Description

The Valeant saga, or what I call a roll-up blow-up, is to be continued in 2016. The stock has gone down from $250+ to $100 since I posted the last short idea but I think the short at $100 still offers very attractive risk/reward over the next 12 months. Below I will try again to simplify the story into a central thesis that anchors on a value perspective over the medium term (9 months to 24 months). I will omit many interesting aspects that drive the story on the margin. Those topics can be brought up in the comments section, but I only fervently hope that the discussion would be more focused on the intellectual merits of the idea.

It's fair for some of you to wonder if the short still makes sense at such a drastically lower price. But a few fundamental developments have changed the story in important ways to warrant a fresh look. In July 2015, the Valeant story was a "platform" stock that could keep buying companies to engineer spectacular inorganic earnings growth on top of a double-digit "organic growth" fueled mostly by egregious product price hikes. It was going to earn a "Cash EPS" of $12 in 2015, going to $16 in 2016 according to Wall Street consensus, which has generously given the management benefit of the doubt on every respect. If this herd mentality lasted longer than I expected, the benevolent high yield market and the inflated equity currency can keep the roll-up going for quite a while, as long as the herd of naive generalist investors turn the other way from the mounting evidence that has become more obvious with each passing quarter. Just think about how close Valeant came to acquire Allergan in 2014 partially using the inflated stock.

Fast forward to today, Valeant now is a show-me story that has neither the equity currency nor debt capacity to make meaningful accretive acquisitions. Under intense spotlight of federal investigations and payors’ special attention, it has become much harder for them to inflate "organic growth" with egregious price hikes and shady distribution vehicles (e.g. Philidor). "Cash EPS" ended up being only $10 in 2015 and will hopefully be $13 in 2016. As I predicted the trailing FCF/share for this Company continue to languish at $5. However, back in July 2015 when faith in Mike Pearson was sky high, delusion could possibly carried this stock to $300+ over time based on the phantom "Cash EPS" numbers. This blind faith has since been broken. Talk to anyone who has done enough work to ever be long this name (ironically myself included) - none of them will be able to tell you with a straight face that the long thesis is based on trust in Mike Pearson. The long thesis has evolved to be premised more on taking advantage of the negative overreaction by the market. There was never any “organic growth” without egregious price hikes and shady distribution vehicles. If Bill Ackman trusted Mike Pearson's $13 2016 Cash EPS guidance, then would he be generating tax losses by selling VRX at 8x P/E, even for a month? This is to remain a show-me story unless something dramatic changes. Without trust in this management, one has to contemplate the possibility that their $5 FCF/share might be closer to real economic earnings, let alone the fact that long-term debt servicing costs has moved up significantly.

Would Valeant sail smoothly to regain the benefit of the doubt in 2016? I think this has a lot to do with how the Walgreens distribution deal unfolds. This will be the crux of this writeup. Unfortunately a lot of ground has to be covered before we can get to this topic.

I have been apprehensive at the idea of writing this post on account of the fact that a cogent argument would require an involved writeup about the drug distribution ecosystem and a deep understanding of its complex dynamics beyond what I possess. In the end, I decided that my feeling of inadequacy needs not deter me from attempting something challenging, as long as I believe I am contributing to the universe’s honest discourse. And if I'm lucky I might at least initiate a meeting of the minds with some smart folks and learn something from the subsequent discussion. And heck, maybe this time I might get even enough votes to reactivate my membership, although I'd much rather be right than win some popularity contest.

I’ve always wanted to share just enough so that those who are curious enough to do some extra work will be helped to the picture while those who expect spoon-fed insight will be left disappointed. But I was struck by how many investors put this name into the “too hard” bucket. I suspect that if I could do a good job analyzing the Walgreens deal thoroughly, then a great many diligent investors might find this name analyzable.

To attempt this I judge that the best way to proceed is to go back and review the kinds of channel innovation Medicis was pursuing back in late 2011 and early 2012. You may intuitively see why it was relevant to start there: the Walgreens deal is meant to replace Philidor so that Valeant can claim that Philidor was a non-event. Now, as many know, Philidor’s genesis was the inspired (but failed) channel innovation that Jonah Shacknai pursued before he sold Medicis to Valeant.

Before 2011, Medicis was practically a one-drug company relying on Solodyn, an oral drug often given to teenagers for their acne problems, for the majority of its revenue and profits. Even after some acquisitions, by my estimates, Solodyn always accounted for more than 50% of Medicis’ profit. Solodyn was a drug that was generating about $400MM of high margin sales when it was about to lose patent exclusivity in 2011. But the creative folks at Medicis vowed to manage its lifecycle the “spec pharma way” by reformulating into a weight-based prescribing regime. Much of the arcane mechanics here are not important for the purpose of our discussion. Just know that if you have a decent sales force to keep physicians in your pocket, then you can often get the docs to practice in a way that allows you to evade generic competition. On the other hand, the PBMs over the years have learned a few tricks up their sleeves that can effectively chip away Medicis’ Solodyn defenses: 1) tiering and copays; 2) prior authorization; 3) step edits; 4) outright refusal to cover the drug. Before we go on to study this great chess game between drug manufacturers and PBMs, I want to present some basic background information.

Below is a good diagram that summarizes some features of the drug distribution ecosystem that are relevant for the purpose of this writeup.

We’re going to focus on PBM first, who controls the purse string and possesses certain powers to pit drugs in the same class against each other in order to control costs.

In the early days of this chess game, PBMs realized that by putting drugs into a lower tier with higher co-pay, they could curb excessive usage on a drug. For example, moving Solodyn from $10 co-pay to $25 co-pay tier made many teenagers think twice before they resort to this oral acne drug. Facing this threat to business volume, Medicis would then give out coupons that cover co-pays so that the $300/Rx Solodyn would cost users less than other cheaper generic alternatives. Medicis also can counter by offering PBMs hefty rebates to get back in higher tiers on formularies. PBMs often can’t resist because many payors don’t get enough transparencies, allowing PBMs to retain a lot of the rebates for their own bottom-line, even though these rebates would perversely increase drug costs borne by the system.

Then PBMs invented prior authorization, step edits and other physician harassment techniques. They learned that if they hassle the doctors with paperwork enough, they could discourage doctors from writing the scripts, notwithstanding the relentless sales efforts by pharmaceuticals manufacturers. In response, manufacturers invented specialty pharmacies as a countermove. These specialty pharmacies provide “service” to physicians so that it becomes as painless as possible for doctors to prescribe the respective drugs.

Realizing that these hassles are largely neutralized by the countermove, PBMs had to bring out the big gun – outright refusal to cover. For aesthetics related drugs such as Solodyn, often PBMs don’t even need to put it on exclusionary formulary to deny coverage. If even a third of the commercially covered lives are denied coverage, physicians would stop prescribing that drug for ALL of their patients (physicians don’t want to prescribe based on coverage). Enterprising drug manufacturers then devised another countermove to preserve universal coverage. Medicis invented the Medisave program so that pharmacies will ALWAYS dispense Solodyn, even if a patient is not covered by insurance, because pharmacies would be made whole by Medicis. As long as Medicis is willing to buy down those uncovered Solodyn scripts, universal access is preserved and PBMs refusal to cover the drug will have nilch impact on physician behavior and script trend. This countermove will cost Medicis a moderate amount of money but it’s nothing compared to the lucrative margin it earns on the reimbursed scripts. Besides Medicis could always raise prices to recoup the deficit from the generous payors who continue to cover Solodyn. If the rebates are lucrative enough and the magnitude of abuse is not material, they tend to get away with it as many payors just don’t have enough incentives and know-how to detect these abuses.

By now you may recognize that this kind of tit-for-tat contest between payors and pharmaceutical manufacturers greatly resembles the dynamics of a contentious chess game. In fact, this is exactly how the geniuses at BQ6Media see it, which is why the Davenports have a weakness for chess-themed names such as Philidor and Isolani.

So with that background laid, let’s go back and talk about the evolution of Medicis’ channel innovation that began in 2011. Jonah Shacknai rolled out the Medisave program to preserve Solodyn’s scripts and then replaced it with Alternate Fulfillment 1.0 and 2.0. Eventually after Valeant agreed to acquire Medicis in September 2012, Alternate Fulfillment morphs into Philidor. If we tabulate the functions each of those iterations incrementally added, we can glean important insights: (I deliberately omit some details of the programs that are of little relevance for the point being illustrated):

Jonah Shacknai thought, “hey if only we can monetize those reimbursable scripts inadvertently coming this way…”

You might astutely observe that in each iteration, new features are added to tackle existing flaws but only to create yet bigger problems. The law of unintended consequences is clearly at work in this complex distribution ecosystem. A fateful mistake was made at AF 1.0 to bypass wholesalers, which we’ll get to later. For now I want to say a few more things about Philidor first.

What does Philidor reveal about Valeant management?

We live in this great society that espouse values such as Presumed Innocence and so some have convincingly argued that Valeant management should be given benefit of the doubt until they are proven guilty over Philidor. Most of us do not know enough to prove beyond reasonable doubt (not even in the imaginary courts of our head) that Philidor is a criminal enterprise. That is the job of the federal prosecutors. While Philidor is busy dealing with a massive subpoena request, we can only surmise the likelihood of Philidor being eventually indicted and Mike Pearson’s plausible deniability. That is the job of an investor anyway.

For a faith-based story that trades at 20x P/FCF with an adjusted earnings that routinely vastly exceed its FCF, whether you can trust the CEO is a rather critical question. This Philidor sideshow, if properly analyzed, does offer a glimpse into how the Valeant management operate. However, I have yet to see a gratifying analysis of what Philidor was about, for a penetrating exposition must begin from its genesis at Medicis. Thus I have gone to considerable length to present my own version of it.

It should be telling that Valeant had gone to such great lengths to conceal affiliation of Philidor and its network of pharmacies, unlike other comparable programs such as Horizon’s PME, Galderma’s Irmat or Medicis’ Alternate Fulfillment. Do you also wonder why when Irmat and Linden was shutdown by PBMs, they sued whereas Valeant instantly shut down Philidor?

To me, the brazen way Philidor operates was stunning. The $200MM revenue Philidor brought in in 3Q15 caught me by surprise. I had always expected Philidor to represent a high volume of scripts but mostly of the low-revenue cash pay type. For Philidor to bring in so much reimbursement, Valeant must have been milking the cow too hard that it inadvertently killed it. Think about it, if they hadn’t ridden R&O so hard, would Philidor have come to the spotlight so soon? This reckless way of operating reeks of a desperation to me.

While AF 1.0 and 2.0 were bona fide errors of business judgment by Jonah Shacknai in a channel experiment gone awry, Philidor is an unequivocal reflection of an unscrupulous culture. (language greatly curtailed out of conservatism)

What was the problem of AF 1.0?

If you look at the 4 iterations, the single unifying feature is the preservation of universal access. This is so existential to any drug that a pharmaceutical manufacturer would go to great length to ensure it. All the subsequent tweaks were just attempts to find the most cost efficient way to preserve universal access. After the Medisave card iteration, Medicis decided to bypass the wholesaler to optimize cost in AF 1.0. This turned out to be penny wise and pound foolish. US branded pharmaceutical manufacturers to this date still have not found a way to bypass the wholesalers without wreaking havoc to their overall distribution system. It is revealing that in Horizon’s PME program, all the participating specialty pharmacies buy through wholesalers. About 60% of US drugs are dispensed by chain pharmacies and mail pharmacies, while the other 40% are distributed through independent pharmacies, hospitals and other providers. While the Big 3 wholesalers (McKesson, Cardinal and AmerisourceBergen) don’t have an impregnable position over the chain and mail pharmacies channel, the Big 3 are still the unassailable gatekeepers for the other 40% of the distribution. So unless a pharmaceutical manufacturer is willing to abandon access to 40% of the market, they all have to align with the wholesalers by sticking with the class of trade pricing mechanism.

The fundamental problem with AF 1.0 and all subsequent iterations is the way universal access was preserved – the cash pay option for uncovered scripts. Wholesalers and pharmacies are paying WAC close to $300 for Solodyn inventory when Medicis’ Alternate Fulfillment channel is openly selling them for $50 to uncovered individuals. This is akin to Adidas dumping a model of sneakers via their online channel for $50 while asking Foot Lockers to pay $300 for the exact same model, or Disney offering ESPN over-the-top for $2/month while asking Comcast and DirecTV to pay wholesale $6/month. You can’t have you cake and eat it too. The traditional channel grew ever more disenchanted and became reluctant to stock the inventory on shelves, forcing more prescriptions to the direct channel over time in a vicious cycle.

The original plan for AF 1.0 was to just send the 6,000/week uncovered Solodyn scripts (out of a total demand of 25,000 Rx/week) to a direct channel that bypassed the wholesale margin. In April of 2012, failing to anticipate the extent of the channel conflict, Jonah Shacknai was still just expecting a quarter of destocking by wholesalers, followed by subsequent sales rebound back to the $400MM level. But the drug distribution version of the Gresham’s Law will be working in full force – the bad drug channel chase away the good drug channel. Doctors who refer their patients to the new channel free themselves from the callbacks and paperwork. Pharmacies and wholesalers are less willing to stock Solodyn, partly because of the ever diminishing retail volume trend, which in turn help shift more scripts to the “bad channel”. In the end, way more than 6,000/week of scripts are shifted away from the “good channel”. Today, 3 years after the channel innovation, only 5,000 Rx/week goes through the traditional “good channel” – the traditional channel was obliterated. When this dynamic became evident, AF 1.0 was tweaked to include a reimbursement component in order to monetize the covered scripts inadvertently falling into the “bad channel”. But this became very challenging when the dispensing channel was not a captive pharmacy with aligned incentives. Right around the same time when this Alternate Fulfillment experiment was blowing up, Medicis was sold to Valeant.

After Valeant took over the helm, when the masterminds that be pushed the envelope further, this experiment eventually became Philidor, the shadowy network of pharmacies secretly owned by Valeant pursuing aggressive monetization of all the scripts that came through the door. The traditional channel for Solodyn has already been obliterated to smithereens, but in theory if Philidor monetizes aggressively enough, it should make up for all the lost revenue from the traditional channel. No suck luck with this theory in real life. The sales run-rate of Solodyn bottomed at $200MM and eventually rebounded a bit to $250MM. It’ll probably never recover to previous height of $400MM before channel innovation started. There’s the respect that makes calamity of so much wholesale margin. US branded drug manufacturers’ class of trade pricing mechanism is here to stay.

What about the Walgreens deal?

The Walgreens deal has a number of innovative components that are of questionable merits in practice. But let’s first focus on how it replaces some of Philidor’s key features:

Clearly the Walgreens deal does not replace a lot of the key features of the Philidor channel which would have meaningful volume and revenue implications. More important, though, is what it does replace. Universal access will be maintained by virtue of a cash pay option at Walgreens counter. Openly selling Solodyn at $50 or Jublia at $75 at over 8000 retail pharmacies when wholesalers and PBMs are made to pay $300/$500 will bring more cannibalizing effects to the distribution channels than that befell Solodyn’s.

It appears that Mike Pearson has thought through this Walgreens deal as much as Donald Trump has his wall-building immigration policy. He clearly scrambled to put a deal on the wire before the Analyst Day in order to bolster his claim that Philidor was irrelevant. But I believe as we move through 2016, the Walgreens deal will prove deleterious to any drugs dropped into this channel. Walgreens also has no idea how this deal will work either. This is a company that had in times past unsuccessfully tried to bypass the wholesalers with respect to branded drug purchases as well as dropping Express Script to its detriment. The new regime is only more clueless. Fortunately for Walgreens, they don’t have to know how the deal will work when they signed it. They merely got paid $150MM cash upfront to accept Valeant’s promise for product discounts over the next 20 years with few strings attached. I understand the deal comes with relatively little enforceable obligations on Walgreens’ part.

Summary Conclusion

-       Philidor offers a glimpse into how Valeant management operate, making VRX a justifiably show-me story.

-       The Walgreens deal will not help Valeant management regain credibility lost during the Philidor fallout.

-       Federal investigations into Philidor and Valeant management might not have plausible deniability.

-       Common sense dictates that there are more cockroaches in the house than just Philidor. (One can argue that Philidor was not be the first cockroach spotted)

-       The potential risks are not adequately priced in in Valeant’s capital structure and stock price, with unsecureds trading at a spread of ~500bps over and 20x P/FCF.

-       There is only $2 billion of FCF versus $30 billion of debt, making Valeant a levered equity play, which usually deserves a low P/FCF multiple. Over the long term interest expense is bound to go up as credit spreads are >200bps wider than before.

-       Adjusting FCF by the understated interest expense, I get $4 of normalized FCF/share. On account of a portfolio of average quality products, I value Valeant at 8x normalized FCF, or $32.

Risk

-       Xifaxan remains an upside risk but the magnitude of upside should be less than $500MM at the FCF level

-       Wall Street gets exuberant about Valeant and awards the platform story a rich multiple again. This can drive the stock up to $130-$140 level, but will then present an even more attractive short opportunity. Considering the risk/reward, this kind of upside risk is manageable. I also note that interestingly Bill Ackman recently bought call spreads with upside capped at $165.

Catalyst

4 more quarters of FCF will highlight the relevance of my valuation thesis.