The Drug Carry Trade: Valeant's Massively Leveraged Long-Short Strategy Is About To Unwind

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By Xuhua Zhou :

Over the years, investors have likened Valeant (NYSE: [[VRX]]) to many things. Famed short-seller Chanos called it a blackbox; prominent hedge fund manager Bill Ackman called it the Berkshire Hathaway of biotech. But let's not kid ourselves. Charlie Munger likened Valeant to a worse version of ITT and Howard Geneen. Meanwhile, Valeant is not quite as mysterious as the fuzzy complex accounting methods would suggest. To truly understand Valeant, investors need to look beyond the complex accounting or cash earnings and zone in on the true economics of the business. Valeant is not a pharmaceutical company; it is a $100 billion drug hedge fund with portfolio manager Michael Pearson at the helm. Now let's redefine Valeant.

Business Description in My Opinion

Valeant acts like an offshore hedge fund, incorporated under the laws of the Province of British Columbia. Its principal strategy consists of acquiring portfolios of drugs at attractive prices while funding it with its advantageous balance sheet at a low cost of capital. Subsequent economic value is realized by taking advantage of our pricing power in such acquired drug portfolios and realize superior returns relative to our blended cost of capital. In other words, Valeant primarily specializes in what is commonly known as a carry trade arbitrage by exploiting the differential between our own blended cost of capital and our anticipated drug price inflation . Portfolio manager Michael Pearson has over 23 years of experience consulting with major pharmaceutical companies such as Merck ( MRK ) and Teva ( TEVA ), identifying drug products that command pricing power in the marketplace. We believe certain drug portfolios embedded within the existing healthcare companies are significantly undervalued due to their low prices.

What is Valeant?

Valeant's business strategy has been polarizing. The world's best investors have split views on the prospects of the company. It isn't hard to see why. Valeant has long been billed as an atypical pharmaceutical company with its repeatedly stated strategy of cutting R&D investments. The value creation process at Valeant has always seemed like a bit of a myth. While Valeant invests an inconsequential percentage of capital in R&D, it somehow manages to acquire a number of drug companies at often significant premiums to market yet still builds staggering equity value in the process. Efficient market hypothesis would suggest that public investors have efficiently weighed the risk and prospect of every company Valeant has acquired and in the said process have already assigned a fair price to those companies. While it might be possible to generate some abnormal returns through intelligence, large-scale arbitrage is generally considered to be hard, if not next to impossible. That makes Valeant's success even more curious as the company pays a price often far above what the public market prices would dictate. In the case of its latest acquisition, it paid over 48% premium to acquire Salix (SLXP). Despite such massive premium, Valeant's current enterprise value is a staggering $75 billion higher than the sum of its total acquisition costs. How is this possible?

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The answer is in fact fairly simple. Critics of Valeant often hold disbelief over Valeant's organic growth, i.e. the improvement in performance of drug products it acquired in the past. The popular short thesis on Valeant is that its core legacy products cannot hold up in performance and have to rely on continued acquisition to mask the declining performance of the products it acquired in the past. I do not share a similar view. Valeant is not a typical roll-up and does not suffer from many of the same issues traditional roll-ups often do. The drug portfolio Valeant acquired in the past differ significantly from assets acquired in traditional roll-ups in one significant way - pricing. Valeant recognizes that demand for drugs is often very price inelastic and the existing system allows the drug company to have complete control over pricing. While the cost synergy does not amount to much, especially given the above-market premium it often pays for its drug portfolio, the revenue synergy is often huge and Valeant is able to realize such synergy by simply rolling out price increases . To enhance returns, Valeant deploys significant leverage to lower its blended cost of capital.

Trade of the Decade - A Drug Carry Trade

The real economics of Valeant's business model are truly quite simple and are almost no different from a carry trade many hedge funds commonly employ.

A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market.

In the case of Valeant, it is a drug carry trade. The strategy involves Valeant borrowing money at its own blended cost of capital to invest in drug assets that will likely provide higher returns due to future expected price inflation. The drug carry trade is really an ingenious idea because Valeant can essentially function as its own central bank, dictating returns on its invested assets, drugs, by setting its own drug prices. It is a "heads I win, tail I don't lose" investment and allows PM Michael Pearson to comfortably take on significant leverage to drive home one of the greatest trade since subprime, that is until Martin Shkreli pooped the party.

Short Valeant, Short More as It Goes Lower as It is Destined to Fail

Sophisticated investors should be most familiar with the unwinding of a carry trade. It is often one of the most nasty experiences for investors that are caught on the wrong side of the trade. The reason for a crowded carry trade unwind is simple. For whatever reason, should the spread between expected asset return and cost of capital narrow, or gears into negative, a carry trade unwinds. In the case of Valeant, investors need to pay attention to two metrics: expected return on its drug portfolio and Valeant's own blended cost of capital.

Expected Drug Portfolio Return 2013-Present

As discussed previously, Valeant's expected drug portfolio return is primarily derived from its ability to dictate prices. Let's roughly equate the expected drug portfolio return to expected drug price inflation. Since 2013, Valeant has been on an extremely virtuous cycle of drug price hikes. Many branded drug products in its portfolio experienced significant price hikes despite having made little modification to the product to enhance its quality. As a result, investors have lifted up significantly the expected drug price inflation and that directly translates into a jump in the expected return of Valeant's drug portfolio.

Expected Drug Portfolio Return Present-Future

A party pooper entered the ring. Welcome, Martin Shkreli, the most hated pharma boy in America. Mr. Shkreli's unscrupulous, greedy move of jacking up a life-saving drug by 5,000% sparked an outrage. While many sell-side analysts have dissed the likelihood of complete pricing regulation in the pharma industry, they often overlooked the powerful impact of public scrutiny. A congressional investigation has so far only picked out two drugs in Valeant's portfolio, but the senators probably had little idea that Valeant has quietly raised prices significantly on well over 30 drugs since they were acquired. Public scrutiny and outrage from price gouging could completely upend Valeant's business model or even put it out of business. Hence, Michael Pearson will have little choice but to slow or even halt the price hikes he had planned to deploy; the potential to roll back certain already implemented price hikes should not be discounted as Shkreli balked under public outrage. The trend has completely turned and the Bank of Pearson is losing its ability to dictate prices and set his own returns. The current expected return on Valeant's asset portfolio seems far misplaced as future realized portfolio return will likely be substantially lower.

Valeant's Blended Cost of Capital 2013 - Now

Valeant's biggest vulnerability is not necessarily in the return of its own product portfolio; rather, Valeant's biggest vulnerability is the ebb and flow of its own blended cost of capital. As Valeant succeeds in convincing investors it can produce returns on the drug portfolio it acquired, Valeant's own stock price experienced an astounding 800% jump over the course of a mere few years. Easy capital market conditions and hunger for yield allowed Valeant to borrow cheaply. Both factors contributed to a significant decrease in Valeant's blended cost of capital since 2013. Such significant drop in Valeant's blended cost of capital can prove to be a curse later on, as it drops the required rate of return on assets it acquires by paying ever higher prices while not fully account for the volatile condition of the marketplace and the unexpected unforeseeable issues in realizing those returns.

Valeant's Blended Cost of Capital Now-Future

As discussed earlier, Valeant's own cost of capital is a function of two things. It's borrow cost and its stock price. Upon news of the Clinton announcement, Valeant's CDS experienced a significant move over the course of a mere three days, demonstrating credit investors' concern on a shift of the expected return of its drug portfolio. Valeant's stock price also tumbled almost 20% over the course of a few days. Both directly result in a substantially higher blended cost of capital for Valeant. More importantly, as the equity value of a carry trade really derives from the differential in spread, downward revision of expected drug portfolio returns and upward revision of its blended cost of capital destroy equity value further and drive up the blended cost of capital even more. The direct result of which is what is commonly referred to as a death spiral in the stock. And the lower the stock price goes, the lower the stock price goes.

Valeant's 10-year CDS have already jumped over 100 basis points in the past three months, including an 80 basis point surge since the Martin Shkreli news came to light.

(click to enlarge) (Source: Bloomberg)

Fundamentally speaking, every business accrues equity by making a spread between its return on assets and its blended cost of capital. How is Valeant different? The key difference in Valeant is that the company's return on asset has become deterministic, or riskless. Pearson figured out that he could abuse the healthcare system by arbitrarily dictating drug pricing and, therefore, determining the return on its asset portfolio. Such riskless return opportunity is supported by the broader U.S. healthcare system and millions of taxpayers and insured. By making the asset portfolio riskless yet earning much higher return than a risk-free return, Valeant's business model flies in the face of basic economics - riskless asset should only be able to earn riskless returns. From the very beginning of Valeant's roll-up strategy, Valeant's fate has been sealed. It is destined to fail.

A Bubble Burst to Starve Capital for Innovation

Folks have been calling a biotech bubble for two years now. The sector bubble really started with Valeant making drug assets riskless while earning a substantially higher return than the risk-free rate. Other market participants quickly caught on by snapping up other drug assets from people who did not understand the newly invented risk-return profile of drug assets. Over the course of two years, industry insiders and investors have largely caught on the nature of the gambit. Instead of taking risks in R&D to generate returns, capital has increasingly been flocking into existing drugs by bidding up their prices as evidenced by Martin Shkreli's staggering $55 million purchase of the effective but inexpensive Daraprim. Martin Shkreli knows he cannot sell the drug at the existing price to make a return; the seller Impax Labs knows that as well. The ensuing story is simply inevitable. Had it not been Martin Shkreli, another person would have popped up.

A bubble in the Biotech index (NYSE: [[IBB]]) will inevitably burst. The earlier it goes bust, the earlier we can return to an industry norm where excess return is made by risking capital. Valeant, the godfather, has to go away for the sake of everyone's health and longevity. The sad part is such a bubble burst will burn so many innocent and unsuspecting biotech investors and further damage risk capital used in R&D. Our life expectancy will probably all be a few months or years shorter than what it would have been if it weren't for all the greed involved in making a profit.

Crowded Carry Trade Unwind, Get Out and Go Short

It would appear the Valeant fund is at the very onset of an LTCM type of situation. Having entered into a massively leveraged carry trade in the drug business, Valeant's ability to dictate drug prices is now in doubt. For the sake of basic human decency, Michael Pearson should and will need to lower drug prices and roll back the magnificent price hikes he has done over the course of the past two years. As its stock price starts to move lower, its blended cost of capital will skyrocket further, pushing the spread into negative territory given the expensive recent acquisitions. Negative spread further destroys equity value and pushes up cost of capital. The loop goes on and stock goes down. Question is, who will be holding the bag?

For the Sake of Basic Human Decency, Rollback Your Price Hikes, J. Michael Pearson!

There is no other way to put it; price gouging life-saving drugs is despicable. The U.S. healthcare system largely guarantees individual access but higher drug costs are eventually absorbed by the entire system and the additional burden is shared by all corners of the society. While individuals no longer suffer due to price gouging, the system overall is being slowly suffocated by Valeant's actions. Since Mr. Pearson started spearheading the strategy of overpaying for drug portfolio then hiking the prices on drugs even more, Valeant became an overnight success. Such success invites copycats and copycats of copycats. Valeant, in many ways, is like a malignant tumor that is rapidly growing in the pharmaceutical industry and has already infected many healthy tissues in the system. If left untreated, the entire pharmaceutical industry will soon become a research-light and price-hiking one. Without investment in R&D with a long-term horizon, the society as a whole will suffer. I obtained pricing information from a pharmacy consultant on a few drugs that are in Valeant's drug portfolio and the price hikes are infuriating.

J. Michael Pearson, for the sake of human decency, drug price hikes such as the one detailed below are simply unacceptable and will have to be rolled back. Mephyton has been owned by Valeant since its Aton Pharma acquisition in 2010.

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Mr. Pearson should also think three times before jacking up prices on an overpaid drug portfolio he acquired from Salix and roll back the egregious price hikes that have occurred already since April 1st. Valeant took over Salix in April and the drug pricing pattern detailed below shows Valeant's strategy in a crystal clear fashion. The U.S. healthcare system should not pay six times for the identical Glumetza simply because Valeant owned the drug. Valeant's shareholders are no more deserving than Salix's shareholders and jacking up prices like this is egregious price gouging.

Glumetza is a once-daily formulation of Metformin, a very inexpensive, first-line treatment for diabetes, but there is no once daily competitor







A single patient taking 2 tabs daily (the recommended dose) would expect to use approx. $80,000 per year of product otherwise available for about $50 as generic Metformin 1000 mg tabs with no change in clinical outcome.

Further, on Xifaxan, please be mindful that everyone will be watching the company. The price has already gone up 10% since Valeant became the new owner. What is the plan?

To the Bulls and Longs

I hold a short position in Valeant fully understanding the bull side of the argument, and here is why the 12x EPS specialty pharma platform value investing approach will fail you miserably.

What the bulls believe:

  1. Political landscape dictates current abusive system will stay in place and Valeant will continue to have the ability to maintain and hike prices of its drug portfolio.
  2. Worst case scenario, public scrutiny will cause Valeant to lose its ability to rapidly raise prices in the near term but the already hiked prices will stay in place
  3. Drug costs have largely stayed stable as at 10% of overall healthcare costs and, therefore, it will not draw undue attention
  4. Even without any additional price hikes, Valeant currently trades at 12x ex-special-item EPS. It is somewhat of a value stock.

The above-mentioned beliefs will hold no water once the public collectively understands the abuse Valeant has committed to the system. The politicians may split along the party line on how to cure the abuse; no politician will find such rampant drug price gouging acceptable. While it might be hard to develop and agree upon a truly effective system to balance innovation, return on capital and affordability, Valeant will go away. To argue for Valeant is to argue against the betterment of the human race.

Valeant will be at risk to roll back the price hikes it has deployed thus far not only because it is the godfather of drug price gouging who started it all, but also because it has the least defensible business model. The publicly stated strategy of no investment in long-term R&D will render all the past price hikes completely indefensible in the spotlight. However flimsy Martin Shkreli's argument of drug improvement might be, we cannot definitively rule out such possibility. Valeant, on the other hand, has a publicly stated corporate strategy of not investing in R&D. It is a major difference.

While overall drug cost as a percentage of healthcare cost has been stable over the past several years. The beneficiary of such cost inflation is completely different. Cost inflation at hospitals are distributed to other stakeholders such as employees and create jobs for the U.S. Even for the traditional pharmaceutical companies, rising prices provided them with capital to invest in R&D. Valeant is an oddball. The additional value almost went exclusively to an offshore entity in British Columbia and subsequently directly accrued to billionaire hedge fund managers and billionaire CEO. Nobody will view this matter lightly, especially in an election season.

Thus far, I have raised zero question about Valeant's accounting, the reliability of its reported organic growth and ex-item EPS. Given the moral compass of the company, investors should not discount things that might be hidden under the hood. Investors should also take notice of Valeant's long-time CFO Howard Schiller's departure. If management at Valeant is okay with price gouging life-saving drugs while straining the entire healthcare system, its shareholders have reasons to question whether the reported numbers can really be relied upon.

A rabbit lets a fox into the henhouse; is the rabbit really safe?

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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