Grey Owl Capital Thoughts On Valeant Pharma

The Past – Managing Risk through Prudent Position Sizing

If you are not familiar with the Valeant story, you have not been reading the business news over the past month. For background on our Valeant Pharmaceuticals investment thesis, see our third quarter letter from 2013. Despite recently losing over half of its market value from late August through late October, we still show an almost 100% gain over the lifetime of our investment in VRX.

From the beginning, we recognized that Valeant is employing a unique and aggressive business model – from an operational standpoint, as well as through the use of significant financial leverage to finance acquisitions. Given the higher risk profile, we twice trimmed the position so that it did not grow to be too large a percentage of our overall portfolio. This is despite the fact that the stock never exceeded our fair value target by much and continued to perform incredibly well from an operational standpoint. The history of our buys and sells illustrates this point.

We first purchased shares in Valeant Pharmaceuticals (VRX) in January 2013 at an average price of $64. We added to the position in June 2013 at an average price of $84. We sold approximately half of our shares in January 2014 at $138. More recently, we sold approximately one-third of our remaining position in August 2015 at $231. After the recent sell-off, we added fifty percent more to our position on October 26, 2015 at an average price of $110. At $110 per share, our total return on VRX has been 97%. More importantly, if our current position (including the shares we just bought) went to zero, we would still show a modest positive return on our entire VRX investment of 16%.

The Present – Are we crazy to be buying VRX again? (Or, risk management via scenario analysis.)

On September 21, 2015, a story broke that a small, private pharmaceutical company, Turing Pharmaceuticals AG, acquired and then subsequently raised the price of a toxoplasmosis drug 5000%. VRX closed at $229 on that same day. Then, news articles began accumulating about drug price increases across the pharmaceutical industry in general. Politicians began to talk about capping drug prices. Critics cited Valeant as one of the more aggressive price raisers. VRX’s share price dropped precipitously. After a few days, it settled in a range between $160-180.

With uncertainty and pressure already surrounding the company, several short sellers published innuendo-filled reports regarding Philidor, a specialty pharmacy Valeant used to distribute several of its dermatology products. The reports suggested that Valeant was using Philidor to “stuff the channel” with inventory and record sales that never really existed in an effort to inflate Valeant’s financial performance. On this news, VRX shares dropped below $100 and have now settled into a range between $95-120. While the “channel stuffing” allegations were quickly rebuked, Valeant cut ties with Philidor on October 30, 2015. It became clear that Philidor had used aggressive (potentially illegal) actions to collect from insurance companies and Express Scripts and Caremark took Philidor off their platforms.

From a risk-management standpoint, we re-examined Valeant’s business in an attempt to determine the potential extent of damage these issues could do to Valeant’s business (aside from short-term movements in stock price). First, we identified the segments of the business exposed to these two issues: significant price increases and aggressive practices at specialty pharmacy distribution channels. Then, we attempted to estimate the magnitude of the issues within these segments.

Price increases. The majority of the significant price increases were within Valeant’s neurology segment. This segment makes up a modest 10% of their overall sales and 15% of earnings. Moreover, Valeant’s recent financial performance demonstrates that the overall business does not rely on significant price increases. The company grew organic same store sales 16% year over year during the first three quarters of 2015. Half of this was via price and half via volume. Current business growth is not reliant on significant price increases. Philidor; specialty pharmacies; “channel stuffing.” Just 7% of both sales and earnings come from the specialty pharmacy channel. More importantly, the insinuations of “channel stuffing” and accounting fraud appear baseless – to the point that the shorts have altered their narrative regarding Philidor to accusations of aggressive insurance collection. The later allegations appear to hold merit as Express Scripts and Caremark cut relationships with Philidor, forcing Valeant to do the same. At $110 and 6.9x 2016 consensus earnings, VRX is undervalued even if we haircut earnings for the 22% that make up the product segment and distribution channel that have come under scrutiny. Further, a brief examination of health care legal settlement history provided by Pershing Square (the second largest holder of VRX stock) on their October 30, 2015 call with investors helped to baseline the potential legal risk to Valeant:

There were 303 health care industry settlements with the government from 1991 through July 2012 for a total settlement value of $29.35 billion. The average settlement was $96 million. The largest settlement was $3 billion. GlaxoSmithKline, Pfizer, Johnson & Johnson, Merck, and Abbott were responsible for a combined $16.53 billion or 56% of the total settlement amount. Violations included: unlawful promotion, kickbacks, concealing study findings, overcharging government health programs, poor manufacturing processes, and monopoly practices. On October 27, 2015 Novartis reached a settlement in principle with the Department of Justice for alleged bribery of pharmacists (at specialty pharmacies similar to Philidor) for converting patients to Novartis drugs. The settlement in principle is for $390 million. Per Pershing Square, “at least one of the products in question was alleged to cause ‘serious, potentially life-threatening’ side-effects and has a ‘black-box’ warning.” There is no indication that any of Valeant’s patients were at risk because of Philidor’s behavior. From our perspective, the legal risk to Valeant is minimized, as Philidor was a separate legal entity not owned by Valeant (though Valeant does have an option to buy Philidor). In addition, should Valeant be legally implicated in any Philidor improprieties, the historical record would indicate total exposure is likely in the several hundred million dollar range and very unlikely to exceed a few billion. From its August peak near $260 to approximately $100 today, VRX lost $55 billion in market capitalization.

The Future – Uncertain for Sure (But, the risk has been quantified.)

No one knows exactly what the future holds for Valeant. Yet, analyzing the accusations against the company and the potential impact on the business, we believe the risk of permanent capital loss to the current share price is modest. At 7x earnings, the upside far outweighs the risk. Even in an overall environment where risk aversion is increasing, there are opportunities to prudently take risk.