It is fascinating to see that Valeant (NYSE:VRX) investors were people who had never invested in pharma stocks before. Look at the 13-F holdings of the largest Valeant investors. You won't find any biotech stocks that do R&D. The Wall Street Journal had also noted this in an article - the largest biotech mutual funds stayed away from Valeant. Investors who invest based on science and technology stay away from Valeant and its clones.
It is interesting that the same irrational arguments used to pump Valeant in 2014 are still being used today. This shows you the power of eloquent shareholder letters and investor communications from Valeant. If you can use the right lingo, you can sell a pile of junk at sky-high prices.
Valeant investors were people who were used to using EV/EBITDA to invest in cable companies. Unfortunately, those formulas did not work for Valeant, even though Valeant's shareholder letters and investor presentations made it appear as if the pharma industry worked like the cable or telecom industry. Valeant's arguments were recycled by Valeant investors in their own shareholder letters and annual meetings. But saying 2+2=5 in fancy language, thousands of times, does not make it true.
This logic-free argument is repeated vociferously in articles and comments by Valeant bulls who bought the stock at prices four times or more than its current price (check the initial Valeant articles of these contributors.) The argument works like this: Valeant's debt is three times its market cap. If you deduct Valeant's interest payment from its EBITDA, you can forget about the debt in the numerator. Since Valeant pays very little tax, what you are left with is the Price/Cash EPS.
For example, if a company has market cap of $250 and debt of $750, the EV is $1000. With an interest rate of 5%, interest expense is $37.5. Suppose the EBITDA is $100. Assume a zero tax rate. Valeant bulls would say that cash earnings are $100 - $37.5 = $62.5. So, the company is trading at "just four times earnings" or "four times cash-flow", "Buy, Buy, Buy!" [$250/$62.5 = 4]. For example, SA contributor and accounting-major Sunil Shah says P/cash-flow is five, in a comment on an article written by medical industry expert DoctoRx. This is typical of Valeant investors, they lack insight into the R&D process. To a man with only a hammer, everything looks like a nail.
The fatal flaw is that the assets which are generating the $100 EBITDA would all go to zero over time unless replenished with R&D or acquisitions (if the assets are sold to the highest bidder right now, it is not clear that the company can pay its debts.) This can be covered up for a while with price-gouging and secret specialty pharmacies to fool insurers. Valeant claimed its shockingly overpriced acne creams were durable, nobody knew there were being sold through Philidor. But eventually everything spills out into the open. Just today, it was reported that Valeant had doubled the price on a 80-year-old drug.
Longtime Valeant bull, analyst Irina Koffler, who had the highest price target of all analysts of $195 per share on Valeant in 2014, now says that Valeant has third rate assets, whose combined value would be around $38 billion, leaving an equity value of $21 per share.
Apart from contact lenses, there is nothing else that is durable in Valeant's portfolio. Everything else is subject to being knocked out by R&D or by the FDA clearing the generic drug backlog. As I have said numerous times in the past, Michael Pearson is not John Malone. Malone's TCI acquired cable franchises that were legal monopolies immune from R&D. Cities granted cable companies a legal monopoly forever, to get them to build out cable infrastructure. The FDA grants an orphan drug designation for only seven years (not that Valeant would have any of those either.)
Non-GAAP accounting where amortization is ignored made sense for John Malone's TCI. It makes sense for other acquisitive companies where the acquired assets have wide moats like dialysis provider DaVita (NYSE:DVA) for example. If one were to acquire Coca-Cola (NYSE:KO) or See's Candy, we can ignore amortization because of the wide moat of these companies. But for R&D-based industries, amortization of capitalized R&D expenses cannot be ignored. Investors need to use their common sense, not the same simple accounting ratios from an undergrad textbook. Applying a formula that works for real estate to R&D-biotech is not common sense.
What to do now?
The title of this article is addressed now. The best way to profit from Valeant's collapse is to invest in biotech companies that do R&D. These companies have been hurt ever since the Valeant-Shkreli scandal began. All their stock prices have fallen steeply. Hillary Clinton has said that she wants pharma companies to spend on R&D, she wanted to set a threshold. Rogue companies like Valeant that are targeted by Hillary Clinton have unnecessarily hurt R&D companies that Hillary Clinton prefers.
There has been a lot of speculation about what Valeant's assets are worth and whether Valeant can repay its debts. Based on what I have seen in the biotech industry, only third-rate companies would buy Valeant's third-rate assets. Needless to say, Valeant bulls don't realize that its assets are third-rate, for they never developed a curiosity for R&D-oriented biotechs.
For example, Valeant was forced to boost its Salix offer from $158 per share to $173 per share because it was outbid by Endo (NASDAQ:ENDP). Endo was regarded as a Valeant-clone and was therefore purchased by many Valeant investors. Endo's shareholder letters when Valeant's COO, Rajiv DeSilva, became Endo's CEO, read a lot like Pearson's own shareholder letters (Rajiv De Silva had worked for Pearson at McKinsey and followed him to become his deputy at Valeant.) Endo has been trading at less than one-third its own 52-week high. Even if Endo wanted to buy anything from Valeant, it is unlikely it can raise the debt to do it.
What is Valeant worth?
My advice to investors is to stay away from this mess. Nobody knows what overpriced junk is present in Valeant's products. Valeant had outbid everyone else for B&L too. In my opinion, there are two kinds of Valeant speculators, those who don't know how much Valeant is worth, and those who don't know that they don't know. It is like Warren Buffett's quiz on valuing an Internet company, he would flunk any student who gave an answer.
Valeant bulls are desperately hoping that people will buy Valeant based on "cash EPS" again. If they were to sell pieces of Valeant to other pharma companies, they know that they would have a hard time paying off the $30 billion debt. For years, Valeant's CEO ridiculed "Big Pharma", Valeant investors echoed this ridicule in their own annual meetings and shareholder letters. But those ridiculed pharma companies, ridiculed because they did R&D to actually discover drugs instead of price-gouging ancient generics, are not going to pay for Valeant's overpriced junk. Those ridiculed pharma companies acquire based on pipeline, technology and future prospects (not EV/EBITDA) - these are absent at Valeant. As many former B&L employees have noted, and as Pearson himself declared in a conference call soon after he bought B&L, only near-term launches were kept. I remember Pearson saying he would "ringfence" the contact lens team that was set to launch soon, and would get rid of other things.
Political attention, free trade and Ricardo's theory of comparative advantage
The stink raised by rogue companies like Valeant and Turing has unnecessarily hurt companies that discover drugs. The media has become fascinated with Valeant and Shkreli. Presidential candidates have sought to partake in this media attention. Biotech stocks fell sharply after Hillary Clinton tweeted about Martin Shkreli. Hillary also has an anti-Valeant campaign ad which talks about a 1980s-era drug whose price was raised astronomically by Valeant. Biotech stocks have not recovered at all after the Shkreli-Valeant news broke last year.
Investors should keep in mind that Hillary Clinton has been pro-free-trade throughout the campaign. While voters would always want drugs to be cheaper, they want new cures even more. Whereas Germany and Japan may not care much for American cars, they pay billions for American drugs (not Valeant's kind of drugs, but for new patented cures). Investors should ignore politicians who tell Michigan voters that they will take them back to 1960 with trade wars and 35% tariffs on imported cars. The rest of the country does not want to pay a lot more for cars so that the Rust Belt can go back to 1960. Similarly, everybody wants new cures streaming out of the biotech revolution, cures which were unthinkable in 1960. When the Nebraska primaries arrive, are politicians going to tell voters that we should all go back to farming like in 1900 (when dysentery was the leading cause of death)?
Economics 101 (Ricardo's theory of comparative advantage) teaches that every country should do what it is best at, and engage in trade, this results in everyone benefiting. Japan cannot discover drugs, America can. So America exports newly discovered drugs and imports cheap cars. Europe and Japan pay billions for patented drugs, these are negotiated in trade agreements. Europe and Japan don't pay for price-gouging on generics by companies like Valeant - they get their generics far cheaper from other companies. Generic drug price-gouging is a problem only in the United States created mostly by the FDA.
The best way to profit from Valeant's collapse is to invest in the collateral damage. There is no way for an investor on the outside to value Valeant. But R&D-based companies have always been very transparent on their revenue growth, unit and pricing, on a per-drug basis. Ignore the political noise, that political noise has no basis in Economics 101. The political noise created in response to Valeant and Shkreli has created a great buying opportunity. The Nasdaq Biotech ETF (NASDAQ:IBB) is down from $400 to $255, the S&P Biotech Index (NYSEARCA:XBI) is down from $91 to $49.
In my opinion, Hillary Clinton has shown the deepest understanding so far about the FDA dysfunction that enabled Valeant (others have shown zero understanding.) She wrote to the FDA asking it to clear the generic backlog that has enabled rogues to profit from price-gouging. She has also said that biotechs discovering new drugs have nothing to fear and that she wants to ensure they spend their revenues on R&D. She is also pro-free-trade. Since she is most likely going to be president, biotech looks like a great buy here. Almost all the drug discovery in the world happens in America, anybody can make cars. Don't forget Ricardo's comparative advantage.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.