The Valeant Perspective - Why are value gurus split on the merits of this pharma business?
Today we are going to focus on a difference of opinion between some genuine heavyweights of the value investing world – with a spot of gouging thrown in for good measure. Before those of a more squeamish disposition choose to click away now, however, we should quickly add that the tone of this piece is not so much ‘The Rumble in the Jungle’ as ‘The Feud on Fundamentals’.
‘Price gouging’ meanwhile is the less than complimentary term for when a seller dramatically raises the price of goods or services to a level that would generally be considered unfair and perhaps even exploitative. Elements of the pharmaceutical sector were recently linked with the practice by US presidential hopeful Hillary Clinton, who described it as “outrageous” and promised “to take it on”.
Over the last few years, certain pharmaceutical businesses appear to have reached the conclusion their sector spends too much money on researching and developing new drugs. Their alternative strategy has been to concentrate on acquiring other pharma companies – paring back costs to the bone while dramatically hiking the prices of existing drugs on the basis someone somewhere will always pay up.
For indications of the magnitude of mark-ups involved, we need look no further than this New York Times article referenced by Clinton. Leading on the 6,000%-odd overnight increase in the price of one drug after it was acquired by Turing Pharmaceuticals, a start-up run by a former hedge fund manager, it also noted increases of 525% and 212% on two heart drugs now owned by Valeant Pharmaceuticals.
Valeant’s chief executive is Michael Pearson, who clearly formed some strong views on how a drug business ought to be run during his 23 years at McKinsey & Co, which included time as head of the consulting firm’s global pharmaceutical practice. Valeant’s share price has done very well under his stewardship but, of course, that is not what has caught our eye here on The Value Perspective.
Long and short
No, what we find fascinating is that some serious names from the world of value are to be found on opposite sides of the investment argument for Valeant. Big fans of the business include, for example, Bill Ackman, the founder and chief executive of hedge fund manager Pershing Square, and the Sequoia Fund, which has strong links to Warren Buffett and his Berkshire Hathaway vehicle.
Not so strong, however, as those of a vocal critic of both Valeant and its chief executive. Earlier this year, Charlie Munger, the Berkshire Hathaway vice-chairman perennially described as Buffett’s right-hand man, made headlines when he observed: “Valeant is like ITT and Harold Geneen come back to life – only the guy is worse this time.”
Without embarking on a history lesson, suffice to say this is not a description to which too many bosses or businesses would necessarily aspire but, here on The Value Perspective, we do not plan to take any sides in this clash of value titans. We do not own Valeant and have undertaken no in-depth work on the business. We would, however, make a couple of observations on the subject of securities analysis.
The first relates to the following chart, which shows how the company’s revenues have grown strongly over the last five years or so – with some $8bn (£5.2bn) reported last year and around $11bn forecast for the current period. Not nearly as strongly, however, as Valeant’s net debt, which has mushroomed from virtually nothing in 2010 to almost $30bn.
Source: Bloomberg, October 2015
Regular visitors to The Value Perspective will know from articles such as Vanilla Fudge that we grow very nervous indeed when a business’s ratio of net debt to earnings, interest, taxes, depreciation and amortisation (EBITDA) heads beyond a multiple of 2.5x. They will also know, from articles such as Merger mystery, that the track records of businesses that are serial acquirers tend to leave us unconvinced of the effectiveness of this strategy.
Still, rather than invite you to dwell on how we might therefore feel about businesses that combine high levels of leverage with a penchant for acquisitions, we will move swiftly on to the dangers of what the AZ Value Investing blog describes (among other things) as ‘PowerPoint investing’ – that is, investing on the basis of a company’s investor presentations rather than its original documentation.
The blog makes its point with two tables, the first of which – reproduced below – was used by Valeant in presentations to investors in 2013 to illustrate the success of the businesses it had bought in the preceding five years. As you can see, the company lists the compound annual growth rate or ‘CAGR’ of each business and an average figure of 12%, as well as recent and forecast revenue numbers.
Source: www.azvalue.blogspot.co.uk, October 2015
Now, there are times when investors will have to dig deep into a business’s report and accounts before they spot an apparent inconsistency – and then there are times when things do not seem quite right from the off. In this instance, you may immediately have felt, as we did, that a rise in revenues from roughly $3bn to $3.25bn may well suggest some growth – but nothing quite as healthy as 12% a year.
So why would Valeant be presenting a CAGR of that size? After all, this is a company where investors are being asked to put a great deal of faith in the chief executive, his strategy, the degree of leverage being used and so on. This question led AZ Value to model all the individual companies in the above table to see how one might go about reaching a figure of 12% growth.
And the relative simple answer is that 12% is the average of all the individual CAGRs in the table – while the relatively simple snag is that that completely dismisses the fact some drug businesses are far more important than others. What actually matters then is the weighted CAGR of each business, which according to AZ Value – and as you can see in the table below – averages out at 6% rather than 12%.
Source: azvalue.blogspot.co.uk, October 2015
Our point is, when it comes to investor presentations, companies are not obliged to give you the whole story, which of course means they are presumably going to look to paint themselves in the best possible light. To our eyes therefore, while there are no good shortcuts to proper fundamental investing, doing so by PowerPoint seems an especially bad one.
With any potential investment – and especially when you need to corroborate what a business is telling you about, say, its structure or strategy – there really is no substitute for obtaining all the original report and account documentation, rolling up your sleeves and digging into the detail. As for ‘The Fracas in the Pharma’, we suspect it is still in the early rounds and there is much more to come. Seconds out …
Fund Manager, Equity Value
I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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