Big Pharma is in trouble these days as the cost of researching and qualifying new drugs has risen rapidly, and in inverse proportion it seems to their ability to find any. Increasingly, the game has become instead one of industry consolidation as companies seek to buy competitors, cut back office costs and slash their own R&D expenditures to the bone.
Of course it ultimately becomes a self-defeating process, as without new inventions sooner or later the process must come to a full stop.
The same has been happening with smaller tier Pharma companies as well; Actavis, Perrigo, Thermo Fisher, Valeant and others have been playing the same game, all having become aggressive acquirors and none more so than Valeant, which is based up in Canada.
Once known as Biovail, and based in Laval Quebec, when a new CEO Michael Pearson came in six years ago in February, 2008 bringing fresh ideas from McKinsey, where he had spent the previous 23 years, he immediately cleaned house and started to play the acquisition game.
In the old days, and when Israel’s own Teva used to do it, it was mainly a game of using a higher P/E ratio stock to acquire listed companies with lower P/E ratios for shares, with the outcome usually still being accretive to earnings per share for the combined entity.
Ever since the last market bust with the financial crisis, however, interest rates have become so low, possibly close to zero in some cases in real terms, that the game has reverted to an even earlier modus operandum instead. Now the game is one of financial leverage, with post-deal valuations increasingly based by the markets based on multiples of EBITDA, rather than focusing on net earnings themselves.
Valeant is an excellent example, and just ten months ago in its latest deal, it acquired eye products company Bausch & Lomb from New York private equity firm Warburg Pincus for US$8.5 billion. To close the deal it raised just US$2 billion of new equity to do so and deployed the rest by way of debt. It is believed that Warburg Pincus tripled their own equity investment on the sale, too, as Valeant took over their own remaining prior acquisition debt balances as well (see JBN link May 28th, 2013 [here]).
The Bausch & Lomb added almost a full third to the size of its balance sheet and was warmly greeted by the financial markets. However, as a result, today Valeant now has a total of US$17 billion of debt, albeit presently paying only about 6% in interest cost annually for the privilege. In contrast it has just US$5 billion of book equity in its balance sheet. Valeant also has US$9 billion of goodwill, US$13 billion of intangibles assets tied up in intellectual property and other, unstated, forms of intangibles, and only about US$1.2 billion of actual, tangible, fixed assets.
For the nine months to September 30th EBITDA covered the company’s interest costs on the debt about 2 times, however, even though the company reported a large net loss after writing off quite a lot of its IP as an impairment charge.
Nevertheless the shares continue to be well liked and, over the last four years alone, have risen more than nine times from under US$15 to a current price of just over US$135 per share. Even in the generally recovering market we have had that is still impressive.
The Valeant CEO Mike Pearson apparently distinctly prefers industry consolidations to new R&D, we understand, and there are even press reports circulating lately that Valeant is still on a roll, and now again looking aggressively for more deals in 2014. Without being cynical, quietly putting the word out in such a manner is a very good way to obtain deal flow, as everyone then knows to come calling who has something to offer. But Valeant, we are told, wants to join the big leagues and reach the scale of Big Pharma itself and join the Roches of this world.
In that context Israeli firm Teva itself sometimes comes up too, as a potential target, in addition to the names above. Teva’s shares are undoubtedly cheap given the impact its struggles to redefine itself have had on its profitability and its share price in the last couple of years. So if the kernel at the core of the company is itself solid it could be a bargain for somebody.
Whether this one will fly, or another one, or whether the whole bubble itself will burst for this kind of acquisition binge as the US Federal Reserve finally brings its quantitative easing policy to an end, remains to be seen however.
The largest single shareholder in Valeant at March 31st, 2013 with 11.4% of the company, was the private investment firm Ruane, Cunniff & Goldfarb whose Chairman and CEO is Robert Goldfarb. Ruane Cunniff & Goldfarb also runs the legendary Sequoia fund, which has regularly outperformed the S&P 500 for the last 40 years or so.
In an investment presentation in 2011, Goldfarb stated clearly that with their private equity investment philosophy they sometimes liked to back the jockey and never mind too much about the horse. Mike Pearson had attracted them to Valeant as a fresh leader with interesting ideas, and so they let him run with it.
As Valeant’s total equity market capitalization sits currently at over US$45 billion, Robert Goldfarb must indeed be pleased with the outcome to date. However at a certain point all the Pharma companies will have to go back to inventing new drugs or die, and for that they will need to have efficient but really inventive teams in place to do so.
I hope Valeant understands that, and will be there at the table when they need to step it up again. Whether it is in three years time, or even ten, until the game changes it will not be so simple if everyone should slash and burn so much in the mean time that there is nothing left. It is not as if the world has been running out of diseases to fix, so to speak.
About Robert Goldfarb
Robert Goldfarb is Chairman and CEO of the private investment firm Ruane, Cunnif & Goldfarb. Ruane Cunnif & Goldfarb manages the Sequoia fund which over the last 43 years has out-performed the S&P 500 by almost 40% producing annualized returns for the whole period of 14.5% per annum.
Between graduating from Yale and matriculating to Harvard Business School, Goldfarb was a Portfolio Manager at Scudder, Stevens and Clark.
He joined Ruane, Cunnif after graduating from the Harvard Business School in 1971. Over the years, he has made a number of successful investments in publicly traded media companies. Mr. Goldfarb is also a Member of the Advisory Board at Mercury Capital Partners.