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Now What? Failed Allergan Deal Strains Valeant

Michael Pearson, chief executive of Valeant, pauses during an interview in April. In January, Pearson articulated a plan to become a Top Five pharmaceutical company by the end of 2016. (Scott Eells/Bloomberg via Getty Images)

Valeant Pharmaceuticals just spent the year in the "make William Ackman even richer" business.

The drug company teamed up with Mr. Ackman, the hedge fund manager, in a hostile bid for Allergan, the maker of Botox. The deal failed, but because Mr. Ackman had invested in Allergan, he made the kind of fortune that in previous eras were reserved for Persian kings.

Put another way, Valeant offered to use money from its lenders and shareholders to transfer their wealth into Mr. Ackman's pocket in order to acquire a company it didn't win. That's not, shall we say, a winning business model for the long term (although Valeant did get a sweetener of 15 percent of Mr. Ackman's profit). So, what is Valeant going to do now? Well, while investors were distracted by the bitterest takeover battle Wall Street has seen in years, a lot happened at the company. A review is in order.

Let's go back to the beginning of the year, when absorbing Allergan was just a molecule of a notion. In January, Valeant's chief executive, J. Michael Pearson, articulated a plan to become a Top Five pharmaceutical company by the end of 2016.

Crunching the numbers, that would mean taking medium-size Valeant, which then had a market capitalization of roughly $40 billion, to $150 billion. That's a lot of drug companies to swallow. When ambition is based on size, other things, like profitability, can fall by the wayside.

"Maybe it was a smart thing, maybe it wasn't, to have that as an objective," Valeant's chief financial officer, Howard B. Schiller, said in a recent interview. "It was really a signal to employees and investors that we are not satisfied, not standing pat."

Interestingly, the public declaration came right when Valeant subtly warned that it wouldn't make analysts' earnings estimates. Back then, Wall Street was expecting the company to earn $8.80 a share this year. The company moved the range down to $8.25 to $8.75 a share.

Because investors generally expected Valeant to exceed its earnings estimates, the company's stock dropped on that earnings forecast, to about $112. Then Mr. Pearson made his ambition public, and the shares took off, rising almost 20 percent. Ah, the magic power of a chief executive's words.

Today, the shares are about $145. Oh, and Wall Street expects Valeant's earnings to sneak in at $8.26 a share.

To be fair, part of that lower earnings power comes because later in the year, Valeant sold a line of aesthetics products, like wrinkle treatment Restylane, to Galderma. The goal was to divest a line that overlapped with Allergan's products. But now that Valeant hasn't come down with its prize, it has neither Allergan's products or the ones Galderma bought. (Maybe that was a good thing, because sales of those products fell off a cliff after they were sold.)

When it lost Allergan, one of the first things Valeant did is what every red-blooded corporation does these days: pledge to buy back its stock. This, of course, is merely financial engineering, meant to soothe the savage hedge fund manager beast. Valeant says it's still going to make acquisitions, though.

When a company that specializes in buying other companies fails to do so, it will buy back stock from investors who have given it money to buy new companies. The merry-go-round spins faster.

It's here that one may recall the famous scene in "Apocalypse Now," when Kurtz, played by Marlon Brando, asks the Martin Sheen character, "Are my methods unsound?"

"I don't see any method at all, sir," he responds.

Mr. Schiller disagrees. "I don't think not getting Allergan is a pivotal point in terms of evolution of the company," he said. "Our strategy hasn't changed and we don't plan on changing it."

His company's stock, thanks to attacks from Allergan, is "grossly undervalued," he said.

But maybe that strategy, of buying companies and unloved products, isn't quite the business model it seems. Does it actually throw off enough cash flow to justify the valuation? The numbers are hard to parse. As one writer on the investor website Seeking Alpha joked, the company reports "VAAP" — Valeant Accepted Accounting Principles.

Because acquiring companies is the key to its business model, it's important to track how those are doing.

Take Bausch & Lomb, which is the biggest acquisition Valeant has made. When it first bought the company, Valeant forecast that it would have $850 million of "synergies," that mysterious corporate phrase that describes cost savings from integrating back-office systems and firing people and the like.

Valeant forecast the costs to achieve those synergies would be 50 percent, or $425 million.

But take a look at what's happened to those costs, as a percentage of the overall synergies. As of its third-quarter financial filings, the company expects $900 million in synergies.

Yet the cost to get those synergies has skyrocketed, to $653 million, including some costs associated with paying off the full stock-option packages of Bausch & Lomb employees. That's 73 percent. (Mr. Schiller argues those are one-time costs for perpetual savings, and is still a better ratio than that of competitors.)

A side note: In Valeant's recent securities filings, a sharp-eyed investor I know (who is betting against the stock) spotted that Valeant had reclassified those payments out of its restructuring costs, making the restructuring costs appear lower. That would appear to paint a different picture than the one Mr. Pearson has sought to depict. On the recent conference call, he said restructuring costs for Bausch & Lomb in the recent quarter came in "less than our guidance."

Mr. Schiller, however, says the company has been clear about the costs and that Mr. Pearson was merely referring to the most recent quarter.

Nonetheless, what the ballooning synergy costs mean is that it's not so simple to keep buying and integrating companies. It's hard to do that efficiently.

The larger point is that investors are in a forgiving mood, for Valeant, for technology companies, for growth, for a well-told story from a chief executive. There are no strategies or financial engineering techniques that they deem worthy of skepticism.

History suggests that state of mind won't last forever.

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