Valeant, Short Selling, and the Too-Hard Pile

Posted on Posted in Case Studies, Investment Philosophy

In general, I find reading short reports to be a very valuable exercise. I don’t do much shorting in my partnership, but I find that for the most part, short sellers provide a useful service to the capital markets and I think that the good short sellers (who are few and far between) often do more thorough investigative analysis than the vast majority of long-only investors.

For a good book on shorting, I recommend reading Scott Fearon’s book called Dead Companies Walking. Even if you don’t short, I think it’s useful to read and listen to short sellers—if you can identify the good ones.

I don’t like shorting because I think it’s a difficult task. The best short sellers often are 100% correct in their analysis, but if they are “early” (meaning the stock keeps climbing for months or even years before their thesis comes to fruition), they can lose all (or more) of their money that they allocated to that short trade. So it’s generally an uphill battle when you are betting against stocks.

But special situation shorting can be very productive, and with mass media outlets and platforms such as Seeking Alpha where a short seller can now publish his or her own research, a good short seller can create his own catalyst. That’s what Andrew Left at Citron does, along with numerous other short sellers. There are a lot of people that cry foul or talk about manipulation when it comes to published short write-ups, but the good news is that the market generally is a pretty good judge of what is good work and what isn’t. Shorts can often successfully knock a stock down 10% or more simply because of fear generated from an article (some investors will always “sell first, ask questions later”), but if the short thesis isn’t based on sound fundamental analysis, the market will quickly correct itself.

Where short sellers really do good work is when they put the effort in and summarize their research on companies that turn out to be engaging in destructive business practices, fraudulent accounting, or operating a business model that isn’t sustainable. Often the market doesn’t understand these situations immediately, but the market always will get these situations right in the end. Short sellers simply expedite the timeframe. They speed up the time it takes for the market to discover these frauds on its own. But short sellers—the good ones—don’t create frauds. They simply discover them and tell the market about them.

So although short sellers often get a bad rap, the good ones provide a valuable service. The bad ones are the ones that deserve bad raps—the ones that simply try to drive stock prices lower by spreading rumors or fear mongering. But in my experience, these types of short sellers a) don’t ever make any money over time, and b) although they might successfully manipulate a stock price lower temporarily, the market will always quickly correct itself. Innocent companies might see their stock prices fluctuate, but won’t permanently be damaged by short sellers if they truly aren’t doing anything wrong. I know there might be occasional exceptions to this, but by and large I believe this is true.

One of the things Ted Weschler once mentioned—he said when looking at health care companies, one of the checklist items he asked himself is whether or not the company adds value to or takes value from the health care system. If the company doesn’t add value to the health care system, then it probably will eventually run into problems.

The Valeant Saga

Last month, Valeant Pharmaceuticals (VRX) was all over the front pages. Short sellers questioned many aspects of the business such as its accounting (which has been in question for years now), its controversial practice of significantly hiking prices of newly acquired drugs, its relationship with a specialty pharmacy and the volume of drugs that Valeant sold through that channel—not to mention broader questions regarding the sustainability of its business model (there are legitimate questions regarding the company’s ability to grow “organically” through volume increases as opposed to price increases and acquisitions).

In other words, one general argument is that if Valeant has a legitimate growth model it should be able to increase revenues and cash flows by selling more drugs over time, not by using more and more debt to buy drugs and then jacking up their prices.

Valeant is used to being attacked by short sellers who for years have questioned its accounting. Andrew Left is probably the most well-known short seller in this case, although his work to me is much more sensational than it is useful (I’m not saying Left is wrong—often times he does good investigative work and is correct, but to call Valeant the next Enron is probably a bit sensational).

However, one blog that in my opinion has done the best work on Valeant is AZ Value Investing Blog. His write-ups are much longer and use far less BOLD FACED CAPS, exclamation points and multi-colored fonts than Left uses, but I think his work is very substantive and worth reading. In fact, pharma is a business that I’ve never really considered for investment, but I learned a lot just reading his analysis of Valeant.

Valeant Sits in My Too-Hard Pile

Let me say that (luckily), I’ve kept Valeant in the too hard pile. I don’t know the pharma industry well, and although I’ve learned a lot reading about it recently, I just couldn’t quite understand the relationship between Valeant and its distribution channel, and how that relationship (or lack thereof) will impact revenue going forward. There are some questions I have a hard time answering.

I understand Valeant’s general model: Buy drugs that have inelastic demand and raise prices. Don’t use a “shotgun” approach to R&D. Instead, focus R&D dollars on drugs that have a much better chance of approvals and future sales, and thus higher returns on capital. So buy drugs that are undervalued, raise prices, slash spending on R&D, and try to grow organically through more focused spending on drugs with a higher probability of success.

But how is it that Valeant is able to raise prices so significantly for these drugs without any pushback from the parties who are paying these prices? Are the insurance companies really just too bureaucratic to notice? Or are these drugs really worth the prices Valeant is charging in a fair and transparent market? If the latter is the case, then I think Valeant has a legitimate model. If the former is the case, then Valeant’s model might be profitable in the near term, but is doomed at some point. This is because insurance companies—for all of their faults—aren’t stupid. They understand that a toenail fungus cream that costs 50x the price of a generic that is just as effective is not worth paying for. Eventually, the insurance companies (or other large payers) will have the largest say in the matter and the cheaper drug will get dispensed. Most health care providers will prescribe the cheaper drug if they understand the price disparity, and most pharmacies are incentivized to dispense the generic brand as well (they generally have much lower margins on the branded drugs and will fill generics unless the script is marked “dispense as written”).

So although there is a lot of bureaucracy among government payers and insurance companies, eventually they will correct these problems by not paying for overpriced drugs that aren’t adding any value. Companies like Valeant might be able to take advantage of this bureaucracy in the short-term, but it’s not a way to produce lasting value for shareholders.

If you’re not adding value to customers, you’re probably eventually going to destroy value for shareholders.

That’s a principal that I try to keep in mind when evaluating investment opportunities, and I’ve learned this through the school of hard knocks. But I find that it is almost always a rule that should not be disobeyed.

Similarly, if a health care company is taking value from (rather than adding value to) the overall health care system, it likely is not going to reward shareholders in the long term either. There might be exceptions to this “rule” as well, but I generally wouldn’t want to bet against this concept.

Whether Valeant is breaking this rule, I don’t know for sure. But the fact that I can’t answer it will keep me on the sidelines. Michael Lewis is probably working on a book right now about Valeant and he will feature the next Michael Burry who either “knew” Valeant was a fraud and shorted it to $0, or “knew” Valeant was the buy of a lifetime and loaded up as he tripled his money. The story of the Valeant saga has already has seen a very interesting plot unfold and it has included some big name characters such as hedge fund titans, government regulators, and even presidential candidates. I will read the book with great interest, but unfortunately will not be a subject in it.

Regardless, it will be fun to watch unfold.

12 thoughts on “Valeant, Short Selling, and the Too-Hard Pile

  1. re: Ted Weschler “when looking at health care companies, one of the checklist items he asked himself is whether or not the company adds value to or takes value from the health care system”
    DaVita (a Weschler pick) is one of the most unethical companies I’ve ever seen. Americans would be a lot better off with a healthcare system like Canada’s (or Australia, etc. etc.). For dialysis, the US way of doing things is very expensive and doesn’t deliver very good patient or social outcomes. Other countries have more frequent dialysis and provide in-home noctural options, so that dialysis patients can live more normal lives and actually hold down a job. They also don’t have patients dying from completely unnecessary EPO overdosing.

    1. Hi Glenn, Thanks for the comment, and you bring up something I’ve wondered about myself. I don’t really know much about DaVita, but you bring up a good point. So I don’t disagree, but I would say that maybe Weschler’s concept about companies adding or taking value from the system is still probably a good concept (even if one of his investments contradicts his own filter).

      1. It seems like a good idea, and I’d be inclined to agree with it.

        However, in practice, it’s kind of maddening. US healthcare stocks have done very well for a very long time. So I don’t know. :/

  2. Hi John,

    Another great post.

    I am a physician and have been following the story pretty closely. As you know, I am also an investor. For the record I am a proceduralist and the breadth of the drugs I prescribe is nowhere near as robust as someone in primary care. Their perspective on this would be infinitely more useful than what I am about to say. But in the absence of such a person, I will go ahead and give you my perspective.

    My general impression is that Valeant’s business model is a tough pill to swallow (pun intended). Whether you are paying for R&D organically or through acquisitions, the expenses need to be accounted for. It’s a mistake to exclude amortization in Valeant’s case from calculations because if your business model is predicated on cutting back on R&D to shunt more cash into acquisitions, then acquisition costs become a recurring cost. Without acquisitions, which may be the case in coming years, they must rely on organic growth.

    It’s unclear to me how they can make up for the hefty prices paid on acquisitions. The acquisitions are quite large and distribution cost synergies are therefore limited. Bausch and Lomb, for example, already had a pretty robust distribution system. As stated above, discontinuing R&D is not exactly a “cost synergy” because the intellectual property needs to be obtained by Valeant somehow.

    So perhaps they have some revenue synergies. The most heavily advertised one is raising prices. This is where my perspective as a physician may come in handy. My general impression is that it is very difficult to raise prices in pharmaceuticals. There are some very well-branded drugs like Miralax or Tylenol which have been off-patent where patients will be willing to pay up. But the overwhelming majority of drugs’ prices are either maintained by patent protection (whose amortization, once again, should not be discounted by investors) or become quickly commoditized by generics. The idea that doctors will start preferentially stating, “dispense as written,” on our scripts for Valeant’s products is a bit of a stretch. None of us like to get phone calls from angry patients, or fight with insurance companies that refuse to pay because an alternative is available. We have every incentive in the world to prescribe the cheaper generic: the doctor wins, the patient wins, and the insurance provider wins. But Valeant shareholders won’t.

    I find it curious that 40% of Valeant’s revenues go through specialty pharmaceuticals. It’s even more striking that there are accusations of Phildor writing “dispense as written” on the behalf of doctors. If this is widespread practice among Valeant’s distribution network, investors should head for the exits. I should note that I’m not making any conclusions about its legality, but rather the sustainability of this business model. Nobody knows the intricacies of Valeant’s interactions with specialty pharmaceuticals, which is an absolute requisite to take a position in the company. So “too hard” is where it belongs for, I think, almost everyone in the world.

    I want to point out that, to date, you are the only one that has reiterated my overarching concern with the company. What value does it bring to the world? To doctors? To patients? To insurance companies? To hospitals? To healthcare costs (17% of GDP)? I am failing to see how this business can sustain itself for 100+ years (which is my investment horizon).

    Keep up the good work, John. You’ve been on a roll lately.

    Regards,

    J

    1. Thanks for the nice words J. I appreciate your comment, and your perspective as a physician. Just a follow up question: In your experience as a doctor (or your knowledge of how general practitioners work), is there any incentive for doctors to prescribe the higher priced brand name drugs when the same drug is available as a generic for a fraction of the cost? Some have said that the specialty pharmacies that act as the point of contact between the doctor and the insurance companies takes a load off of the doctors (it allows them to outsource some of the hassle of dealing with insurance companies and the headaches involved with that process and instead focus on care). Other than the hassle of dealing with insurance companies or maybe just not being aware of certain generic alternatives that are available, why would a doctor ever prescribe the higher priced drug?

      1. You ask a very interesting question. I’m going to give you an answer that is perhaps too much information, but represents my knowledge on the topic to date. Consider this a poor man’s version of scuttlebutt.

        In order to qualify as a generic, the drug must demonstrate 80-125% bioequivalence. By this I mean the serum levels of the drug must be 80-125% of the range of what the branded drug demonstrated in clinical trials. This reduces the time to market, cost, and burden of proof necessary to bring the drug into the patient’s hands for the generic producer. For the overwhelming majority of the drugs, this is sufficient 99.9% of the time.

        There are some problems with the protocol for generic drugs. First, the mixture of capsule compounds with the active component may produce a different effect than the active component itself. Some Neurologists believe this to be the case with anti-epileptics, and are therefore incentivised to prescribe “as written.” Second, there are few follow-up studies on generic drugs to prove 80-125% bioequivalence produces the same clinical outcome in patients. As I have mentioned before, one of the advantages is the cost savings on having to do all the large-scale clinical trials, so you would expect that these studies will never be done. Once again, the majority of the time, doctors are OK with this caveat. It is plausible that 80-125% serum levels will get you the desired effect so there’s not much point in spending money to dig deeper.

        That is the scientific reason to choose a prescription drug over a generic, which is a sliver of the story. By far the biggest reason to prescribe a generic is out of habit. We are not perfect people, contrary to what T.V. shows would suggest. Just like for you, there are only 24 hours in a day, and we suffer from a Big Data problem in that there is too much science for us to reasonably consume. So pharmaceuticals rely on advertising and other habit-forming activities to make us choose one drug over another. This is a huge part of their business model. The chains of habit are too light to be felt until they are too heavy to be broken. Branded drugs have the advantage of necessarily coming out before the generic form. So we form our habits on the branded drug, and often times have no idea when the patent expires. The majority of physicians will prescribe the branded name over the generic name (the generic drug is often times intentionally hard to say, lengthier to write, etc. the branded name often rolls of the tongue easier — this is not a coincidence).

        Pharmacies, privy to the fact that physicians are often times unaware of when a generic is available, will automatically dispense the generic version of a branded name if it exists. I agree with this policy. But if a doctor really insists on the branded form, they must write “dispense as written.” Hardly any of my colleagues do this. We have pretty much no scientific reason to, and from a healthcare-structure standpoint we have every reason to desire the generic (for the reasons I mentioned in my prior post).

        This is a very long-winded answer to your question, but I think likely provides you with valuable insight into the pharmaceutical industry. My overall impression is that there is very little reason, whether scientifically or pragmatically, to “dispense as written.” This is why I find it so startling that Valeant uses specialty pharmacies and Phildor installed a practice of writing “dispense as written” on our prescriptions.

        Happy to answer any other questions you may have.

        Regards,

        J

        1. Great information. Thanks again J. Do you have any experience (or second-hand experience being around the primary care providers) dealing with specialty pharmacies? I’m trying to better understand their reason for existence. I have a friend that has talked with many different retail pharmacies, and I’ve talked to a few pharmacists myself at these locations (Walgreens, CVS, etc…). Most of them say they don’t even carry a drug like Jublia-the Valeant drug for toenail fungus (or they just keep one on the shelf at a time) because it is so expensive and the patient often forgets to bring in coupons needed to offset the copays. I’m trying to understand how specialty pharmacies fit into this general sequence. Why does a doctor decide to work through a specialty pharmacy like Philidor? Is it simply because these specialty pharmacies help deal with the insurance company and help patients get the reimbursements/coverage they need? Or is it out of habit or simplicity?

          Thanks again for sharing your insights. Very interesting…

          1. Another good question, and something I’m trying to work through on my own time (I don’t short, so my interest in Valeant is largely academic). Several of my family members are primary care physicians, and if you leave me your contact info I will get back to you with my impressions after I accumulate more data. One question is why insurance is willing to pay them since they’re more expensive, and my brother-in-law works at a major pharmaceutical firm and I will corroborate data with him as well.

            My initial impressions are that specialty pharmacies are largely an arbitrary business model choice. I’m not a pharmacist, and even worse I’m a surgeon, so I am about as simple a doctor as you can find. The entire purpose for their existence is to ‘improve access to drugs’ to patients. But I’ve gone through survey data and it seems the reason patients can’t access those drugs are because they are high cost. Which leads me to the question: why would insurance companies pay up for them? I will have to ask my brother-in-law.

            There are certain types of drugs that are hard for regular pharmacies to store. Some are perishable. Some need to be very delicately titrated on dosage and patients need special counseling. Some need certain types of tools to administer, such as syringes for injections. So a specialty pharmacy can take on the ‘niche’ role of doing this for patients. The problem is that Valeant’s drugs don’t seem, to me, to fall into these categories.

            Let’s take Jublia, for example. The non-branded name is eficonazole (longer and doesn’t roll off the tongue as easily). The -azole class of drugs are antifungals that are actually quite old. There are many alternatives and many of them are cheap/generic. I don’t routinely treat toe fungus but I’m going to tell you that most non-podiatrists don’t spend too much time perseverating over toe fungus. If one doesn’t work, we try the next one. If that doesn’t work, we move to the next class of drugs. There’s a whole lot of different options before you have to resort to something as costly as Jublia. So I’m failing to see how you can generate ridiculous amounts of sales through 3rd and 4th line drugs. The problem with costly drugs is, unless there’s literally only one option to use, doctors don’t prescribe them. So now you’re in a tradeoff situation: cost vs. volume. You can’t have both. Color me a pessimist, but I’m skeptical about Jublia. Or any other drug that has comparable economics.

            The answer to this problem must be that specialty pharmaceuticals are circumventing the traditional ‘pathway’ for prescriptions. I’m going to be doing more investigation on how they work in the coming days. My e-mail is jathinb@gmail.com — shoot me an email and I’ll get back to you.

  3. John and J,

    Really enjoyed above discussion between you two about Valeant, I am also a physician and an investor and have watched Valeant from sidelines and one of the reason was I didn’t quite understand how their drugs were benefitting patients. Jublia has 18% efficacy, which is less than the efficacy or cure rate of Vicks Vaporub ( Yes, that Vicks!), although the trial done was very small.

    So most of the time I don’t invest in companies where I don’t understand how it will create value for the customer and I think that saved me from making lot of mistakes.

  4. “If you’re not adding value to customers, you’re probably eventually going to destroy value for shareholders.”

    Though the statement seems true on the surface, on closer inspection it may not be. The determination may hinge on what is meant by “adding value.”

    For example, it is no longer a controversy whether the nicotine industry, mostly cigarettes, sells a product that harms its users. Yet, the industry was one of the best performing during the last century and continues in this one. If “adding value” here is delivering convenient dosages of nicotine once a habit is formed, then value is delivered though the lifetime value of the customer is reduced by the product itself. Per other consumables, similar arguments are being made today by some about fast food, sugary soft-drinks, alcohol beverages, etc. as many more in developed nations live sedentary lifestyles.

    One can argue that the “added value” in the above products is the immediate gratification a person attains from consuming the goods. In addition, businesses selling these goods have had a tough go lately because of reduced acceptance of some of their primary products. Still, other sectors are harder to justify.

    It’s not just goods where this occurs. There are libraries full of scholarly studies that conclude that active fund managers underperform their benchmark indexes over time, even before taxes are accounted for. This is largely due to high expenses relative to index funds. The common shares of asset management companies have nonetheless been one of the best performing sectors over the past several decades since index funds became widely available and publicized in the ’70s. A counter-argument could be that these funds are sold via advisors with loads and hence it’s the advisor who is attaining the value since he needs product to sell. Still, it’s hard to ascertain the end-consumer’s additional value on average from such investments.

    In contrast, there are also industries where consumers attain great value and shareholders achieve modest or little gain. First, there are the “economic paradoxes” of utilities such as waste and water/sewage, which add great value to any citizen and often have natural monopolies with the latter, yet usually have merely modest returns. Electric power utilities and downstream oil and gas companies are each energy necessities in developed countries, yet one has had economic returns that vastly overshadow the other. Railroads, especially passenger, have had poor returns during most of the 19th and 20th centuries despite their economic importance. Warren Buffett has noted in this era same phenomenon with airlines and internet industries (e.g. many internet backbone fiber companies have visited bankruptcy court at least once).

    So, isn’t that statement an oversimplification?

    1. Yeah I think it’s a generalization. I wasn’t saying that it is a hard and fast rule, but it something that I think holds true the vast majority of the time. There are always exceptions that you could point to, as you’ve done (although I wouldn’t want to bet on companies selling nicotine for the same reasons I referenced, despite past performance). As for fast food or sugar, I don’t buy the argument that selling sweets is somehow immoral or “not adding value”. I like sweets, and I enjoy an oreo cookie occasionally. I know what I get when I buy a package of Oreo’s, and I’m a willing to pay the price in exchange for the “value” I’m getting (delicious empty calories). Just because it’s not a salad doesn’t mean the cookie doesn’t hold value to me in excess of my cost. I guess Buffett feels the same way about his 5 cans of Cherry Coke per day. So I guess you’re right in how you define value. That said, I don’t think these examples can even compare to the VRX situation, which is almost unquestionably taking significant value from its customers (insurance companies in VRX’s case for the most part, and across the industry it’s tax payers via government payers as well as insurance companies). VRX can do this in the short run, but as we’ve begun to see with the large PBM’s cutting off Philidor and other similar distribution channels, this won’t last for long.

      So I wouldn’t take it too literally or assume there are never exceptions, but I think that a business that adds value to customers is a much better business that takes value from customers (despite the occasionally exception with a great record).

      Thanks for the comment.

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