Reflecting on the rise and fall of one-time TSX favourite healthcare stock Valeant Pharmaceuticals, performance improvement specialist Sam Watts warns readers that a company’s continuous acquisitions can cause management to neglect sound business fundamentals.
“Greed, for lack of a better word, is good.” – Gordon Gecko (Wall Street, 1987)
The recent decline of healthcare stock Valeant Pharmaceuticals International Inc. (TSX─VRX) shares has caused serious soul-searching about the concept of “greed” within the investment community.
What role, if any, did blind greed play? Did investors deliberately ignore evidence that Valeant’s valuation was unsustainable?
In my consulting practice, I have the opportunity to interact with senior business leaders in North America. The topic of Valeant’s current predicament has been raised in casual conversation with remarkable frequency.
Everyone, it seems, claims to have been surprised by the speed and scope of the drop of the drug manufacturer’s share price.
Valeant was the darling of the stock market, trading at levels well above $230 while acquiring 23 healthcare businesses since 2010.
In 2015, numerous articles were written in highly respectable publications by seasoned business journalists that sang the praises of CEO Michael Pearson and the “new pharmaceutical business model” that Valeant appeared to be creating.
Fast forward to early 2016 and the situation has reversed dramatically. Investors are all too aware of the various legal issues, regulatory challenges and public relations nightmares that have surrounded Valeant like a perfect storm.
The company’s debt level currently exceeds its market capitalization. Covenants will need to be re-negotiated. Strategic options, such as asset sales, are being actively entertained.
At last check, Valeant shares were not experiencing much positive traction (trading at an average of around $40 a share in mid-April) despite the announced departure of Mr. Pearson. So, a question worth asking is: What lessons can investors draw from the steep decline of Valeant stock?
I’d like to propose three rather basic lessons:
Human health is not a commodity
Marketers of regular consumer products can raise prices at will. The pharmaceutical business has different drivers. Medical care is a motherhood issue. Drugs are part of the equation.
Advances in health and scientific progress matter because they dictate pricing and value.
Most pharmaceutical companies fully understand that there is a clear moral and medical dimension to pricing that isn’t merely a supply-and-demand equation, factored by competitive positioning.
The Valeant playbook of raising the prices of mature drugs served to spread expenses to every payer across the public and private health insurance systems.
Valeant misunderstood the level of opposition that can be generated when virtually every stakeholder in the system is offended.
The perception of predatory pricing strategies is at the root of some the ongoing legal and congressional investigations.
Mission creep can be diversionary
Companies that are perennially working on the next acquisition cannot devote sufficient energy to ensuring that fundamental business disciplines are followed in the organization.
Acquisition-focused companies have a propensity for becoming intoxicated by the art of the deal and are subject to subtle temptations to bend the rules.
With hindsight, it is clear that Valeant didn’t pay enough attention to some of its business practices. Intense pressure to hit certain targets often creates an unspoken culture of doing whatever is required to make the numbers happen.
The result is that executives become locked on to a need to find ways to present a pre-ordained set of numbers to lenders. This pressure can cause good people to ignore their moral and ethical compass.
Valeant’s primary raison d’être appeared to be acquiring assets quickly in a drive towards bigness. The next deal was always the most important thing.
Investors ought to be cautious when a company’s strategy hinges on continuous acquisitions.
Beware of complex accounting
Investor inattention to financial footnotes always comes back to bite. Cursory assessments of any company’s financial disclosures never tell the story adequately.
Valeant’s financial structure is exceedingly complex. With so many acquisitions, it is extremely challenging to sort through the numbers and make sense of them.
Confusion is multiplied by the “air” that is part of most acquisition accounting. It shouldn’t take a financial genius to be concerned about the levels of goodwill that show up in Valeant’s statements or the amounts attributed to acquisition-related restructuring charges.
When everything is moving up, investors tend to assume that smarter people must have the details under control. When things begin to tank, everyone begins to identify parts of the financial statements that are less than forthcoming.
My fearless prediction is that Valeant will emerge from the mess in a few years, but that its shares will not appreciate substantially in the medium term.
At best, they will become a mid-level pharmaceuticals player. With the right management team, it will sell off some assets and then focus on its remaining core day-to-day business.
For value-driven investors, there is something to be said for well-managed, boring, organically growing organizations. Perhaps Valeant will eventually go that route.
Investor’s Digest of Canada, MPL Communications Inc.
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