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.


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