New Valeant fails to inspire

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Valeant’s business model has taken a turn – and investors do not like what they see. A declaration that price increases and acquisitions – the big reasons why topline revenue has grown 30% annually for the past five years – may be less of a focus has caused shares to plummet by one-third this week, capped by a spectacular 19% fall to a two-year low of $118.32 yesterday.

U.S. prosecutors and short sellers have asked questions about pricing and distribution practices, at a time when the company acknowledges that it may not maintain its furious acquisition pace and has begun talking up internal research and development. For long-term investors, the strategic shifts have turned Valeant from less of a sure thing to more of a high-risk play, and they have adjusted their own holdings accordingly.

The biggest risk is that the recent focus on the group’s pricing practices will lead to a stronger backlash than already seen – Valeant’s position on the list of biggest drug price increases, particularly those with generic alternatives, has been particularly hurtful (After Turing, the industry’s biggest price gougers, September 23, 2015).

With the rest of biopharma shares, Valeant has been on a losing streak since August when pricing was seized on as a potential vote winner for some of US presidential candidates. While some of the heat has since come off Turing Pharmaceuticals, which brought the matter to an inflection point last month, Valeant has found itself in the sights of lawmakers.

A subpoena from US prosecutors last week regarding pricing, patient support, product distribution and data provided to the Centers for Medicare and Medicaid Services made clear that it would be looked at closely. Again spooking investors.

This week brought fresh misery in the form of a report from short-selling firm Citron Research. Citron has alleged that Valeant is overstating its sales by using a network of speciality pharmacies to store inventory. This charge triggered yesterday’s losses – if shares had closed at intraday low of $88.58, it would have wiped away $20bn in market valuation.

Valeant responded to Citron’s charges yesterday by stating that shipments to those pharmacies are not recorded as revenue and sales are recorded only when patients receive Valeant’s drugs. The group also said that while inventory held at these pharmacies is recorded as part of consolidated corporate inventory balances, there is no sales benefit from accounting this way.

The company's statement allowed shares to rally from yesterday's intraday lows, but in early trading today Valeant was off another 15% to $100.80. Among the buyers yesterday was hedge fund Pershing Square Holdings, whose chief executive, William Ackman, played a role in Valeant's failed attempt to buy out Allergan last year.

Will Valeant still be Valeant?

Citron’s report and pricing issues aside, there are other reasons for Valeant becoming a less attractive buy. The furious acquisition pace of the past few years – topped by the $11.4bn takeout of Salix Pharmaceuticals in March – has helped drive an elevenfold increase in total worldwide revenue in five years. But chief executive J Michael Pearson acknowledged in the third quarter earnings call that this strategy might not be maintained.

In part, the company has amassed a debt pile of $30bn, 5.3 times its earnings, and it wants to reduce that ratio to below four times earnings by the end of 2016 – effectively putting the lid on further large M&A transactions.

In was almost certainly a nod towards the politically sensitive issue of price gouging, Mr Pearson also noted the company will shift away from transactions based around acquiring products and subsequently raising their prices.

Furthermore, the group might become a seller rather than buyer for some of its portfolio – specifically, the pricing-dependent neurology line that is shrinking as a share of the company’s revenues.

More surprising from the call was Mr Pearson’s focus on organic growth and deriving expansion via R&D, something that has not been at the forefront of Valeant’s strategy. He suggested an R&D budget of $400-$500m in 2016, almost double the budget from 2014. Group chairman Ari Kellen said the group is looking expand its scientific expertise beyond eye care to add gastrointestinal and oncology.

So even if Valeant emerges from the current firestorm, the company has signalled that it has reached a point beyond which its previous strategy may not be sustainable. The big question will be whether it can succeed as a company that relies on organic growth and greater pipeline prowess, but it is taking some time for investors to adjust the uncertainty and risks this new approach will involve.

To contact the writer of this story email Jonathan Gardner in London at jonathang@epvantage.com or follow @ByJonGardner on Twitter

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