Merger Mania Under Scrutiny
In our Q2 review, we pointed out the exceptional long term performance of health care stocks, and in particular, the improbably strong performance of pharmaceutical and biotech shares (noting that about 70% of the companies in the Nasdaq Biotechnology Index had not even reported a profit over the prior twelve months). Our conclusion at the time: “It’s enough to leave the citizens of Graham & Doddsville scratching their heads.” In the intervening months, a number of interesting developments have taken some of the shine off this sector.
In September, a little-known pharmaceutical company CEO (and former hedge fund manager) named Martin Shkreli caused a social media furor when news broke that his company, Turing Pharmaceuticals, had acquired the rights to 62 year-old generic drug, and promptly raised the price from $13.50 to $750 per pill. Health care providers and patients-rights advocates were outraged, and the public backlash prompted legislators to more closely scrutinize a recent trend of incongruous price hikes on certain long-established generic drugs.
Normally, generic drugs are much cheaper than their “branded” counterparts (once the patent on the branded drug expires, the identical compound can be manufactured by multiple competitors, driving down the market price). However, if a drug’s target market is a very specific niche or rare condition, it is likely that generic production will eventually consolidate under a single manufacturer (competitors may find it uneconomic to divide such a small market). Theoretically, new competitors can enter the generic market at any time. In practice, the FDA approval process is costly and time consuming; new entrants are discouraged from making the effort if the generic drug in question is already cheap and the addressable market is limited in scope. Recognizing this, savvy pharmaceutical executives perceived an opportunity: if they acquired the sole manufacturer of a “neglected generic” drug, they would have a window of time–months, often years–before a competitor could complete the FDA approval process and bring another version to market. During this time, they could freely raise prices and reap monopoly profits. Obviously, this is a rather short-sighted (not to mention ethically dubious) proposition.
The poster-child for this strategy is Valeant Pharmaceuticals (VRX), a company which experienced exponential growth under the tenure of CEO Michael Pearson, who took over in 2008. Through a series of ever larger acquisitions (including a tax inversion in 2010 which moved the company to Canada and brought it a lower corporate tax rate), Pearson built up Valeant’s pipeline of branded and generic drugs. Along the way, the company raised prices on drugs it acquired, slashed research and development expenses, laid off redundant staff, and borrowed heavily to finance acquisitions. Investors cheered the results, as “adjusted earnings” soared and the stock appreciated more than twenty-fold between 2008 and its peak in early August.
Along the way, several analysts began to question the sustainability of Valeant’s M&A-oriented growth strategy, which is predicated on the availability of cheap debt and/or an expensive stock which can be used as acquisition currency. Some skeptics pointed to Valeant’s use of aggressive accounting measures which did not conform to generally accepted accounting principles. Most damning were a pair of research reports published in October from short-seller Andrew Left of Citron Research: the first focusing on the extent of Valeant’s price increases for acquired drugs, and the second revealing a controversial and previously undisclosed relationship between Valeant and a subsidiary drug distribution company called Philidor. Citron alleged that Valeant’s opaque relationship with Philidor was being used to artificially inflate reported sales of some of its drugs, and drew comparisons to the type of fraud perpetrated at Enron. Valeant belatedly acknowledged (and initially defended) the relationship with Philidor, then abruptly shifted gears and announced that it was severing ties with the distributor. Smelling smoke, investors headed for the exits, and to date Valeant stock has sold off more than 70% from its peak:
While many well-regarded fund managers (including several value investors) own Valeant stock, this is one company which we put in the “too difficult” pile. Our valuation process is oriented toward the very long term, and aims to conservatively discount the future cash flows of a business. With a company like Valeant, we think there is simply no way to confidently estimate what their cash flows will be 10-20 years out. The firm’s growth is mostly based on acquisitions and, like all pharmaceutical companies, its assets have finite lives (due to patent expiration or encroaching generic competition). Yet, management has rather recklessly taken on a large amount of debt (nearly 15x the amount of free cash flow generated over the last 12 months). We’ll continue to watch this one from the sidelines.
Important Social Security Update
In late October, Congress passed a budget bill which eliminates a favored social security filing strategy–known as “file-and-suspend”–that many married couples (including some of our clients) have used to maximize their projected lifetime benefits. While there is still a six month window until the changes take effect (and applicants who have already pursued this strategy will have their benefits grandfathered in), those who have yet to reach full retirement age may be impacted by this change. If you have any questions about how this may affect your plans, please contact us and we will be happy to review your filing strategy, based on the new law.