One of the hottest debates in hedge fund land is starting to boil over

Bill Ackman looked calm at the Bloomberg ‘Most Influential’ Conference on Tuesday.

He usually does, especially when he’s offering his help.

“I guess maybe I could help Valeant with PR,” he said with a chuckle.

“They are not good at PR and perhaps government relations … they went from being a very small pharma company to being a very big pharma company fairly quickly. And they’re a bit of what I call an outsider company.”

The crowd didn’t share Ackman’s sense of humour that day, it seemed, as no one else laughed.

Perhaps that’s because Ackman (the ultimate insider) was defending a hedge fund darling that had seen better days. Since Sept. 18th, Valeant’s stock has lost a quarter of its value.

Over the last two weeks especially, accusations that it arbitrarily and exorbitantly jacks up the prices of drugs it purchases into its portfolio while dramatically under spending its peers on R&D have started flying at Valeant from all directions.

This year, Valeant raised the prices of its brand name drugs by 66%, Deutsche Bank said in a recent report. That’s 5 times more than other drug companies in the space.

Bill ackman
Bill Ackman at Bloomberg Bloomberg, screenshot

House Democrats have even asked to subpoena the company and call its CEO to Washington to explain himself.

Presidential candidates Hillary Clinton and Bernie Sanders have both called out the company.

This price gauging issue was brought to America’s attention when hedge fund manager Martin Shkreli got a nation-wide wag of the finger for jacking up the price of a drug he’d purchased by 5,000%.

The practice wasn’t illegal of course, but it was arguably unethical — something that the market has never had much success at differentiating.

Bloomberg’s Stephanie Ruhle made that ethics point — and brought up Shkreli — to Ackman during her interview.

“That’s not my favourite version of how to make money for sure,” he responded.

“And obviously those kind of glaring examples are going to attract a lot of attention. There’s been a lot of attention on Valeant cuts dragged into the story. A very small part of Valeant’s business is repricing drugs.”

The question is, then, why has Valeant been dragged in? And what is its business anyway?

VRX one month
Valeant over the last month Yahoo Finance

Love it.

If you love Valeant, this is how you explain its business model:

Valeant “is not a company whose strategy can be easily categorized,” said Nomura’s Shibani Malhotra in a recent note reassuring clients that the stock was still a buy.

Malhotra also said that it is not built on predatory pricing post acquisitions, but rather on efficient capital allocation.

Ackman explains it in much the same way. He also says that it has had a “massive contribution to drug development, almost more than any other company” despite the fact that its peers spend 15%-20% of their revenue on R&D to its 3%.

“Valeant doesn’t pay dividends, so it’s no cash leading the system,” Ackman said on Tuesday. “And not buying back stock, right. So they generate a lot of cash flow. Where does it go? Well, they spend about 3 per cent of revenues on R&D.”

Ackman continued: “They spend money building plants to make pharmaceuticals. They pay their employees. Valeant believes that they are not good at drug development, i.e., our really coming up with new molecules and taking them all the way to the approval process.

“That’s a — has been historically a very low return business.”

And no one wants a difficult, low return business by definition.

Instead, Valeant focuses on marketing and distributing the drugs it acquires through M&A. That is what the company believes it is good at.

To make that happen, though, it must increase the prices of the drugs it acquires, according to Ackman.

An unfortunate side effect, according to this argument.

So where an traditional drug company raises prices so that it can work on the next innovation, Valeant is raising prices so that it can by the last innovation.

“Now if you regulate prices, if you say you can’t charge market for a drug, that’s going to reduce the profit,” Ackman said.

“That’s going to reduce the cash they have to buy the next drug company. That’s going to reduce the returns the entrepreneur, the scientist, the startup can receive starting a drug company.”

Hate it.

If you hate Valeant, this is how you explain its business model:

Valeant jacks up the prices of the drugs it purchases because it doesn’t grow organically. In fact, for years short-sellers have accused the company of being a roll-up — a company that uses aggressive accounting to appear healthier than it actually is.

“Drug revenues have always been a withering asset class; even more so for Valeant’s strategy of buying mature drugs already in the market,” wrote short selling firm Citron Research in a recent note.

“Attrition of drug revenues is normal in the pharma business, as newer products, better treatments, expiring patents and competition from generics all eat away earlier-achieved revenue runs.”

For most companies, this is a cyclical thing as old drugs get older and new drugs go into the pipeline. But since all of Valeant’s drugs are old, its detractactors posit that it has to raise the prices of all the drugs it acquires.

Pharma average price increase

Last year, Ackman unsuccessfully tried to help VRX buy Allergan, another pharmaceutical company. Allergan also claimed that Valeant had no organic growth. On top of that, it was concerned that Valeant would take Allergan’s R&D cash to do M&A deals, acquire more companies and move on.

And it needs that cash. Because VRX’s valuation is low as measured by P/E, it’s not very attractive for them to use their stock to finance M&A. After its failed Allergan purchase attempt, Valeant acquired another drug company, Salix, in an all cash deal.

Oh and then there’s the consumer …

“Obviously if you’re a consumer and all of the sudden your drug goes up in price, that’s something you’re going to be sensitive to,” said Ackman on Tuesday, “but very few people pay gross price.”

What does it matter if you’re not paying gross price, though, if the price you’re paying is still too high?

That, according to the Financial Times, is what Berna Wilson experienced when Valeant increased the price of Syprine, a drug used to treat a rare condition called Wilson’s disease. Despite having good insurance, her out of pocket cost went from $US510 a year in 2010 to $US12,000 a year in 2014.

That’s some kind of gross price.

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