As recently as early August, Valeant Pharmaceuticals (VRX) was flying high, continuing its history of aggressively pursuing acquisitions and profiting greatly from newly-acquired drugs. However, exactly what had allowed the firm to grow at a substantial pace has caused a precipitous fall in its share price and may cause significant pressure to the biotech industry (IBB) as a whole in the relatively-near future, or so some are positing.
Valeant has a reputation for growing through acquisitions and aggressively cutting costs during the integration of newly-acquired companies. Through the acquisitions of other biotech and pharmaceutical companies, Valeant becomes the owners of various drugs, of which it then has control over pricing. This is where the company, in the eyes of some politicians, has become too greedy and “overdone” in the amount of incremental profits it generates purely from the price lever.
Certainly it is commonly accepted across the pharmaceutical industry that lofty drug prices are appropriate for companies that take the burdensome research and development risks to bring a new treatment to market. Traditional large drug firms spend between 15%-20% of annual sales on research and development. Where Valeant has encountered trouble, as have some other biotech companies, is in the significant price increases of drugs that have already been on the market for an extended period of time before taking ownership of the drug. That it has spent only ~3% of its sales on research and development in each of the last few years makes it perhaps, in the eyes of some, unworthy to capture such incremental outsize profit on the basis of price alone.
The bond market has already started punishing Valeant for its efforts to side-step the traditional route of profiting from drug development as its 10-year notes issued in March have lost substantial value. In fact, Valeant has relied on the debt markets to fund recent acquisitions through the issuing of new debt, creating one of the worst credit profiles of any major drug company. The firm had over $30 billion in long-term debt on its balance sheet as of June 30, up from just over $15 billion at the same time in 2014. This massive accumulation of debt has funded a dozen acquisitions during the past year, cumulatively valued at ~$15 billion, the source of the unwarranted drug price increases.
Until recently, this practice had benefitted shareholders substantially; shares were trading above $260 as recently as August 5. In fact, one of the defenses used by management when accused of price gouging was that the firm has a duty to its shareholders to squeeze the maximum amount of profit out of each drug. The company also cited the pricing mismatch coming from newer drugs that treat the same diseases as the older drugs it was acquiring for the massive inflation in its drug prices. In any case, it’s much easier for politicians to swallow the lofty drug prices, if the company is actually investing to develop the drug, instead of just acquiring them.
The New York Times has run multiple pieces in recent weeks that highlight Valeant’s price increases of drugs that it did not develop itself. The issue has also become a talking point for 2016 US Presidential candidates, hardly an indicator that any candidate will act on his or her promises, but it is bringing the issue to the front of everyone’s minds. Regardless of whether or not one agrees with the moral issue of raising the price for potentially life-saving drugs to squeeze every bit of profit out of any one product, the increased scrutiny on the pricing power of Valeant and its peers is detrimental to their businesses. If it doesn’t happen during the next administration, the likelihood that it may happen during subsequent ones is not reduced.
In the first half of 2015, price increases had a material impact on Valeant’s performance. In its 10-Q for the quarter ending June 30, 2015 the company stated, “The growth in the Developed Markets was driven primarily by price, as significant volume increases in U.S. dermatology and U.S. eye heath were offset by volume declines for certain U.S. neurology & other/generic products.” Developed Markets sales grew by ~$1.1 billion in the first half of 2015, representing a ~38% increase. This growth dynamic may very well be gone in the near future, and that’s why the market has been panicking.
Though the incredibly profitable practice has worked well for Valeant for some time, some are now building in the very likely scenario that the spending and drug price-hiking spree will come to an end, if not immediately than very soon. Fortunately for the firm, it has acquired various pipelines of the smaller companies it has taken out over the past year, bolstering its own pipeline, but regulatory risks are building and Valeant will be at the forefront of the political battle. It will need to increase its R&D spending to prevent considerable erosion in sales in coming years, and that means lower profits, too.
We’ve steered clear of much of the carnage in biotech this year, and Gilead Sciences (GILD), which is trading at roughly half the median market multiple, remains our favorite idea in the biotech space. We believe its share price already reflects some pricing pressure on its blockbuster hepatitis-C cure Harvoni, and the market is not giving it full credit for the drug’s global applications, in our view. We value Gilead’s shares significantly higher than its pricing levels today.
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