Valeant is a pharma company that, until 2015, was thought to have struck gold in pioneering a new business model. It is the erstwhile brainchild of J. Michael Pearson, who took over as CEO in 2010 with the idea of acquiring rather than developing drugs. The thesis: R&D of new drugs is inefficient and unpredictable. Instead, build a platform to market and distribute and then buy up drugs that have already been developed and approved. And as icing on the cake, relocate to Canada to lower the effective tax rate from 25% to 5%.
This worked like a miracle in the early years. Revenues went from $1 billion to $8 billion by 2014, driven by dozens upon dozens of acquisitions in that span. VRX went from $15/share to over $200. At its peak, it was Canada’s most valuable company.
But the rule of thumb in finance is: there is never anything new under the sun. An acquisition oriented growth strategy relies on two prongs: 1.) affordable financing, and 2.) affordable targets. Thanks to the financial crisis, interest rates were at a generational low, so Valeant was able to issue debt with abandon. And as their stock rose, they were able to supplement their shopping spree with equity. The second prong proved to be a problem as they grew ever larger. To move the needle, they needed bigger acquisitions. By 2014, there were only a few targets large enough, and none of them were keen on selling out – at least not at a price anywhere near a bargain.
Mr. Pearson’s solution was novel: team up with a large hedge fund to hunt together. Enter William A. Ackman’s Pershing Square Capital, who in 2014 took a large stake in Botox-maker Allergan and pledged to vote his stake in favor of a hostile $50 billion Valeant takeover. To make a long story short, Allergan fought tooth and nail, and escaped Valeant by wooing a white knight in Actavis to acquire them instead for $66 billion.
Meanwhile, Mr. Ackman took home over $2 billion in profits from his Allergan trade. Pershing Square Capital finished 2014 up 40%. What happens next will form the moral of the story: he rolled his entire Allergan profit into VRX.
Valeant’s consolation prize in the wake of Allergan’s rejection was a $10 billion acquisition of Salix. By then, Valeant’s balance sheet had become bloated with debt. Less than $6 billion in equity was supporting almost $50 billion in total assets. And into this highly levered entity Mr. Ackman invested almost 20% of Pershing Square’s capital.
Almost everything went wrong subsequently. Valeant was discovered to be using extremely aggressive, borderline illegal tactics in pushing their drugs. They were also jacking up the prices on their drugs after acquiring them, sometimes as much as 10 times their original price, raising the ire of Congress and Presidential candidates. Charlie Munger accused them of being deeply immoral. As their stock began to collapse amidst intense public scrutiny, they lost their currency to do acquisitions; nobody wanted to be acquired by Valeant anymore anyway. Doctors began pulling back on prescribing their drugs.
VRX has since crumpled from $260/share down to $10. There is serious doubt whether they will survive their $1.8 billion of annual interest payments. Mike Pearson has been ousted as CEO, and Mr. Ackman, a man with an unquestionably high IQ and nearly unlimited resources, sold his shares last month at the bottom for a $3 billion loss. And it’s not just Mr. Ackman. Scores of brilliant fund managers had piled into VRX, even the venerable Buffett-endorsed Sequoia Fund.
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As a fellow investor, it’s bad form (and possibly bad karma) to revel in too much schadenfreude. Things can and will go wrong all the time. Management can be dishonest, government can conspire against our interests, consumer tastes can change on a whim. If you’re in the business long enough, you’re not really doing your job unless you have a few deep scars. There are just too many factors out of our control. But what we can control is our buy/sell judgment. Not just whether to buy/sell but how much to buy/sell.
And so the lesson of leverage for us is: look-through. One may be adding implicit leverage to one’s portfolio by investing too much in companies aggressive with debt. If Valeant had been more modestly levered, their survivability would not be in doubt and their stock would still retain significant value (although it probably would not have gone stratospheric earlier either). There would have been more margin of safety, which, in the complex and uncertain world we live in, should be a virtue we strive for.
“I don't have any advice for young people who want to get rich. Basically, I think the desire to get rich fast is pretty dangerous. My own system was to get rich slow. It protracts a rather pleasant process. After all, if you get rich fast all you can do is be robbed by your own employees your yacht and so forth. Whereas if you get rich slow you amuse yourself over a lifetime.”
-Charles T. Munger, 2015 Daily Journal Annual Meeting
