Valeant Pharmaceuticals (NYSE: VRX) might be the largest $8 billion a year (sales) specialty pharmaceutical company that people (outside of Wall Street) have never heard of. The firm has grown by leaps and bounds in recent years thanks to an acquisition spree that has seen annual revenue soar nearly eight-fold from 2010 levels of $1 billion. The Valeant story began to really pick up steam in 2008 when the company hired J. Michael Pearson as its new CEO. Pearson, a former Director at McKinsey & Company, brought with him a new strategy for Valeant underpinned by his years of experience working with healthcare executives. His core tenet is that R&D spending in the sector has historically had dismal results, wasting billions of investor capital with minimal successes (relative to the failures anyway). Rather than mimic most others in the sector by spending billions on research and development that was inherently risky, Valeant waits for promising therapies to be developed by other companies and seeks to acquire companies and/or products either after they have reached the market, or are so close that the risk of failure is minimal. Valeant focuses on running an efficient sales and marketing enterprise, working with known quantities, rather than bet the future on research that could very well fail.
To say that the early years of this strategy were successful would be an understatement. Valeant's acquisition binge created a lot of value for investors, as VRX shares rose from $13 per share on February 1, 2008 (the day Pearson took over the CEO job) to an all-time high of $153 six years later in February of 2014. The stock has fallen on hard times since, however, as the company's latest acquisition target, Allergan (NYSE: AGN), has rebuffed Valeant's overtures.
And herein lies the problem that Valeant is likely to continue to face long after the battle with Allergan is resolved one way or the other. Valeant has made no secret that their operational strategy is to acquire competitors with well established product lines, shift those products over to their salesforce, and slash costs by firing overlapping salespeople as well as the scientists who are developing new products in the lab. You can imagine how much synergistic value Valeant can extract from a buyout of another healthcare company if they fire their salespeople and gut their research and development programs. That is how VRX shares have performed so well over since Pearson was named CEO.
As Valeant grows through acquisition, they need to buy larger and larger companies to continue that growth. After all, if you slash R&D spending at your own company, the only way to grow or replace lost revenue from products that will eventually go off-patent is to keep buying more and more companies. Given their large size now, their problem is twofold; first, there are fewer and fewer potential targets that can allow them to grow materially, and second, everyone knows what their strategy is and competitors are reluctant to agree to be acquired, since that will mean that most of their employees will be fired immediately. You won't meet too many CEOs who would be eager to agree to such a plan. In Allergan we can now see what may become all too common down the road for Valeant; an environment that makes it much tougher for the company to execute its stated strategy.
I think it is important to think about this from the point of view of investors. For many years now Valeant shares have commanded a premium valuation in the financial market because the strategy itself is perfectly sound on the surface. They can spend less on R&D and have much higher margins that other companies, and each acquisition has far more synergies under their umbrella than it would elsewhere. However, what happens when Valeant gets so big that there is a limited supply of potential new targets? And what happens when those companies are likely to tell Valeant to take a hike if approached? All of the sudden Valeant's business model becomes a hindrance rather than a strength. As growth becomes ever more elusive, you should expect that the multiple that investors are willing to pay will reflect that fact.
As a result, I would postulate that over time Valeant shares may trade at a discount to their peers rather than a premium. That fact alone could very well make it a tough road ahead for VRX shareholders. Right now Valeant sports an enterprise value of $55 billion on just $8 billion of sales. And that's after the stock has tumbled from over $150 to under $115 per share. Many Valeant bulls think the stock is cheap after that drop, but I can certainly see scenarios where the business model hits roadblocks and the premium valuation starts to dissipate. Buyer beware.
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