Valeant: It's Not a Game of Chess – Part IV

The key to Valeant’s business model was its acquisition strategy. Valeant used the following parameters to guide investors on its acquisition criteria:

· 20% internal rate of return (IRR) hurdle

· Cash pay-back period of 5-6 years

· Zero value for pipeline assets

· Assume patent life ends upon patent expiry

· Assume low to minimal growth

· Assume local statutory tax rate for the business rather than Valeant’s lower tax rate

On the surface, some of the assumptions look very conservative, such as patent lifes ending upon patent expiry, zero value for pipeline assets and low to minimal growth. But anybody who works in the pharmaceutical industry will immediately spot within those assumptions that a cash pay-back period of five-to-six years and 20% IRR hurdle is almost impossible to achieve with the amount of acquisitions Valeant has done. So how did Valeant (VRX, Financial) get away with it to investors?

Well, in the beginning, Mike Pearson’s acquisition strategy worked beautifully since:

1. There was some low-hanging fruit in the specialty pharmaceutical industry for Valeant to grab.
2. The deal size was manageable compared to the Bausch Lomb and Salix deal.
3. Competition from other specialty pharmaceutical companies was low.
4. Valeant’s debt level was also manageable.
5. Valeant’s reputation had not gotten around in the industry.

A roll-up can produce fabulous financials on the way up, which Valeant did. As the strategy worked, a cult was formed in the investment community that called Mike Pearson by first name and published reports that urged not to bet against Mike because of his track record. These words from a Jefferies analyst in April 2014 pretty much summed it up:

“Can Valeant keep up the pace? While common concerns –- including "it’s a roll up", the high leverage ratio and a perceived lack of transparency –- are understandable, Valeant shares have dramatically outperformed. Virtually every guidepost put forth has been exceeded. The latest is to become a top-five pharmaceutical company by the end of 2016. While this is truly a lofty goal, it’s hard to bet against Valeant's track record. ”

What started as a possible but unsustainable business strategy turned into a financial engineering and accounting game eventually. The following posts detailed Valeant’s acquisition game. Interested readers should read them extensively -- great analysis.

Valeant: A Detailed Look Inside a Dangerous Story Well Told – PARTS I, II & III

Valeant: A Detailed Look Inside a Dangerous Story Well Told – PART IV

Another great analysis was done by Allergan (AGN, Financial). In May 2014, Allergan issued an SEC filing that presented the case against Valeant. It was almost like a short report on Valeant. This is almost unprecedented in terms of the target company fending off the acquiring company so viciously. Allergan is a very reputable company and Allergan’s then-CEO was a much-respected figure in the pharmaceutical industry. Perhaps it’s because of the damned social proof bias that investors shrugged it off.

But it’s not just the financial engineering that makes Valeant’s acquisition strategy unsustainable. Companies are made of humans and the human side of business matters too. For instance, in this article, the author detailed how Valeant’s management team was not being truthful about the motives of the acquisitions:

“Valeant’s entire existence raised a middle finger to the rest of the industry,” says one investor, explaining why the industry detested Pearson. The problem, though, wasn’t so much Pearson’s ideas, but rather his execution of them. While in the process of acquiring Medicis, a company that made aesthetic products in the same vein as Botox, Pearson reassured the company’s employees that, while there would be a “best of the best” competition for jobs, he expected the Medicis people to win, and there would be even more jobs at the company’s Scottsdale, Arizona, headquarters in a year. Instead, the day the deal closed, almost all the employees were presented with black folders that notified them they were fired. “I was sickened by the deception,” says Jonah Shacknai, Medicis’s former CEO. Another CEO says Pearson told him he would never make a hostile offer to acquire his company, only to have Pearson turn around and do exactly that.

And it’s not just how Valeant’s management treated the employees of acquired companies. I used Glassdoor quite a bit to get a feel to a company’s culture and to discover potential red flags. You don’t have to dig too far to find Valeant has a lot of disgruntled employees, and they raised some serious red flags.

“Had to do work of three people. Very politic and everyone is afraid of losing their jobs with each new acquisition. Keeping a job is a gladiator fight between potential acquired company employees and existing employees.”

“Very Unstable. They acquire companies and lay everyone else off.”

“Too much stress, all the time. Company integrates new acquisitions, but lays off most of the workforce from the acquired company, leaving Valeant employees with double the workload, and no time to adjust to new processes.”

“Excessive work piling up as people resign daily. Lack of direction and not set process to follow as they continue to acquire companies. People trying to claw their way ahead stepping on others as the rush to the top. A negative work environment with lack of accountability.”

This is why I agreed so strongly with Mr. Munger earlier this year at the Daily Journal Meeting when he said: “The interesting thing is how many high-grade people it took in.”

Let’s take a look at the list of gurus who it took in:

• Bill Ackman (Trades, Portfolio)
• Jana Partners (Trades, Portfolio)
• Andreas Halvorsen (Trades, Portfolio)
• Lee Ainslie (Trades, Portfolio)
• Wally Weitz (Mr. Weitz sold the position before the meltdown after he had dinner with Mike Pearson)
• Steve Mandel (Trades, Portfolio)
• John Paulson (Trades, Portfolio)
• Glenn Greenberg (Trades, Portfolio)
• Chris Davis (Trades, Portfolio)
• Lou Simpson (Trades, Portfolio)
• Ruane Cunniff (Trades, Portfolio)
• First Eagle Management
• Jeff Ubben (Trades, Portfolio) (To be fair, Value Partners (Trades, Portfolio) took a stake in Valeant long before the debacle.)

This is absolutely fascinating.