Valeant Pharmaceuticals is trying to acquire Allergan, the maker of Botox.
The tactics it’s using to do so might end up killing the pharmaceutical industry.
Valeant first approached Allergan in April 2014. It has twice raised its bid, which it is making with hedge-fund manager Bill Ackman. Allergan has so far rejected each of Valeant’s three overtures. Valeant’s most recent offer was made on May 30.
But Allergan says it isn’t rejecting Valeant’s bid because of price.
It’s rejecting Valeant’s business model.
Valeant’s Business Model
Valeant is a pharmaceuticals company now domiciled in Canada. In 2010, Valeant acquired Canadian pharmaceutical company Biovail, and following the acquisition moved its headquarters to Montreal.
As of February, Canada’s corporate tax rate was about 26.5% compared to about 40% in the U.S., according to data from KPMG.
Under current CEO Michael Pearson, the company has executed more than 100 deals as part of a strategy to grow through acquisitions, according to The Wall Street Journal.
On Valeant’s first quarter conference call, Pearson said that in the first quarter alone, the company completed 10 transactions.
Pearson elaborated on what Valeant looks for in an acquisition, saying it looks at cash flow and what he called a, “…Certain return to our shareholders.”
When Pearson refers to a “certain return” for shareholders, he walks into a central criticism of Valeant’s business model: Namely that Valeant strips costs, including research, development and staff, from the companies it acquires and just sells their finished products.
But is low R&D spending sustainable?
Allergan’s Self-Defence Strategy
In a letter to Valeant CEO Pearson, Allergan CEO David Pyott said Valeant’s latest offer does not include enough “sufficient or certain value to warrant discussions between Allergan and Valeant.”
In a May 12 letter rejecting Valeant’s first increased offer, Pyott said:
Valeant’s strategy runs counter to Allergan’s customer focused approach. In particular, we question how Valeant would achieve the level of cost cuts it is proposing without harming the long term viability and growth trajectory of our business. For those reasons and others, we do not believe that the Valeant business model is sustainable.
One of Allergan’s main problems with Valeant’s business model is that the company does not invest in research and development.
In its latest presentation rejecting Valeant’s offer, Allergan said its 2013 R&D costs were equal to about 17% of its revenue, while Valeant’s R&D spending was equal to about 2% of revenue.
On Valeant’s first quarter earnings conference call, Pearson said he expects the company to exit 2014 with R&D spending at about a $US200 million per year.
Allergan argues that its R&D spending doesn’t result in a bunch of wasted money. The $US7 billion it spent on R&D between 1992 and 2013 resulted in about $US50 billion in cumulative sales, the firm said.
The company also said additional R&D spending will result in $US120 billion in additional sales over the next ten years.
This chart of R&D spending as a percentage of revenue drives home how much less Valeant spends on R&D than some of its biggest pharmaceutical rivals.
Valeant’s aggressiveness has gotten significant attention in the market. Jeremy Levin, former CEO of Teva Pharmaceuticals, told The Wall Street Journal that, “Valeant will eventually run out of things to buy… A company without R&D short-term and mid-term can be viable, but long-term is not.”
John Hempton, a noted finance blogger at Bronte Capital, has also expressed his concerns with Valeant, and is currently short the stock. He has promised a series of posts analysing Valeant’s financials.
BI’s Linette Lopez detailed some of the problems with Valeant’s ploy, writing that Ackman and Valeant aren’t seeking to buy Allergan, but swallow it whole and digest it quickly.
Also following Valeant’s first offer for Allergan, the FT’s John Gapper argued that if the entire pharmaceutical industry adopted Valeant’s approach, drug discovery would grind to a halt.
Gapper outlined two visions for the pharmaceutical industry, one where companies invest heavily in new drugs, and another where R&D spending is cut, “to save cash and please Wall Street.”
Gapper called it a “moral choice.”
Following Valeant and Ackman’s latest offer, Ackman disclosed in an SEC filing that his Pershing Square fund is preparing a hostile bid for Allergan.
A hostile bid is when a potential acquirer engages directly with the shareholders of the company, rather than the company’s board, regarding its takeover proposal.
A hostile bid now seems likely, given that Allergan’s CEO said Valeant’s latest deal isn’t worth discussing.
Ackman owns nearly 10% of Allergan’s stock, and the company has already adopted a so-called “poison pill” provision preventing any shareholder from acquiring more than 10% of the company, so his voting sway over Allergan’s decision will not increase.
This story, however, is unlikely to reach a conclusion soon: Citing analysts at BMO Capital, the FT said the fight could last “well into” 2015.
The Death Of Pharma?
Just this week, Merck purchased pharmaceutical company Idenix Pharmaceuticals for $US3.85 billion; in its first quarter, Idenix recorded no revenues. And while Merck is certainly betting that Idenix’s hepatitis C drugs in development will be approved, the deal essentially amounts to a one-time R&D expense.
R&D spending is not dead.
But others have started to imitate Valeant’s methods for boosting their stock price. The Wall Street Journal notes that Endo Pharmaceuticals has begun to adopt an acquisition strategy similar to Valeant’s.
Shares of Endo are up more than 77% over the last year.
Valeant’s strategy has also been a boon for shareholders, who have seen the stock gain more than 8x since Pearson joined the company as CEO in February 2008.
Whether or not Valeant and Ackman are successful in acquiring Allergan, this deal has certainly raised eyebrows among investors and executives in both the pharmaceutical space and the broader market.
Expect pharmaceuticals companies to start taking closer looks at their strategies before someone else does.