS of $13.25 to $13.75 per share, compared to 2014 revenue of $8.3 billion and $2.67 GAAP diluted earnings per share.

In the past decade, Valeant has generated positive free cash flow, more than doubling in 2014 to $1.82 billion and reporting $2.08 billion for the trailing 12 months. Valeant has also grown at scorching annual five-year rates of 40.8% for revenue, 55.9% for revenue, 29.9% for free cash flow and 10.4% for book value.

But the company has also drawn criticism for its unusually low amount of R&D spend, which totaled 8% on pharmaceutical products, Pearson said. Valeant differs from its peers in that it makes individual capital allocation decisions on a quarterly basis, rather than setting an annual budget for R&D.

“We don’t spend as much as other on R&D. I think that’s okay. We’re a very funny industry where people judge how much you spend rather than what new products you have coming out. I think that will change. But that’s the way it is,” Pearson said.

As another change of course, Valeant said it would not use balance sheet cash for acquisitions next year, instead focusing on paying down debt. At third quarter end, the company’s long-term debt stood at $30.2 billion next to cash of $1.4 billion.

The market responded to Valeant’s Investor Day and lowered forecast by sending Valeant shares up 8% on Dec. 16 to close at $118.47. Shares have since erased their gain, closing at $108.58 on Friday, down 2.51%, amid a broader market decline of 2.35% for the Standard & Poor’s 500 Index.

Pershing Square’s Bill Ackman (Trades, Portfolio), holder of roughly 10% of Valeant’s outstanding shares, has continued to support the company and increase his position on the volatility. The stock’s performance contributed to Ackman’s worst year for Pershing Square, which reported negative returns of 19.7% gross for the year through Nov. 30, compared to a 3.0% gain for the S&P 500.

“We added to our investment because we believe that Valeant shares are enormously undervalued,” Ackman said in his fourth quarter letter, dated Dec. 15.

“While we expect a degree of disruption to Valeant’s dermatology business, we believe that the fundamentals of Valeant’s overall business remain strong. Just this morning, Valeant announced a 20-year agreement with Walgreens Boots Alliance, Inc., the largest pharmacy chain in the U.S. with more than 8,000 units, which will ‘more than replace’ Valeant’s Philidor specialty pharmacy distribution. We believe that this agreement will go a long way to addressing concerns about the disruption to Valeant’s dermatology business by expanding convenient and affordable access to Valeant products, and will help restore credibility by the company partnering with the largest and best-managed pharmacy chain. The agreement provides for discounted pricing for Valeant’s dermatology and ophthalmology products reducing costs for the health care system.”

Noted short-seller Jim Chanos (Trades, Portfolio), founder of Kynikos Associates who holds a short position in Valeant, disagreed about the company, telling CNBC Friday morning that it did not save the health care system money and contrasting it with Gilead Sciences Inc. (GILD, Financial). Gilead’s hepatitis C drug, while expensive, ultimately saved the system money because it provided a cure for the disease, reducing the need for chronic care.

Some of Valeant’s dermatological drugs, rather, were raised 800% to 1000% and offered less savings in the long run, he said.

“You begin to wonder, is society, is that really going to move the needle in health care costs, or is it just simply people paying that don’t realize they’re being charged that much?” He asked. “And I think, in Valeant’s case, it’s more the latter than the former.”

Though the company generated roughly $5 per share in free cash flow, Chanos said, “We just don’t think the model works.”

“And the $5 a share assumes no amortization of the purchased drugs. They have $43 billion invested in their company. Half of that is purchased R&D, and if you write that R&D off economically over 10 years, that’s about $5 to $6 a share,” he said.

Among numerous guru holders of Valeant shares, five sold out in the third quarter, including George Soros (Trades, Portfolio) and Jana Partners (Trades, Portfolio). Only one, Leon Cooperman (Trades, Portfolio), initiated a position in the company, reporting a purchase of 484,915 shares.

Not a Premium Member of GuruFocus? Try it free for 7 days.