Valeant: O Tidings of Comfort and Joy

As every holiday movie watcher knows, it’s your Christmas spirit—the very power of your belief—that gives Santa’s reindeer the get-up-and-go to deliver a sackful of toys. But like those woebegone characters who openly question the very existence of gift-bearing emissaries from the frozen north, we doubted Valeant’s ability to wring new sales from old drugs, to conjure organic growth from existing brands facing generic competition. Shareholders had a party, and we were grumpily bah-hum-bugging over by the bar. We didn’t believe.

And so, in the midst of this holiday season, we are gathered here today to announce our triumph over doubt, our victory over misgivings, and our embrace of the festive spirit. What ghostly portend of a ghastly Christmas future has restored us to the faithful flock? Well, like Scrooge before us, first we need a look at Christmas past.

Valeant completed the acquisition of Medicis on 11 December 2012, almost three years ago today. And before Valeant’s warm embrace, sales of Medicis’ acne treatment Solodyn had fallen through the ice, so to speak, according to the respective 10-Q filings:

A Marketwatch article told the tale:

[Valeant] stock has fallen back amid worry that sales of Medicis's blockbuster drug, Solodyn, may be declining faster than expected.…

Solodyn generates about 40% of Medicis's annual sales, analysts say. Morgan Stanley & Co. estimates the treatment accounts for around 75% of the company's earnings per share. A Medicis representative declined comment. Valeant Chief Executive Michael Pearson, in an interview, said he agreed with the 40% revenue estimate, but declined comment on the profit projection.

Some analysts are taking issue with the drug's growth prospects, amid signs of flagging sales. Solodyn prescriptions in the U.S. fell 44% during the last week of August from a year earlier, according to data from IMS Health, a healthcare information company. In the first two months of the third quarter, Solodyn prescriptions fell 24% from the first two months of the second quarter, according to Piper Jaffray & Co., based on IMS data.

On Sept. 14, Morgan Stanley downgraded Valeant to equal weight from overweight, “concerned about Solodyn's growth outlook.”

But Valeant was unbowed. While its forecast of $250-$275M (p. 10) in sales for Solodyn in 2013 was far too high (actual was ~$200M, p. 5), a fairly sizeable decline from what we can see of 2012), sales appear to have stabilized in 2014 ($210M, p. 9) and even started growing again (LTM: $250M, #7 product worldwide as of 3Q15, p. 5).

Forgive the mixed metaphor, but another holiday tale provides a nice summary: sales of Solodyn that could barely satisfy Wall Street for another quarter (give or take) have miraculously lasted more than eight quarters (give or take).

During this time, retail prices of Solodyn have climbed from about $700 in 2011 to over $1100 for a 30 day supply. On Valeant’s account, they sold more pills at higher (list) prices, despite competition from cheap generic alternatives. A holiday miracle, indeed.

But how? How can you sell more volume of an old drug at a higher list price while facing generic competition? In fact, a recent article in JAMA Dermatology made the observation, after checking retail prices of several dermatology drugs over a six-year period, that prices for Valeant's drugs had risen the most.

The ValeantNow PR commandos, quick to the barricades, helpfully pointed out that Valeant sells a lot of dermatology drugs and that they didn't own these for the entire period, just lately. Apparently retail prices rise of their own volition, and the fact that “these products faced generic competition” makes such increases less notable, not more. (Note to analysts: we see the opportunity for more “cost synergies” in the marketing department: at Valeant, prices self-levitate.)

Generous to a fault, Valeant takes pains to remind us that its net prices have risen much more modestly. On the 3Q15 conference call, Mike Pearson said (p. 7):

As most of the commentary around price centers on the wholesale price or list price, we wanted to provide a more clear picture on what Valeant actually realizes from a price action, which is considerably different than what has been portrayed. If you look at the top 10 dermatology products, which represent approximately 62% of our dermatology portfolio, we took, on average, a 14% gross price increase on these products this year, yet we realized less than a 2% price increase on a net basis.

…

In reality, we increased price on 85 of our 156 branded pharmaceutical products, or 54% of our products. And our average gross price increase was 36%. It is important to note that our realized price increase was 24%.

Furthermore, Valeant’s “patient assistance” (aka “access”) contributions to unnamed foundations grew far faster than its revenue, at a rate of 128% compounded from 2012 to 2016 (p. 39), reaching a projected total of ~$1B in 2016. And yet a recent presentation states 14% of “organic growth” in the “promoted branded Rx business” was due to “gross-to-net adjustments” (p. 86). As net revenue is gross minus “cash discounts and allowances, chargebacks, and distribution fees...as well as rebates and returns” (p. 33)—things that make net less than gross—doesn’t growth from gross-to-net adjustments mean a decrease in a discount? Meaning net prices rise? (Also, discounts can shrink only so much before disappearing; perhaps a better name for paying someone cash to buy one’s drug would be “subsidy.” Colour us curious as to how “durable” this source of organic growth will prove.)

Point being, this is befuddling. Apparently Valeant risked widespread public opprobrium, unwanted press attention, the ire of Congress, and even federal investigations for what we are told is a minor benefit to realised prices. And nobody, apparently, pays list prices. So why did they raise them? And if they hadn’t raised gross prices, would net prices have declined? And if the explanation for the gross-to-net difference is the stunning growth in rebates and discounts, what is the point of raising prices only to, in essence, give out lots of coupons, except in the hope that such coupons don’t get used? Giving someone gold so they can purchase your frankincense and myrhh is a strategy, I suppose.

You can see why we were perplexed. We didn’t believe they could raise prices, grow volume, and increase “organic growth.” And, defying us, they did it. How? Well, Valeant pretty much told us. In two words: “alternative fulfilment.”

Here’s then-CFO Howard Schiller describing, at the Goldman Sachs Healthcare Conference on June 11, 2013 (p. 7), the improvements Valeant made to Medicis’ original program. (Note: Two weeks later, Philidor would receive its first pharmacy license in Pennsylvania, having signed a contract with Valeant within its first month of existence.)

Howard Schiller, CFO, Valeant

So I probably think under Medicis, alternative fulfillment was held out a little bit too much as the holy grail. I really think it's -- it's actually the starting points, and in some ways, it was quite a clumsy starting point. It wasn't that different, but it's a process where we have generation two and generation three. But it's all trying to focus on profitable scripts, and stay away from those scripts that are unprofitable, and more judicious use of co-pay cards and the rest, and making sure when a customer, a patient is covered, you get reimbursed for it.

Gary Nachman, Analyst, Goldman Sachs

So do you feel like you've made a lot of progress from when you took over, and now you can see, a couple years from now, you'll be at a point where what you're talking about really comes to fruition? I mean, not just with (multiple speakers)

Howard Schiller, CFO, Valeant

Yes, I think -- I'm hoping -- we've got generation two and generation three, which I'm hoping sort of turn it into a pure defense, into more of an offensive tool to allow us to grow profits. And that's really the focus, is growing profits.

Alternative fulfilment with a focus on profits is what we now know (knew?) as Philidor.  Here's what that looks like in the field:

The elves at Philidor, creatures of the Christmas spirit all, were happy to sell Valeant’s dermatology drugs at low, low prices. To our understanding, it worked like this: if an insurance company could be persuaded to cover a Valeant drug dispensed by Philidor, the patient paid little if any cash co-pay. But if the patient didn’t have insurance or was ineligible for co-pay assistance, Philidor would supply the drug at a greatly reduced cash price. Outwardly, this is charitable, as patients get cheaper medicines and harried doctors and pharmacists don’t have to spend time on the phone dealing with reimbursement issues. It is also an offensive weapon to combat payers’ attempts to substitute generics for expensive Valeant drugs, including requirements for proof of clinical necessity or completion of step-therapies (trying the generic first).

Philidor was, in a sense, a prescription “drift net”: if doctors could be persuaded by Valeant’s sales reps to direct patients to Philidor to fill prescriptions, then Philidor’s elves worked their magic. If your insurer could be persuaded to pay, Philidor’s team billed them the ever-increasing full price. But if you were uninsured, your carrier couldn’t be swayed, or your co-pay couldn’t be legally waived, then Philidor sold you Valeant’s drugs at much lower cash prices warding off generic substitution. Since your local Walgreens or CVS won’t spend hours on the phone trying to convince a reluctant insurer that a branded drug is required—unless your doctor wrote “dispense-as-written,” they’ll just give you the generic and you’ll be on your way—Valeant needed what is essentially a tied pharmacy, namely Philidor.

This, we must admit, is diabolically clever. List prices for drugs can skyrocket, and some insurers will be persuaded to pay them (net of rebates). Average net prices, however, won’t move up as much, as some prescriptions are sold cheap to those insurance won’t cover or whose co-pays can’t be legally waived. Meanwhile the volume of Valeant prescriptions dispensed grows, as some patients who would have bought the generic at Walgreens get the branded drug instead at prices low enough to avoid substitution (especially as the captive pharmacy does not offer a substitute). Insurers’ second line of defence after co-pays—extra paperwork for harried doctors and pharmacists to prove the medical necessity of a higher-tier medication with a generic alternative—is deftly evaded by a team of elves dedicated to obtaining as large a reimbursement as possible, apparently by any means necessary.

What’s more, finding ways to get insurers to pay for a large number of expensive branded prescriptions is a nice cudgel with which to beat them into agreeing to trade larger rebates in one therapeutic area for better coverage in another. Six months later, at another Goldman Sachs conference on Jan. 7, 2014, Mr Pearson described the progress of Solodyn and “alternative fulfilment 2.0” (p. 7-8):

Gary Nachman, Analyst, Goldman Sachs

On the derm side, just we've talked about this in the past, but the alternative fulfillment program that you inherited with the Medicis transaction and Solodyn has been sort of the bellwether product and you guided very conservatively and then it stabilized. It seems to have declined a little bit more recently. Just in terms of what they were trying to accomplish to improve the profitability of the prescriptions, have you guys gotten there? And is that an important part of the derm business at this point?

Mike Pearson, Chairman & CEO, Valeant Pharmaceuticals International

No, I'd say we didn't -- we have not been as successful with Solodyn as we had planned and that is why we have -- now the one silver lining that has been a very good bargaining chip with managed care. And since it is one of the largest and most expensive derm products, we have been able to trade discounts for Solodyn to include other products or get pricing in other parts, so we have been using that pretty aggressively. So from an economic standpoint, it delivers more than its weight.

The AF program was I think rolled out a little bit too quickly and there were lots of bugs in it and we have a next generation that we're going to -- which we are implementing, which we aren't going to talk about the details of, but net-net I think Solodyn, it's a lot less important to us now than when we -- than it was to Medicis obviously.

Perhaps investors will inquire what the loss of Philidor will mean for those rebate discussions.

It doesn’t end there. Like Santa’s network of hidden workshops, Philidor was non-reporting, so volumes dispensed and prices paid were invisible to the outside world. Had Santa not been extra careful to file UCC statements securing his interests in the elves’ tools—and not crossed paths with an obstreperous pharmacist at R&O—we would have been none the wiser.

Add to this financial consolidation, removing the requirement to identify Philidor as a customer. Throw in a set of nested zero-strike options to avoid the need (perhaps) to re-license the pharmacy in 50 states. Toss in a mountain of LLCs with obscure names that Valeant was shocked (shocked!) to learn about thanks to the damnable short sellers who were kind enough to inform them. The point being, Santa’s no dummy.

On this hypothesis, Philidor allowed Valeant to increase list prices and to show volume growth besides—all without anyone noticing. Anybody who can deliver millions of presents while remaining utterly invisible has some serious reindeer-power (or works for Alibaba).

We believe that Philidor was a bigger success than Valeant and most investors (ourselves included) could have imagined. But now, with Philidor unwound, Valeant now faces the task of rebuilding its network of atypical “specialty pharmacies” that dispense its expensive branded products in the U.S.

To get a sense of how challenging that might be, we need to get our arms around Philidor’s contribution to Valeant’s results. Just how successful was this secret fulfilment network? On a scale of one to “team of eight flying reindeer,” Philidor was Rudolf. Let’s talk numbers.

Valeant maintains that Philidor’s contribution to pulling the sleigh has been modest, at best. On the Oct. 26, 2015, call they said:

• In Q3 2015, Philidor represented 6.8% of total Valeant revenue (p. 10)
• Philidor accounts for 5.9% of Valeant net revenue YTD (p. 11)
• At the time of the Purchase Option Agreement in December, 2014, Philidor YTD 
net sales were $111 million  (p. 53)

Mr Pearson emphasized Philidor’s apparently meagre contribution, stating on Nov. 10: “Lost in all the news about Philidor is the fact that it represented only $190 million of revenue in the third quarter, or 6.8% of our $2.8 billion in overall revenues for the quarter” (p. 4). With $454.9M of revenue YTD (5.9% of the total) and $189.5M in 3Q (6.8% of the total), that means 1Q+2Q were $265.4M, an average of $132.7M for the first two quarters. In other words, on average, Philidor exceeded its entire 2014 total in the first quarter alone. That is impressive growth.

Philidor grew from almost nothing to almost 7% of sales over three quarters. If we weight the 1Q and 2Q figure of $265.4M by Valeant’s US revenue in 1Q15 and 2Q15, we can estimate that Philidor has been growing at an average of 28.5% quarter over quarter in 2015. (As far as we know, Philidor only operated in the United States.) Had Philidor’s only customer not decided to sever a relationship it defended as “legal and maybe…unusual” (p. 20) mere days before, we presume such growth would have continued. Applying the same growth rate of 25.9% that we estimated for 3Q/2Q, Philidor could have hit $238.5M in 4Q revenue, for a 2015 total of $693.4M. (Arguably we could have weighted this by dermatology sales instead—see below—but the difference is minor, and non-dermatology products were being added to the Philidor stable.)

Perhaps you are a jaded Wall Street type who doesn’t find this particularly notable. Well, consider this: over the first three years of meaningful revenue generation, Philidor trounced both Google and Facebook in dollars collected. (Yes, most of this was pass-through to Valeant. ’Twas ever thus.)

Most companies facing the difficult problem of how best to announce a wild success choose the “shout it from the rooftops” solution. But as we all know, other than his mode of entry and egress, Santa likes to keep his methods a bit more covert. Asked on July 31, 2014, about the stupendous growth of the “second generation” of alternative fulfilment (aka Philidor, up and running for over 1.5 years by that time), Mr Pearson was a bit more circumspect (p. 38).

Greg Fraser, Analyst, Deutsche Bank

Okay. And then just a last question on the alternative fulfillment initiatives. I know you've made improvements there, versus what Medicis was doing. Can you just give us a sense of how much volume tends to run through that channel? And what products you've [rolled] that program out to?...

J. Michael Pearson, CEO, Valeant

We're not going to give specifics. It's—we think it's a competitive advantage that we have. And it is still primarily the Medicis products, although not exclusively the Medicis products. And—but I don't want to give specific numbers, but it is a very successful initiative.

(When word of Philidor leaked out, Valeant was quick to mention that other companies had “specialty pharmacy” relationships, too (p. 8). How a common, nothing-to-see-here industry practice is also a competitive advantage is for wiser folks than ourselves to contemplate. Perhaps such itinerant wise men could also tell us why we know Philidor’s revenue to two significant figures but its “EBITA” to barely one [“~7%”] and then only for 3Q.)

Anyway, the elves at Philidor—toiling away in invisible, snow-bound factories—were even more industrious than Santa could have hoped. Beyond their contribution to overall growth, Philidor had the potential to shift the mix of sales in ways that mattered greatly to Wall Street, and hence to Valeant. Like the spoiled children they are, Wall Street types aren’t satisfied with a pricier gift every year; they also want more in number. More concretely, Wall Street wishes for “organic” growth in revenues, meaning increases in volume, not just price.

As above, it seems reasonable to assume that Philidor only operated in the US, as otherwise it would have needed licenses to ship medications to other countries (and Valeant would need rights to sell each drug in those countries). So while management compared Philidor to total revenue, let’s have a look at our quarterly estimates compared to U.S. sales in 2015.

Now 9.6% (3Q) isn’t all that much more than the 6.8% we were told, but it’s a heck of a lot more than 2.5% (1Q) and closer to the magic 10% of materiality. And remember, Philidor was only $111M for all of 2014. If anything, Philidor was rapidly becoming far more important to Valeant than they let on.

But even this comparison leaves something out. For as we explained above, what distinguished Philidor was its ability sell Valeant’s branded drugs. According to the most recent quarterly earnings presentation (p. 24), sales of “U.S. Branded Rx”—the beating heart of Philidor—were $914M in 3Q15. As Philidor’s revenues in the same period totalled $189.5M, Philidor was responsible for 20.7% of US branded drug sales. (That’s not quite two reindeer out of eight, for those not yet sick of the Christmas metaphor.)

In fact, if we look at US “same store sales,” Philidor’s contribution to Valeant’s growth is even more apparent. As a percentage of “same store sales” in each quarter of 2015, on our estimates, Philidor’s revenue had mushroomed from 9.7% in the first quarter to 14.4% in 3Q, and could have reached 16.5% of US same store sales in 4Q15 (using the original 10% “same store sales” growth estimate Valeant provided for 4Q).

Philidor itself accounted for a substantial portion of same store sales growth. If we take it out entirely, then such growth is cut in half, and might even be negative in 4Q15 on our estimates. If only 50% of Philidor’s revenue is lost, the “organic sales growth” numbers would look far less gaudy. Moreover, Valeant has disclosed the increase in price in US branded Rx (the vast bulk of Philidor’s revenue, we believe). Even if only 50% of Philidor’s revenue is lost, the average price increase for US branded Rx exceeds the remaining rate of organic growth. The implication: volume growth ex-Philidor is minimal/negative. Not only that, but we are told dermatology prices rose less than other segments, meaning that ex-Philidor, the average price increase as a component of same store sales growth is higher yet.

Now Philidor didn’t dispense every product sold by Valeant. As Mr Pearson stated on the Nov. 10 conference call, Philidor’s revenues were “99% dermatology” (p. 10).

Using this figure, we discover that Philidor accounted for almost 40.3% of dermatology revenue in 3Q15 and 33.4% of 2015 YTD. Dermatology was a bright spot for Valeant this year, having generated $438.9M more in revenue through the first three quarters of 2015 than it did over the same period in 2014. As Philidor notched $454.9M YTD, versus ~$111M in 2014, it seems fair to conclude that the vast majority of this year’s dollar growth in US dermatology revenue was effectively Philidor.

And this, dear reader, is the problem: Philidor succeeded all too well. Philidor managed to make old drugs with generic competition into “durable” machines for “organic growth.” Sell-side analysts, the most eager believers in the power of the corporate Santa Claus, were right all along: Valeant did have something special. It just wasn’t the “decentralized operating model” (p. 3) and the heaping dollop of McKinseyism that everyone thought.

But now, on direct orders from the Christmas-hating grinches at PBMs, payers, conspiratorial nattering nabobs of negativism, and—who else?—Congress, the miracle on Horsham Road has officially declared its receipt of a lump of coal. Valeant, meanwhile, is working very hard to “put in place a new specialty program to complement the retail scripts” (p. 7) to replace Philidor.

One problem, of course, is that PBMs and payers are wising up to what’s been going on. And they have ways to fight back against the rising tide of “specialty pharmacies.” A pharmacy that dispenses almost entirely branded dermatology drugs from one company tends to stick out, we’d imagine.

Also, if it took the magic of Philidor to make drugs like Solodyn grow “organically,” how “durable” are those products really? Some have argued that growth in IMS-reported prescription numbers after Philidor’s disclosure in late October shows that Valeant didn't really need them anyway. (They come not to praise Philidor, but to bury it.) Why, then, did Philidor exist at all? How was it a “competitive advantage?” Why did a rapidly growing portion of Valeant’s revenue pass through its fingers? Valeant says that drugs sold by Philidor were less profitable. So who needs the hassle and the secrecy? The point is not that there’s no demand for Valeant’s drugs, only that Philidor makes such demand appear artificially robust, in our estimation. If nary a prescription will be lost without Philidor, surely Valeant wouldn’t have sought to expand it or, after its hasty burial, to resurrect it.

On that note, we pause here for a brief holiday message.

Dear “specialty pharmacy” workshops that Valeant is feverishly rebuilding atop the ruins of Philidor. We wish to inform you that Santa may be watching you via a joint steering committee, may have superhero supernumeraries stationed on your premises, may have a zero-strike option to purchase you, and may even be consolidating your naughty-and-niceness onto his big ledger. But should a present-delivering mishap occur, you elves are on your own, ’cause Santa is legally indemnified. Pay attention, Direct Success Pharmacy of New Jersey.

Enough about them. What about the people most in need of our thoughts and prayers during the holiday season, the large institutional shareholders? Reuters reports that “Investors said Wall Street wanted three things from Wednesday's meeting: a 2016 forecast for earnings around $14 per share versus the $11 projected for 2015, no more bad news or surprises, and a new plan for selling dermatology products through specialty pharmacies.” We confess that we don’t quite understand why a promise of “no more bad news” would be more convincing today than it was on say, October 19, the date of the third quarter call on which Philidor's existence was first disclosed. Maybe we’re getting too old for Santa.

Anyway, for those who believe, in whose heads dance visions of sugarplums, 20% IRRs, six-year cash paybacks, and up-and-to-the-right price charts, what will they find in their stock(ings)? Like all well-behaved children—mindful of their manners when Santa is watching—what investors want most is a return to the happy golden days of yore. For once we are old enough to learn the truth about Santa, receiving presents is never the same.

But don’t worry, Valeant’s got a plan. And, like kids on Christmas morning, shareholders can’t wait until 8 AM EST on December 16, when a jolly man in a suit will slide down the conference call chimney bearing gifts, good tidings (non-GAAP) for the new year, a hankering for cookies, and the joyous and comforting news that the end of the Philidor miracle was a non-cash event.




Postscript

Overflowing with the holiday spirit, I’ll save the cheery folks at ValeantNow a few minutes.

Here are a few responses they might consider, and why I believe they are wrong.

1) Philidor wasn’t acquired until December 2014, so it wouldn’t be part of “same store sales” or “organic growth.”

This is a distinction without a difference. First, Valeant has stated that Philidor was an ordinary, arms-length customer before December 2014. Sales of drugs to Philidor—like any pharmacy—were thus included in Valeant’s 2014 revenue. Comparing 2015 to 2014 is perfectly fair, as the drugs sold to or through Philidor were counted in Valeant’s revenue in both years (and as far back as 2013, when it started). When Valeant consolidated Philidor is irrelevant.

Second, if we excluded Philidor’s revenue from same-store sales in 2015, then the stated numbers wouldn’t match. Total US sales in 3Q15 were $1,968.2M, while “same store sales” were $1,315.4M, a difference of $652.8M. The difference should roughly match 3Q sales of products acquired in 2015. To wit: GI and Urology/Oncology, acquired this year from Salix and Dendreon, generated $462.8M and $69.3M in 3Q15, while Isuprel and Nitropress added $50M and $35M, respectively. Those four together total $617.1M. If we are to add Philidor’s $189.5M to this $617.1M, then the reported same store sales figure is overstated. (Even ignoring Isuprel and Nitropress, the difference would be too large.) Point being: Valeant counted Philidor’s numbers in organic growth, and so do we.

(Note that the total U.S. Sales numbers in Table 3 and Table 6 of the 3Q press release don’t match, at $1,968.2M vs. $1,947.8M, respectively, and the difference is more than the footnote to Table 6 explains. We’ve used the figure from Table 3, as it’s the largest such difference and thus would be most contrary to our explanation.)

2) “Philidor didn’t only dispense Valeant products.” Ok, but as you have told us, the difference is about $1M a quarter (p. 8).  We’d be happy to have a detailed breakdown of the price and volume of each drug Philidor dispensed (see #3 below), so please feel free to provide one.

3) “Philidor dispensed more than just branded products.” Sure. Please provide a list of the Valeant products Philidor dispensed, with a count of prescriptions filled and average total prices paid, grouped by drug and by co-pay amount.