Saturday, June 21, 2014

Valeant Pharmaceuticals: a Batesian mimic

Ever since Grant's Interest Rate Observer criticized Valeant Pharmaceuticals (VRX) a couple months ago, the company has attracted a lot skepticism about its business model. Grant's and the other critics imply that VRX is a Ponzi analogue: it makes lots of acquisitions and slashes R&D, which boosts near-term earnings at the expense of the company's long-term health. To mask the deterioration of its previous acquisitions, VRX has to keep making new acquisitions and play a lot of accounting games.

Another, less-publicized problem is that VRX is highly leveraged and its business model relies on cheap debt to earn adequate returns. The company has $17bn of debt (and tangible book value of -$17bn) compared to quarterly revenue below $2bn. The yield on its outstanding debt is in the 6-7% range. The financing VRX has arranged for its Allergan takeover is expected to yield even less, about 5.5%. VRX isn't cheap-- it trades at ~8x EV/sales-- so if it has to pay down its debt or refinance it at higher rates, the stock will crater. VRX's investors are making an implicit bet on a perpetual credit bubble.


Why is VRX popular?

I think VRX is a sham and its business model is a total joke, but a lot of other people have already written about the company's flaws, so I won't dwell on them. I think it's more interesting to discuss why so many well-respected investors have bought into the Valeant story. There seem to be two reasons why VRX is popular.

The first is that large pharmaceutical companies tend to waste a lot of money on research and development. At least that's a common perception among investors. VRX's strategy of slashing R&D to the bone capitalizes on investors' dissatisfaction with the pharmaceutical industry's usual way of doing business.

The second is the idea that VRX's president, Michael Pearson, is a great capital allocator in the mold of Henry Singleton, John Malone, and other people profiled in William Thorndike's The Outsiders. VRX's presentations encourage this kind of comparison, touting its commitment to "superior capital allocation" and running a decentralized company. Bill Ackman, who's teamed up with VRX in its hostile takeover of Allergan, takes this a step further with a presentation that explicitly compares VRX and Pearson to Thorndike's outsiders.

I was critical of The Outsiders because the book has methodological problems and the people it profiles derived a lot of their success from aggressively using leverage. But whatever their flaws, I think the strategy VRX/Pearson uses is far worse.


Batesian mimicry

There's a phenomenon in nature called Batesian mimicry. Wikipedia defines it as "a form of mimicry typified by a situation where a harmless species has evolved to imitate the warning signals of a harmful species directed at a common predator."

In other words, a harmless species develops superficial features that make it look like a more dangerous species. The dangerous species has spent a lot of energy developing and maintaining the qualities that make it dangerous to predators, and Batesian mimicry lets the harmless species free-ride off that.

Eric Falkenstein has applied the concept of Batesian mimicry to finance, arguing that a similar process fuels business cycles and bubbles. His idea-- I'm grossly oversimplifying here-- is that when an industry produces high returns, investors look for ways to invest in that industry. To simplify the process of finding good companies to invest in, they emphasize superficial qualities that have historically indicated strong future performance. This creates an opening for lower-quality companies to mimic these characteristics, free riding on the strong returns of earlier, higher-quality companies.

Falkenstein offers the dotcom bubble as one example of this. In the late 1990s, several internet companies that pursued large market opportunities were willing to lose a lot of money to gain market share. This strategy was successful, and their stock prices surged. Investors responded by throwing money at a lot of other internet businesses that had big dreams and lost money. Most of these companies were low-quality mimics: eToys, Webvan, etc.

Falkenstain casts Batesian mimicry as a process specific to asset clases. Investors, drawn to the strong historical returns of railroad bonds, or commercial real estate, or dotcom stocks, or housing, chase progressively lower-quality investments (i.e., mimics) in the same asset class.

I'd take it further and argue that Batesian mimicry isn't limited by asset classes. It can also occur with regard to capital-allocation strategies irrespective of asset class. And that is essentially what Valeant is: it's a Batesian mimic of the people profiled in The Outsiders. VRX copies the superficial aspects of successful capital allocators, but its really a debt-fueled roll-up with bad accounting.

Here are a few comparisons:

• The outsider CEOs were fanatical about cutting expenses, but the expenses they cut were things like glitzy headquarters that contributed nothing to future profits. The outsiders' cost-cutting was essentially about resolving the agency-principal problem. VRX cuts expenses that, although they may be made in an undisciplined fashion, contribute to future profits. The outsiders cut fat, VRX cuts muscle.

• Many successful capital allocators emphasize cash flow rather than reported earnings because reported earnings can understate a business's true earnings power, so VRX reports "adjusted earnings" to bridge the gap between the two. But VRX also reports "adjusted cash flow," which is a travesty of the logic behind adjusted earnings.

• VRX paid a mid-teens EBITDA multiple for Bausch & Lomb. It got into bidding wars for two of its smaller acquisitions. It got into a bidding war with itself for Allergan. This isn't the behavior of a great capital allocator.

• VRX's adjusted earnings exclude amortization of finite-life intangibles. This kind of amortization isn't a cash cost, but it's a very real economic cost, so VRX's "adjusted earnings" distort economic reality. There's a big difference between e.g. Capital Cities amortizing a broadcasting license and VRX amortizing a drug it's acquired that will go off patent in two years.

• The outsiders who did roll-ups did so to achieve a scale advantage, e.g. John Malone and his cable systems. VRX's scale advantages are minimal by comparison.


The big picture

VRX cuts R&D down to 2-3% of revenue. Bulls say that more R&D isn't necessary because much of VRX's business is generic drugs and over-the-counter products rather than patented drugs. This defies common sense. Teva spends ~7% of revenue on R&D and hasn't grown much, so most of its R&D is likely needed to stay in place. Even consumer products require R&D: new delivery mechanisms, new product formulations, new branding, whatever.

Many people say that Pearson is impressive in his presentations and public statements. I care a lot less about how articulate a CEO is than how much integrity he has, and VRX's effort to acquire Allergan raises serious questions about that. Pearson partnered with Ackman in a way that let him reap insider-trading profits. What Ackman did was technically legal, but it was still grossly unethical, and Pearson's willingness to partner with him suggests bad judgment at a minimum.

Eight times revenue is a terrible price to pay for a company with minimal (arguably, negative) organic growth.


Conclusion

In nature, Batesian mimics are sheep in wolves' clothing. In Falkenstein's analogy, they're the opposite. I think VRX is a class wolf in sheep's clothing: beneath the appearance of a successful capital-allocation strategy, it has a fundamentally flawed, Ponzi-style business model. Five years from now I expect people to be asking, "How could anyone have thought this was sustainable? How could so many smart investors have been fooled?"

8 comments:

  1. Your analysis of VRX is somewhat superficial. But I agree with your general thesis. I also agree that the Ackman/VRX deal seems fishy.

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  2. + points for bringing in something from ethology into an investing blog

    That said, I can’t tell from the post – how well do you understand the healthcare industry? The following statement could be blatantly inaccurate or an ok approximation depending on the specifics.

    “There's a big difference between e.g. Capital Cities amortizing a broadcasting license and VRX amortizing a drug it's acquired that will go off patent in two years.”

    In short it depends considerably on what type of drug it is. In short, is it a small molecule or a biologic? And what’s the delivery system? If we’re talking about a small molecule in a vanilla pill form, your statement probably holds, otherwise, probably not at all.

    Note: I don’t have a view on Valeant; it is outside my Circle of Competence. I suspect it is outside of a lot of people’s CoC’s though.

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    1. "how well do you understand the healthcare industry?"

      I hardly know it at all.

      My point about amortization, which I might not have expressed well, is this: let's say VRX acquires a drug for $100 and it produces $150 of cumulative profits following the acquisition. Then the true economic profit is only $50, but VRX tells investors to focus on "adjusted earnings," which include the full $150. VRX spends money to grow by acquisition, but it wants people to value it as if the acquisitions were costless.

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  3. congrats you nailed it! great read 17 months later

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  4. Sound analysis - doubt for the right reasons. Thanks for sharing your thoughts.

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  5. This is like the tenth time I've read this and it just keeps getting better and better as events develop. And it was absolutely awesome the first time.

    Largely out of stubborness, but I've hammered away at your basic point about depreciation of the intangible assets ad nauseum. I thought it showed either willful blindness or sheer incompetene that all of Wall Street continued to accept "cash eps" even after Valeant began amortizing Salix/Xifaxan - which was 15 billion of patent cliff.

    Please write more damnit!

    Dorsia.

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