VALEANT: Valiant Vendor or Voracious Villain?
An analysis of a controversial pharmaceutical company’s business and operating model
Valeant Pharmaceuticals did the impossible. Over the last few years, they have established themselves as a key player in the pharmaceutical sector without investing in research and development. Valeant’s past success was largely driven by a close alignment between its business model and its operating model, while their recent challenges have been related to a public that is not ready for their provocative approach to the business of healthcare.
A CONTROVERSIAL BUSINESS MODEL
Valeant’s business model is built around the acquisition of smaller pharmaceutical companies rather than through investing in research and development [1]. This model is based on their observation that R&D has become a low-return proposition for many large pharmaceutical firms, who struggle to develop blockbuster drugs that can repay the $2.5 billion investment [2] required to bring a new product to market. Instead, Valeant creates value by identifying promising companies in attractive drug categories, acquiring them with the help of loans at historically low interest rates, improving efficiency through R&D cuts, and utilizing lower tax domiciles to house intellectual property [3]. Moreover, Valeant often captures additional value by increasing the price of drugs that they view as underpriced, especially in smaller patient markets, where generic manufacturers are unlikely to compete [4].
A WELL-ALIGNED OPERATING MODEL
Valeant’s operating model is closely aligned with its business model, especially with respect to their allocation of R&D human capital, acquisitions-focused culture, and payables collection processes.
Valeant allocates significantly less resources on internal research and development compared to other large pharmaceutical companies, at approximately 3% of total revenue, compared to approximately 8% to 24% for many large pharmaceutical firms (Figure 1). On the other hand, Valeant pays approximately 12% of its total revenue in interest expenses, largely as a result of financing its acquisitions through loans. This outcome is driven by their operating principle to focus on bringing new products to market (output), not R&D spend (input) [5]. Their limited R&D spending is devoted to line extensions and late-stage development programs, which have a higher probably of success.
Figure 1 – Comparison of three cost drivers for several major pharmaceutical companies [6].
The acquisition processes at Valeant are also highly aligned with their business model. Their operating principle [5] is to target high-growth business segments, both in terms of therapeutic areas and geographies. Specifically, Valeant has targeted North America and emerging markets, such as Asia, Latin America, Central Europe, Eastern Europe, Russia, and North Africa. Their acquisitions team focuses on completing a high volume of deals, at approximately 25 per year, including many deals too small to report financially [7].
Valeant’s operations related to cash collection are also aligned with their business model. They are concerned with government-driven price decreases, which impact their business strategy of acquiring underpriced drugs and subsequently increasing their prices. To avoid this risk, they focus on providing products in less price-sensitive markets and have achieved over 75% of sales through cash pay or reimbursement through private insurance [5].
AN UNCERTAIN FUTURE DESPITE CLEAR ALIGNMENT
The close alignment of the operating model with the business model creates a competitive advantage for Valeant. Their low investment in R&D human capital, culture of acquisitions, and cash collection processes enable their business strategy of acquiring promising drugs, reducing costs, and increasing prices. Their business strategy, however, continues to face criticism (see video below). Public condemnation related to their strategy of increasing drug prices has caused the public to be suspicious of their other activities. For example, in October 2015 the short-selling research firm, Citron Research, accused Valeant of nefarious accounting practices, which decreased investor confidence in Valeant management and led to a deflated stock price ($257 in July 2015, $70 in November 2015) [8]. Furthermore, Valeant’s business model is dependent on their ability to continue to complete large acquisitions, which will become increasingly difficult as their reputation for cost-cutting spreads, as evidenced by their failed acquisition of Allergan in 2014 [9,10]. Moreover, Valeant’s strategy is dependent on the availability of low interest rates, which may change if investors begin to question the sustainability of this business strategy. While it is clear that there is alignment between business and operating models, it is less certain whether Valeant will be perceived by the public as a cleverly-structured provider of pharmaceuticals or as opportunistic middlemen for necessary medicine.
Figure 2 – Video of Aswath Damodaran, professor of finance at NYU, discussing Valeant’s business model with Bloomberg’s Joe Weisenthal, Alix Steel, and Scarlet Fu [11].
REFERENCES
[1] Udland, M. (2014) “VALEANT: How a Canadian Pharmaceutical Company Could Destroy The Industry As We Know It.” Business Insider. Accessed: 12/08/2015. Available online at: http://www.businessinsider.com/valeant-business-model-2014-6
[2] Mullin, R. (2014) “Cost to Develop New Pharmaceutical Drug Now Exceeds $2.5B.” Chemical and Engineering News. Accessed: 12/09/2015. Available online at: http://www.scientificamerican.com/article/cost-to-develop-new-pharmaceutical-drug-now-exceeds-2-5b/
[3] Goldfarb, R.D. and Poppe, D.M. (2015) “Letter to Clients and Shareholders.” Business Insider. Accessed: 12/08/2015. Available online at: http://www.businessinsider.com/sequoia-losing-on-valeant-stake-2015-10
[4] Helfand, C. (2015) “Valeant CEO defends price hikes, business model in letter to worried employees. Accessed: 12/08/2015. Available online at: http://www.fiercepharma.com/story/valeant-ceo-defends-price-hikes-business-model-letter-worried-employees/2015-09-28
[5] Valeant. (2013) “Shareholder Letter”. Valeant Investor Website. Accessed: 12/08/2015. Available online at: http://s1.q4cdn.com/484041954/files/2013_AR/letter-to-shareholders.html
[6] Graph generated in Microsoft Excel using data obtained from http://finance.yahoo.com/
[7] Wayne, A. (2013) “Valeant Agrees to Buy Bausch & Lomg in $8.7 Billion Deal.” BloombergBusiness. Accessed: 12/08/2015. Available online at: http://www.bloomberg.com/news/articles/2013-05-27/valeant-agrees-to-buy-bausch-lomb-for-4-5-billion-cash
[8] Gara, A. (2015) “Valeant Plunges 30% After Short Seller Citron Research Makes Fraud Allegation.” Forbes. Accessed: 12/08/2015. Available online at: http://www.forbes.com/sites/antoinegara/2015/10/21/valeant-plunges-30-after-short-seller-citron-research-makes-fraud-allegation/
[9] Lachapelle, T. (2014) “Is Valeant’s Buy-to-Grow Strategy Sustainable?: Real M&A.” BloombergBusiness. Accessed: 12/07/2015. Available online at: http://www.bloomberg.com/news/articles/2014-05-26/is-valeant-s-buy-to-grow-strategy-sustainable-real-m-a
[10] Nickel, R. and Oran, O. (2014) “Losing Allergan deals blow to Valeant reputation.” Reuters. Accessed: 12/09/2015. Available online at: http://www.reuters.com/article/us-allergan-m-a-valeant-pharms-idUSKCN0J121520141117
[11] Damodaran, A., et al. (2015) “Is Valeant’s Business Model Broken?” BloombergBusiness. Accessed: 12/06/2015. Available online at: http://www.bloomberg.com/news/videos/2015-11-11/is-valeant-s-business-model-broken-
The morality of Valeant’s operating model is often brought into question from an emotional perspective but here’s a counter argument. Pharmaceutical companies invest in R&D for a return which (sometimes) is through selling the drug on the market. Valeant is just offering another channel through which pharmaceutical companies can make that return: having their drug acquired. True, if EVERY pharmaceutical company did what Valeant did, it would be a disaster. But that doesn’t mean there isn’t a space for Valeant. As for the price increases, Billy Ackman swears the company is just as strong without them.
Valeant is just another predatory pharmaco preying on poor patients.
Nicely written article! I also feel that Valeant is not actually capturing unrealized value since drug markets are not efficient (e.g. consumers do not have choice, no fear of competitive response, etc). I also question how sustainable their business model is, regardless of how effective their operating model is.
Thanks for writing about Valeant! I’m worried about companies whose growth comes ~solely from pricing increases. It invites public criticism (politicians, the public), more regulation, and new entrant copycats. Copycats might not appear here because of the first two issues. 2015 was a huge year for M&A, but as we enter a rising rate regime, acquisition rollup strategies will become harder to execute. Valeant’s cherrypicked disclosure about how its prior acquisitions are faring may be masking underperformance.
Thanks for this great analysis of Valeant! The business model you described actually reminded me of The Medicine’s Company’s model (from our marketing case), which purchases the rights to drugs that other companies have abandoned and brings them to market. Interesting how The Medicine’s Company has such a good reputation, and Valeant has such a bad one! I think the basis of Valeant’s business model does actually create value in that they provide resources (financial, regulatory guidance, marketing, etc.) to the small firms that they acquire to help bring the drugs to market. In my opinion, raising prices isn’t such a terrible thing, as Valeant still has to make a return so they can reinvest in acquiring other companies and continue bringing life-saving drugs to market. The question is how much should they raise the prices, and where’s the line between making a fair return and price gouging the patients. Professor Dolan needs to be brought in!
Agree with comments made by Robert and Steven Chen. Valeant does not have a future in healthcare past this decade. The process of cutting R&D in the companies they acquire will come back to haunt them in the long term, as they find it harder and harder to find new companies to acquire. As more societal and political pressure gets place on pharma, they will need to justify revenue driven chiefly from cost cutting and price increases. Now that more people are watching pharma pricing structures, they’re going to get hit hard.
Nice job Jason! Good read – totally agree that there is effective alignment if you just think about the idea of using cheap debt to fund acquisitions for your product pipeline and then raising prices when the market will allow it. However, I wonder whether this strategy, combined with their rapidly rising stock price over the last several years, pressured Valeant into pushing this strategy to a precarious extreme whereby any macroeconomic changes (not to mention accounting shenanigans) could really hurt them (interest rates rising, govt pricing regulations, stock price declining and making acquisitions tougher, etc.).
Nicely written article. You clearly did your research. I’m not sure I entirely agree though with your main premise that Valeant’s acquisitive roll-up strategy in place of any meaningful R&D program is indicative of operational and business strategy alignment. Valeant has chosen to pursue a structure in which M&A has replaced organic growth via R&D under the premise that this is more cost effective. As Valeant continues to grow, the minimum required size of such an M&A deal is going to increase because otherwise it wouldn’t be enough to “move the needle” in terms of driving growth. As the company grows, the pool of viable potential deals that Valeant could pursue in place of R&D continues to shrink. As this pool of potential deals shrink, Valeant will need to lower the bar in terms of quality of deals it will pursue in order to continue this growth trajectory. Thus, in an effort to continue M&A driven growth, Valeant is going to be forced into pursuing lower quality deals as it gets bigger. Valeant management also recently announced that it was going to start increasing R&D spending (not to the extent of some of theirs, but more than they have historically). This would suggest that after some turbulent times, they are starting to warm up to the more traditional view of R&D spending.
Great post Jason! Valeant’s business model is interesting and certainly creates a way for them to play in the pharmaceutical space without investing in the necessary capital requirements that other manufacturers do. One of my main concerns is whether the acquisition strategy is sustainable for the long term and if they will be able to continue to source value-add drugs. As noted above there are a number of reasons why this may be the case, but one specific situation I could envision is that as pharmaceutical companies see the success of Valeant’s business model, they may hold on to their drugs in development longer, or pursue a similar strategy within their own organizations.