June 2016

Introduction: Valeant may strain to engineer way out the in door

By Robert Cyran

Valeant Pharmaceuticals International is a classic case of how Wall Street clings to the power of an idea, and just how hard it can be to let go. Consultants and hedge funds used the drug company as a vessel to redesign a huge segment of the American economy, ostensibly to make it more efficient, while extracting profit in the process. As Valeant embarks on the next phase, with its first results under a new chief executive, the question is whether Valeant can financially engineer its way out the same way it got itself into trouble.

At its peak, Valeant grew to become a $90 billion company on the back of a debt-fueled acquisition binge, gigantic price hikes on the drugs it bought and cost cuts that largely slashed research and development of new therapies. Early investors enjoyed a 30-fold return. Valeant inspired a slew of copycats, many beyond the pharmaceuticals industry.



Compensation consultants clamored to see how the executive team, led from 2008 until earlier this year by former McKinsey consultant Michael Pearson, rewarded themselves while turning a sleepy firm originally formed by the ex-prime minister of Yugoslavia into one of the world’s biggest drug companies. More recent deals for Salix Pharmaceuticals and Bausch & Lomb, for which Valeant paid more than $27 billion combined, including debt, captured the imagination of investors – and ultimately Congress, but it was a smaller acquisition back in June 2010 when the company’s market value was less than $3 billion that first attracted Valeant to Breakingviews.

In many ways, that transaction foretold the troubles that were yet to come. It was a complicated mess of a merger where Valeant combined with Biovail, a drug company that had been accused of accounting fraud by the Securities and Exchange Commission, to reduce its tax bill by relocating to Canada.

It would take half a decade before the downfall took hold. Along the way, various subsidiaries and associated firms sued each other, employees were revealed to have used superhero aliases in emails, pushy investor Bill Ackman became Valeant’s de facto spokesperson and the company fired its chief financial officer but couldn’t remove him from the board of directors.

The company, with its shrunken $10 billion market value, in April hired Joseph Papa from rival Perrigo to lead a turnaround. In some ways, it signals more of the same. Papa merged Perrigo with an Irish rival a few years ago to reduce the company’s taxes and later spearheaded a rejection of unwanted suitor Mylan, only to have the company’s stock tumble by more than half.

Nevertheless, investors may be counting on more financial wizardry. Japanese rival Takeda and buyout shop TPG recently offered to buy Valeant and break it up. Valeant could sell big businesses on its own, too. The trouble now is that $30 billion of debt coupled with the neglect of R&D could make it hard for private-equity firms or other suitors to make deals work. That doesn’t mean all concerned won’t try, though.

Published on June 6, 2016

(Left image: REUTERS/Eduardo Munoz)

(Right image: REUTERS/Jonathan Ernst)

 

Contents

FROM $2.5 BILLION TO $25 BILLION

Biovail sale oddly leaves its owners in control

Hasty hostility costs Valeant its Cephalon quarry

Sometimes extra-rich pay packages actually do work

Valeant shows how some M&A favors the brave

 

FROM $25 BILLION TO $90 BILLION

Dawn raid makes comeback via activist drone strike

Valeant’s M&A machine may soon overheat

Valeant’s slashing could trigger FDA lashing

ValueAct’s Valeant return hints at value trap

Valeant’s activist deal too clever by half

Deal junkie Valeant shoots up on $10 bln fix

Valeant pops risky $1 bln libido pill

 

FROM $90 BILLION TO $25 BILLION

Valeant’s back-foot problem flares up in Congress

Valeant’s platform trembles beneath Ackman’s feet

Valeant sets tone for post-M&A accounting scrutiny 

 

FROM $25 BILLION TO $10 BILLION

Chancellor: The illusion of debt-fuelled earnings

Valeant CEO gets called on $100 mln excess

Valeant poised to cause much collateral damage

Valeant’s latest fix reinforces its challenges

Podcast: Bill Ackman

Valeant plays chicken with death spiral

Podcast: Valeant spiral

Valeant’s multiple organ failure puts it in ICU

Valeant’s new CEO a good choice for a dim future

 

Biovail sale oddly leaves its owners in control

By Robert Cyran

It’s a neat trick to sell a company at a premium and keep a controlling interest. But Biovail is pulling it off. Specialty U.S. drug group Valeant is effectively paying 15 percent over the market price for Canadian rival Biovail – yet the latter’s shareholders are ending up with 50.5 percent of the merged group. There is a rationale, but the danger is it’s too complex.

There is strategic logic. Valeant, whose chief executive Michael Pearson will head the combined company, thinks $175 million of annual cost cuts are there for the taking. If so, these savings could be worth more than $1 billion today – against the combined market capitalization of the two firms of $5.8 billion.

Yet tax problems could have killed the deal. Biovail’s operating subsidiary is based in Barbados. To preserve its low tax rate, that company needed to be the entity doing the acquiring. Meanwhile, also for tax reasons Valeant needed to end up owning less than half the combined entity. As the bigger company by market capitalization before the deal, that meant making a cash payout for its own shareholders part of the deal.

The result is a curiosity. In return for giving up their collective control, Valeant shareholders end up with cash and shares in Biovail worth $42.77 for each Valeant share – about $3 less than their value before the deal – plus a promise of another $1 in the form of a dividend before the end of the year. For Biovail shareholders, the merger values their shares at a premium.

Valeant shareholders may figure that their share of the mooted synergies should be worth slightly more than the premium they are ceding to Biovail’s owners. Furthermore, Valeant gets to appoint the tie-breaking director on the combined board – subject to Biovail approval.

Even so, Biovail’s checkered past justifies a certain skepticism. A few years back the firm accused hedge fund SAC Capital and others of conspiring against it – but ended up facing Securities and Exchange Commission charges, which it settled. That may all be in Biovail’s past now. And on one interpretation, Valeant’s clever structuring has allowed the business benefits to trump pesky tax problems. But it would be a shame if it turns out strategic discretion was neglected in that valiant effort.

Published on June 21, 2010

Hasty hostility costs Valeant its Cephalon quarry

By Robert Cyran

Hasty hostility has cost Valeant Pharmaceuticals its quarry. The drugmaker hoped to snaffle rival Cephalon in weeks with a proxy fight it launched late in March. But Valeant made it clear it wouldn’t get in a bidding war. That left plenty of room for white knight Teva Pharmaceutical to swoop in for Cephalon with a higher, $6.8 billion offer.

Hostile deals are difficult to seal. Instead of quiet backroom conversations, everything is played out in public. Valeant’s effort to dismiss the managers of Cephalon was a recipe for rancor. There was also an element of opportunism about the $73 a share offer it took directly to Cephalon’s shareholders. Valeant said if it didn’t get enough support by mid-May, it would walk away. At best, the would-be acquirer indicated it would increase its offer only slightly if Cephalon opened its books.

The result was merely to flush the quarry into the open, where it has now been bagged by Teva. The white knight is stumping up $81.50 a share, a 12 percent premium to Valeant’s price, partly based on the belief that its target’s pipeline has value – something Valeant didn’t recognize. A softer approach by Valeant might have made Cephalon less reflexively hostile.

Alternatively, a higher initial bid might have scared off rivals. But Valeant missed that trick, too. Sure, it offered a 24 percent premium to Cephalon’s market price, but health companies often attract twice as much. And figures from its past mergers suggest Valeant low-balled the annual cost savings that the combination would have created. The fact that investors marked down Valeant’s stock by 7 percent when it said it was abandoning its bid implies value may have been left on the table.

Even though it misplayed its hand along the way, Valeant is right to fold now. Engaging in a bidding war, or overpaying, would have set a bad precedent for future transactions. The company thinks buying up rivals, cutting costs and selling their undeveloped drugs is a recipe for value creation. There are still plenty of targets, such as Forest Laboratories and Endo Pharmaceuticals, which fit the bill. Next time, expect Valeant to play its cards more patiently.

Published on May 2, 2011

Sometimes extra-rich pay packages actually do work

By Robert Cyran

In just about three years, Michael Pearson has received about $200 million in stock as chief executive of Valeant Pharmaceuticals. Sound outrageous? Not to shareholders of the drugs group which last week walked away from a bid battle for rival Cephalon. Indeed, the incentives may very well explain that sensible decision.

Consider the way Valeant pays Pearson. At its most basic, Pearson is motivated in the way a private equity firm might be. To begin with, Pearson had to put some of his own money at risk. When he took the job in 2008, he was required to personally buy $3 million of the company’s stock. He bought $5 million.

Then he was rewarded a form of restricted equity that would pay him as much as $4 for every $100 of value created on his watch. But there was a hitch. The stock only vested if shareholders were treated to a 15 percent return annually. That’s like the hurdle ratios common in private equity – though they are usually much lower than 15 percent.

Moreover, if the return for shareholders hit 30 percent per annum, his rewards doubled, and they tripled if returns were more than 45 percent per annum. That meant more shares for outperformance, which mathematically keeps his share of all value created for shareholders at about 4 percent.

The incentives seem to have worked brilliantly. A dollar invested when Pearson came aboard Valeant’s predecessor company in 2008 would be worth about four times as much. Valeant stock is up more than 80 percent this year alone. As a result, Pearson is now sitting on securities worth some $200 million.

This, more than anything else, may explain why Valeant last week walked away from its attempt to acquire Cephalon for $5.7 billion. As originally, and hostilely, pitched, the deal made sense for Valeant, which would have reduced Cephalon’s heavy spending on R&D and prioritized selling the company’s existing drugs.

But when Teva Pharmaceuticals waltzed in with a 12 percent higher bid, Valeant didn’t get distracted. Rather than engage in a capital-destructive bidding war, it walked. Investors liked the discipline – the shares are almost 15 percent higher than where they were before the company made its initial bid. That’s reward enough for Pearson.

Published on May 10, 2011

(Image: REUTERS/Christinne Muschi)

Valeant shows how some M&A favors the brave

By Robert Cyran

Valeant Pharmaceuticals shows how some M&A favors the brave. Buying $8.7 billion Bausch & Lomb is the biggest deal yet for the acquisitive company, but it comes with huge cost savings that investors glorified. Chief executives elsewhere should take note.

A big part of Valeant’s success has been its ability to find drugs in the marketplace instead of the lab. It shares have gained 10-fold over the past five years compared to just 50 percent for the sector at large.

The industry spends huge sums on research and development because the prospect of developing a blockbuster is so alluring. Unfortunately, lab productivity has lagged, broady delivering a poor return on overall investment. The internal rate of return for the top 12 pharmaceutical companies last year was only 7 percent, according to a study by Deloitte and Thomson Reuters.

Instead, Valeant buys up smaller firms and deeply slashes costs. Whatever expertise it may lack with test tubes it more than makes up for with the accounting ledgers. Valeant’s tax rate is only about 5 percent. The combination has been potent, especially when new purchases are thrown into the mix.

Valeant estimates it can cut $800 million of costs by uniting with Bausch & Lomb. It’s an impressive sum – amounting to about half its target’s R&D and administrative costs – considering the eye-care company was already owned by notoriously stingy private equity. Applying a standard corporate tax rate of 30 percent would make the savings worth about $5.6 billion today, or about the same amount added to the company’s market value following the deal’s announcement. If Valeant can keep its tax rate down, the value created will be greater.

Chief Executive Michael Pearson sees room for more takeovers, particularly in ophthalmology and dermatology. He even alluded to the idea that Valeant isn’t yet as large or diversified as $250 billion Johnson & Johnson. That’s plenty of ambition for a company almost a tenth the size. So long as Pearson adheres to the same financial logic, investors will stay on side. And with M&A activity broadly stagnant, CEOs elsewhere might consider the lesson from Valeant.

Published on May 28, 2013

Dawn raid makes comeback via activist drone strike

By Robert Cyran and Richard Beales

Remember the dawn raid, when a would-be acquirer built up a stake before the target realized it was under attack? Activist investor Bill Ackman has come up with a kind of drone strike version. His Pershing Square Capital Management hedge fund and Valeant Pharmaceuticals have teamed up to grab a potential 9.7 percent stake in Allergan, with a hostile takeover by Valeant ready for deployment.

The acquisitive Valeant has reasons to be receptive to such an arrangement. For one thing, it’s essentially the creation of an activist hedge fund, ValueAct Capital, which set it on the path of serial dealmaking. Slashing research and development costs and applying its low tax rate to acquired businesses has served investors well. Its stock is up more than tenfold since it started buying rivals in 2008. The prospect of another deal kicked its shares 10 percent higher after regular market hours on Monday, taking its market capitalization up to $46 billion.

Moreover Valeant, which contributed $76 million to Pershing Square’s Allergan war chest, knew that nearly 10 percent of shareholder votes were in deal-friendly hands before it had to announce its intentions. Ackman has also committed to buy $400 million of Valeant stock at a discount and to hold considerably more for at least a year if the company does manage to buy Allergan.

For his part, Ackman gets to skip the step in which, after buying a stake in a company he thinks is ripe for a shake-up, he then tries to make something happen. Instead he has a ready-made buyer. The result so far is a gain of at least $1 billion on paper -and he hasn’t even yet had to turn cost-effective call options, through which Pershing Square has acquired the bulk of its economic interest, into shares.

A successful outcome isn’t assured for a hostile Valeant offer for Allergan. The two companies compete in the plastic surgery area, so antitrust regulators may ask questions. And after Allergan’s shares popped 20 percent on Monday, it’s now larger than its suitor with a market value north of $50 billion.

There are rules that would have forced a Valeant disclosure much sooner had it started accumulating stock in Allergan for itself. Of course, Ackman is putting up most of the capital and there’s no suggestion anything should have been revealed sooner. Even so, another set of watchdogs may wonder whether this novel battlefield tactic is too stealthy for comfort.

Published on April 22, 2014

(Image: REUTERS/Brendan McDermid)

Valeant’s M&A machine may soon overheat

By Robert Cyran

Valeant’s M&A machine may soon overheat. Some of the brain trust behind its hyper-acquisition strategy is leaving the board just as the pharmaceutical company embarks on its biggest deal. Buying Allergan would swell Valeant to about $75 billion in market value with a gargantuan debt load. Finding meaningful targets will be much harder.

Fred Hassan, the former Schering-Plough boss and current private equity honcho, and Mason Morfit, of activist hedge fund ValueAct Capital, are leaving the board along with Lloyd Segal from Persistence Capital. Valeant says its size and scope now creates conflicts with their day jobs. Morfit, in particular, was instrumental in picking Michael Pearson to be chief executive and setting the company on its takeover trail.

VALEANTMNALARGE

Note: Thomson Reuters values include net debt of the target company.

Valeant’s growth presents other, perhaps bigger, problems. In 2008, its market capitalization was about $1 billion. That meant buying a firm like Dow Pharmaceutical Sciences for $285 million – many of similar size still exist in the sector – was a big deal back then. Today, it would barely register.

Bill Ackman, Valeant’s hedge fund partner in the Allergan transaction, points out that there are 58 drug or device companies worth more than $10 billion apiece, for a sum of $3.2 trillion. Most of them would make poor targets, though.

The strategy at Valeant is to slash research and development. That works at places where drugs are difficult to make, sales are too small to interest rivals or there’s brand loyalty. Most of the companies on Ackman’s list – and all the ones worth over $50 billion – invest heavily in R&D or eventually face shriveling sales.

At Valeant, sales of existing products increased just 2 percent last year. It reckons there’s growth for Allergan in emerging markets, but that may be harder in practice than in theory. And if revenue starts to decline, Valeant could find the expected $30 billion of net debt post-Allergan to be rather imposing.

Together, the two companies reported less than $4 billion of EBITDA last year. Even after the promised $2.7 billion of savings from the merger, it would leave the combined company with debt of eight times EBITDA. That’s on the extreme end for leverage at a pharmaceutical group. For Allergan shareholders being offered Valeant stock, it’s a good reason to inspect the deal apparatus closely.

Published on April 24, 2014

Valeant’s slashing could trigger FDA lashing

By Robert Cyran

Valeant Pharmaceuticals’ promised slashing of Allergan’s costs could trigger a Food and Drug Administration lashing. If the Canadian takeover machine succeeds in its $47 billion hostile acquisition of Allergan – in cahoots with activist hedge fund manager Bill Ackman – Valeant expects to cut its target’s research and development spending by 80 percent. How it could do so without eating into required regulatory spending is a puzzle.

The two companies have totally different models. Valeant thinks R&D is often wasted: Cut it, and the profits will flow. There’s something to this idea. The return on investment in a typical biopharmaceutical portfolio often fails to cover its cost of capital, according to McKinsey – the old employer of Valeant Chief Executive Michael Pearson.

Allergan, more old-school, is committed to finding new drugs. Alongside some failures, it has had big successes such as expanding the medical uses of blockbuster Botox. Over half the wrinkle remover’s sales now come from treating migraine headaches, overactive bladders and the like.

Wall Street seems to favor Valeant’s method. Its stock is up more than tenfold since 2008. Allergan’s share price has merely tripled. But Valeant needs more and bigger deals to keep growing. That can’t go on forever, perhaps a reason why Pearson told big investors Valeant would consider a break-up if it became too large, according to Reuters.

Going after Allergan so aggressively -including promising an improved offer on May 28 – could indicate that the Valeant CEO is feeling the pressure to deliver growth. Perhaps haste and incomplete information explain why, according to news reports, he told analysts Allergan had a golf course that Valeant could get rid of to save money. There’s no such golf course.

A shortage of data also might help explain why Valeant thinks a $200 million R&D budget is sustainable, let alone sufficient to expand the uses of Allergan’s existing products and develop some late-stage drugs. Allergan spent $550 million last year on trials for these purposes, and an additional $200 million on studies of drugs already on the market.

Even with outsourcing and contributions from Valeant’s laboratories, it’s hard to see much scope to fund expansion or research and testing of new drugs. There’s even a risk of underfunding mandated studies of already-approved drugs. Skipping those allows the FDA to pull them off the market. That really could throw a wrench into Valeant’s financial machine.

 Published on May 20, 2014

ValueAct’s Valeant return hints at value trap

By Robert Cyran

ValueAct’s valiant return to Valeant Pharmaceuticals hints at a value trap. The departure of the activist fund led by Jeff Ubben from the drug company’s board in May set off a slide in Valeant stock, the currency so critical to its M&A-driven strategy. ValueAct is rejoining the board, and may buy more shares. Some good investments, it seems, are harder to leave than they are to make.

The San Francisco activist hedge fund is in large part responsible for Valeant’s success. It helped appoint Chief Executive Michael Pearson and drew up the lucrative compensation scheme that encouraged him to go on a massive shopping spree, which Valeant then capitalized on by slashing R&D and other spending at its targets. Wall Street loved the story, sending the stock up about 10-fold.

While Ubben’s fund has done extraordinarily well, cashing out may be proving problematic. Valeant is now a $43 billion company and saddled with lots of debt – to bag the big game it needs to grow, it needs to use its stock as currency. About 60 percent of its proposed $50-billion-plus takeover of Allergan comes in the form of equity. If Valeant’s stock weakens, so does the appeal of the deal.

Ubben says his fund never sold any stock. He has consistently defended Valeant’s business model. The perception that the smart money was considering cashing in, however, encouraged a self-reinforcing spiral downward – helped by criticism of Valeant’s business model by short sellers such as Jim Chanos, and Allergan’s bruising defense.

ValueAct’s return, and its promise to buy more stock, will dampen these attacks. Valeant’s stock rose 3 percent on the news. Yet Valeant’s business still needs big acquisitions to grow -and that requires a strong stock. Leaving may be just as difficult – maybe even more so – when ValueAct does actually decide it’s time to move on.

Published on Sept. 20, 2014