One of my primary takeaways from the collapse of Valeant (NYSE:VRX) was that media reporting, particularly in the digital age, is get page views and ask questions later. I probably should have been more cognizant of the issue, but it took a story where I knew the facts (like Valeant).
Full disclosure: I have been a Valeant shareholder since 2011, and I have suffered losses. My position is currently underwater, and I will freely admit that the company committed many errors (Philidor disclosure being the most detrimental).
That said, the latest story from The New York Times is egregious and materially misrepresents reality. Let me present to you the facts behind price appreciation credits, and why they are immaterial to the Valeant story. The credits are simply not a reason to be long or short the stock.
What are price appreciation credits?
Price appreciation credits are fairly straightforward, and this is what The New York Times represented accurately. When a drug manufacturer like Valeant, Pfizer (NYSE:PFE), or Johnson & Johnson (NYSE:JNJ) raises the price of a drug, the drug wholesalers, who hold inventory, give the manufacturers a credit for the difference between the new price and the old price. This is a pretty common, vanilla practice. Wholesalers like McKesson (NYSE:MCK), AmeriSource Bergen (NYSE:ABC), and Cardinal Health (NYSE:CAH) generally receive a servicing fee (this take depends on the drug but likely 1-3% of the ASP). They simply move the drug to the end consumer, so there is no reason for this part of the supply-chain to capture the full-value of a price increase. Otherwise, if a drug went from a list of $5 to $10, the wholesaler would capture $5 of value on its existing inventory.
Admittedly, I do not believe every firm writes this specific language into contracts for the distribution of their products. Valeant clearly does. And there is nothing wrong, illegal, or even remotely shady about this practice. The bottom line: price appreciation credits ensure that the drug owner captures the economics of a price change.
How Valeant "cashed in twice"?
As I read this article, I failed to see any rationale behind the title of the article, How Valeant Cashed in Twice on Higher Drug Prices. The article actually articulates these credits in the same way that I articulated them in the above paragraphs. Valeant hiked the price of its drugs and received the economic benefit of the action.
I suspect that Valeant "cashed in twice" because the author believes that Valeant somehow received the end-user price for the drug as well as the credit. This is obviously not true. The wholesaler received the revenue from the price increase and then passed the economic benefit to Valeant. As I said, this is not cashing in "twice," though, clearly, Valeant cashed in.
Price appreciation credits will be lower in the future
Again, the article makes a bold proclamation about how Valeant will not receive any cash from its future price appreciation credits under its new, less aggressive pricing strategy. Yes, this is completely true, and Valeant acknowledged it.
However, I believe the article intended to make price appreciation credits sound like a one-time event. In reality, Valeant will receive the economic benefits of higher prices that came from the price increases as long as the price remains high. The appreciation credit will be a one time true up, but in the following years, the cash flow will simply hit the financial statements in the same way that any other revenue hits the financial statements. This is not controversial; this is vanilla accounting.
Why were these pricing credits so exaggerated in 2015 relative to other years? I think the reason is the nature of Nitropress and Isuprel. These products are injectable pharmaceuticals, which probably have a significant amount of inventory in the wholesaler channel at a given time. The prices of Nitropress and Isuprel were increased 212% and 525%, respectively. Therefore, the combination of inventory and dramatic price hikes likely caused the material spike in credits.
Some products, like Nitropress and Isuprel will face generic competition and their financial profiles will decline. This is not new news. Each product certainly has several outstanding abbreviated new drug applications (ANDAs) outstanding, and Valeant will then face lower prices and lower market share. Again, this is benign and well-known information. Every pharma company suffers financial losses in market share and pricing from generic competition.
Bottom line: do not rely on headlines
One of the most important virtues of investing is the search for the truth. Embrace being wrong, embrace changing your mind, and do not rely on secondhand information to make decisions. Read what The New York Times wrote, read what I wrote, but most importantly, try to understand the actual mechanics of the wholesaler appreciation credit. I believe that you will conclude Valeant did not cash in on higher drug prices twice.
Disclosure: I am/we are long VRX.
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.