Thursday, June 12, 2014

Choose Your Own Adventure: Prince Valeant

The Valeant response PowerPoint deck reads like a choose your own adventure book depending on what slide you start on. They somehow seem to be conveying that they take R&D seriously, but also that you shouldn't take R&D too seriously.

In the same deck that Valeant discusses its core research/innovation strengths, they also inform us that their quality staff is part of R&D and that real innovation comes from outside big pharma. Part of Valeant's argument is that the average economic returns from R&D spending is below the cost of capital for ten select big pharma companies(slide 10). I'm sure it's just coincidence that Valeant's response utterly fails to consider what the return on Allergan's R&D activities were. Myles Udland astutely points out that the $7 billion Allergan spent over the last 11 years has resulted in $50 billion in sales.
Valeant also points out(slide 27) that they have invested in, or partnered over 70% of acquired projects, like that is supposed to smooth out the worry lines in Allergan's frozen brow. Glancing at Valeant's Q's and K's, "investing in projects" for Valeant appears to be the equivalent of Beatrix Kiddo sparing the life of Sophie Fatale.

  1. Valeant wants information
  1. Pharma as an industry, through B&L's deformed body, will witness the extent of Valeant's mercy. 
Valeant appears to be less of a pharma company than it is a Human Resources company in the sense that humans appear to be a resource they are willing to exploit.

After quickly dispatching the Crazy 88 (played by all the companies Valeant has swallowed), I picture Mike Pearson's hulking frame peering into the open trunk of his car containing the barely living carcasses of two of his former prey: Keep your wicked lives John Jacob Bausch & Henry Lomb, just tell Dave Pyott in I'm coming for his arms.

You'll remember that Valeant acquired Bausch & Lomb. You may even remember that B&L was going to go public again last year before they were acquired. According to Bausch & Lomb's S-1 they were spending about $220 million on R&D annually. B&L also proudly touted their R&D effort as being supported by over 850 engineers, scientists and other specialized personnel sprinkled across 25 sites (21 plants) on four continents. They went on to add within the Employee Relations section of their S-1 that they employed 762 full time R&D employees. Before B&L, Valeant acquired 43 different portfolios and kept 17, while partnering off 15.  Just a couple of months before B&L filed their S-1, Valeant's 10-K reported having ~400 employees in R&D with $162 million in in-process R&D write offs. They followed 2012 with an additional $153 million in write-offs in in-process R&D in 2013. Valeant writes off more IPR&D than they spend on R&D while simultaneously cutting R&D staff that was supporting B&L's R&D. I'm sure there's a strategy buried in there.


What really brings it home for me is slide 21 of 's response presentation to  shareholders. Valeant notes that they count quality as part of their 748 member R&D organization staff. Typically when looking at operating expenses, quality falls under COGS. According the Valeant's 10-K: 

Cost of goods sold includes: manufacturing and packaging; the cost of products we purchase from third parties; royalty payments we make to third parties; depreciation of manufacturing facilities and equipment; and lower of cost or market adjustments to inventories. 
Expenses related to research and development programs include: employee compensation costs; overhead and occupancy costs; depreciation of research and development facilities and equipment; clinical trial costs; clinical manufacturing and scale-up costs; and other third-party development costs.
For a company that has ~100 marketed products, this seems like an incredibly small number of R&D staff, especially if they have to support quality efforts as well. In fact when you look at Valeant's R&D expenses proportionally to the number of "R&D" staff they have it is a shockingly anemic $157K/head, which includes compensation, overhead, depreciation, clinical trials etc. Even using their new number of 748 R&D, it's still only $209K/head. It is difficult for me to understand exactly how much money is going to research and really makes me wonder what the *real* R&D staff number is. I also can't help but wonder how they are accounting for their quality assurance costs and what their R&D spend would look like if quality assurance was a component of COGS and not R&D. If quality assurance is a major piece of Valeant's "R&D spending" of 3% of revenues, which is pittance in comparison to the rest of the industry, what would R&D look like without it?

It is not such a subtle point when you consider that R&D isn't just what you probably think. You could spend $100 on a killer beaker and it would count towards R&D. R&D costs aren't just direct research costs though: don't forget that you can tuck license agreements, milestones & upfronts in there too. That is kind of where Valeant's deck really falls apart. They can make the claim that most innovation is obtained outside of big pharma, but when Valeant commits to spending $200 million on R&D activities a year it is also a commitment to do almost zero in-licensing from the very source Valeant claims most innovation comes from. By way of egregious example, Philip Morris, spent $449 million on R&D in 2013 and they pretty much just roll tobacco.

All of this begs the question whether it is really prudent for Allergan shareholders to accept Valeant's offer and forgo the $120 billion in sales over the next ten years attributable to Allergan R&D for the sake of $10-15 billion is R&D cost savings(aka pink slips) and non-existent licensing deals? 

This of course doesn't take into account the hundreds of millions in "one time" write-offs that Valeant would certainly take in connection with the deal, but then again, "one time" write-offs appear to be a quarterly component of Valeant's ongoing business activities, so who am I to judge?

(Side note: unlike Valeant, I didn't see any one time write-offs of R&D assets in Allergan's recent quarterly or annual filings)

Being that Allergan spent $349 million for the first quarter of 2014 (or 21% of total revenues) compared to Valeant's $200 million annual projection, I see how there is an R&D disconnect between the companies.

Monday, June 2, 2014

The Cosmetics of Substance

I'm convinced that Ackman's investment in Allergan is somehow an allegory warning us about cosmetic beauty as an aspirational goal. Should we be aspiring to achieve cosmetic perfection or ground ourselves in substance? As is the case with much of what I say, it always sounds more poetic in my head, although I'm convinced Ackman's Herbalife thesis is the plastic, duck-lipped, attention-loving blonde Hedge Fund equivalent of Heidi Montag.

A landmark opinion written by George H. Wu was filed today in California's Ninth District Court of Appeals and left little room for cosmetics. The substance of the opinion was decidedly bad for BurnLounge and decidedly monumental for Herbalife and other established MLM companies. It was monumental because the Court was very careful to review all relevant case law, as well as Kohm's FTC advisory letter from 2004, and the opinion should establish clear guidelines for MLM companies as well as regulatory agencies assessing the legality of such companies.

In the opinion the Court noted that

  • the rewards BurnLounge paid to Moguls were primarily in return for selling the right to participate in the money-making venture—the Mogul program. The merchandise in the packages was simply incidental.

  • We agree with the district court that BurnLounge was an illegal pyramid scheme in violation of the FTCA because BurnLounge’s focus was recruitment, and because the rewards it paid in the form of cash bonuses were tied to recruitment rather than the sale of merchandise. (I added emphasis)

Interestingly the court also put the kibosh on both the FTC's and BurnLounge's arguments regarding internal consumption. The Court said that:

  • BurnLounge is correct that when participants bought packages in part for internal consumption (to obtain the ability to sell music through BurnPages and to use the package merchandise), the participants were the “ultimate users” of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme. But it is incorrect to conclude that all rewards paid on these sales were related to the sale of products to ultimate users. 
  • Whether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice. See Omnitrition, 79 F.3d at 781. In practice, the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants. (I added emphasis)

In the Court's opinion they also cited the FTC's test for determining whether a MLM is an illegal pyramid
“a pyramid scheme is characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.”
When I read the opinion a couple of very important distinctions came to mind with respect to Herbalife:

  • Purchases bought in part for internal consumption defined "ultimate users" and internal sales did not constitute a pyramid.
  • the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages;

Effectively, purchasing an IBP and signing up as an Herbalife distributor does grant the right to sell a product, however distributors are rewarded for the sale of products to ultimate users, not for recruiting. When an Herbalife distributor sells an IBP to a new distributor member there are ZERO volume points associated with the sale of this fully refundable starter pack. Volume points (which sets up the compensation structure for Herbalife distributors) are based on sales of consumed products, NOT on starter packs. This is an extremely important distinction because BurnLounge moguls were compensated based on the sale of starter packages, whereas Herbalife distributors are paid on the sale of products but not the IBP. When an Herbalife distributor signs up a new member to their downline they are required to sell the IBP to the new member without markup. In addition to earning no volume points a distributor has to sell the IBP at cost. Distributors make no money on the sale of IBP's at all. Furthermore, unlike BurnLounge, there is also no requirement for Herbalife distributors to sell a minimum number of IBP's. In fact many Herbalife distributors will NEVER sell an IBP. You only need look at Herbalife's 10K's and 10Q's to quickly determine that the overwhelming majority of revenues flowing into Herbalife are based on sales of products and not starter packages.

Interestingly the Court also seems to agree with the Vander Nat intent in that internal sales for the purpose of use are full fledged legitimate sales to end users. The Court also noted with respect to BurnLounge,
Rewards for recruiting were “unrelated” to sales to ultimate users because BurnLounge incentivized recruiting participants, not product sales
The short side could have saved themselves a lot of pain and suffering had they simply heeded Northwestern University's Professor of Marketing Anne Coughlan when she astutely outlined in July 2012 why Herbalife is a legitimate MLM.

One has to wonder how an organization like Herbalife that...

  1. pays absolutely nothing for the recruitment of a distributor/member, 
  2. that has robust internal consumption, robust external sales(evidenced by at least 30% of sales are directly drop-shipped to customers that are not distributor/members) and 
  3. that compensates distributors solely on the basis of product sales 
...could ever fulfill the FTC's own guidelines for what constitutes an illegal pyramid scheme?

After today's written opinion, Bill may need more than botox to smooth out those frown lines. If he's not careful, he may subject himself to yet another Loeb colonic, followed by a tummy tuck, liposuction and chemical peel courtesy of Herbalife, Bill Stiritz and Carl Icahn.

So again..."I have to ask how the Shorts sleep at night?"