Wall Street Financial Engineering At Work—–How Valeant Got Vaporized

If you need evidence that Wall Street is a financial time bomb waiting for ignition look no further than the recent meltdown of Valeant Pharmaceuticals (VRX). In round terms, its market cap of $90 billion on August 5th has suddenly become the embodiment of that proverbial sucking sound to the south, having plunged by nearly two-thirds to only $34 billion by Friday’s close.
VRX ChartNo, Valeant was not caught selling poison or torturing cats during the last 90 days. What is was doing for the past six years is aggressively pursuing every one of the financial engineering strategies that are worshipped and rewarded in the Wall Street casino.

Indeed, Valeant’s evolution during that period arose straight out of financial engineering central. That is, it was a creature of Goldman Sachs and the various dealers, underwriters, hedge funds and consulting firms which ply the Bubble Finance trade.

At the end of the day, the latter have turned the C-suites of corporate America into gambling dens by attracting, selecting and rewarding company wrecking speculators and debt-crazed buccaneers to the top corporate jobs.

In this case, the principal agent of destruction was a former M&A focussed McKinsey & Co consultant, Michael Pearson, who became CEO in 2008.

Pearson had apparently spent a career in the Dennis Kozlowski/Tyco school of corporate strategy. That is, advising clients to buy, not build; to slash staff and R&D spending, not invest; to set ridiculously ambitious bigness goals such as taking this tiny Canadian pharma specialist from its $800 million of sales to a goal of $20 billion practically overnight; to finance this 25X expansion with proceeds from Wall Street underwriters, not internally generated cash. He even replicated the Tyco strategy of moving the corporate HQ to Bermuda to slash its tax rate.

Pearson’s confederate in this scorched earth corporate “roll-up” enterprise was Howard Schiller, a 24-year veteran of Goldman Sachs, who became CFO in 2011, and soon completed the conversion of Valeant into a financial engineering machine.

During their tenure, Pearson and Schiller spent about $40 billion on some 150 acquisitions. At the same time, they militantly eschewed investment in drug research and development in an industry who’s very purpose is the development of new drugs and therapies.

Yet the alternative strategy they peddled to the occupants of the hedge fund hotel that became increasingly crowded with VRX punters as its shares soared was downright nonsensical and economically vapid. It could only have thrived during the late stages of a Bubble Finance mania.

In essence, Pearson and Schiller claimed that the rest of the industry was infinitely stupid, and that tens of billions of market cap could be created instantly by the simple expedient of buying companies with seasoned drugs and then jacking up prices, often by orders of magnitude.

In fact, Valeant has acquired a reputation for ferocious price increases. In one year alone the company raised the price of 81 per cent of the drugs in its portfolio, by an average of no less than 66 per cent.

The point here is not to echo the Hillary Chorus in favor of government drug price controls. Quite the contrary. Despite a crony capitalist inspired patent regime and the endless legal obstacles thrown up by the Big Pharma cartel, the drug market is not immune to the laws of economics. Raise the price of drugs radically enough and you will attract competitors into the market with new formulations that circumvent the patent, or generics which will swamp it on expirtation.

Nor does that truth completely exempt even small volume or so-called orphan drugs. In those instances, it takes massive price gains to move the aggregate revenue needle. That is, exactly the kind of egregious increases that stir a political firestorm among users and providers and bring the Hillary brigade to the TV cameras.

Accordingly, Martin Shkreli’s 5000% increase of Daraprim went dark even faster than his Twitter account.

At the same time, they slashed staff and chopped down R&D spending to a comically low 3% of sales compared to the industry standard of 12% to 18%.

Finally, this Wall Street witches brew was stirred together in pro forma financials that assumed these price hikes would be permanent and that these back-of-the-envelope cost savings were immediate. The resulting profit projections, of course, had virtually nothing to do with the company’s actual results, but they did conform to sell-side hockey sticks like a hand-in-glove.

As the New York Times noted in an piece over the weekend:

Looking at Valeant’s real earnings compared with its make-believe ones exposes an enormous gulf. Under generally accepted accounting principles, the company earned $912.2 million in 2014. But Valeant’s preferred calculation showed “cash” earnings of $2.85 billion last year. That gap is far wider than at other pharmaceutical companies presenting adjusted figures.

Needless to say, it did not take long to turn Valeant into a veritable debt-mule. Its debt outstanding rose from $400 million in 2009 to $31 billion at present, and that’s the rub.

To wit, Valeant has been a cash burning machine under its Wall Street driven M&A spree. So it has no possibility of making ends meet under a continuation of the much vaunted strategy crafted by Wall Street wise guys.

Indeed, its demise was a near certainty. On the one hand, it was destined to blow-up if it kept “growing” via debt-fueled M&A. Contrariwise, its peak stock market value at 100X GAAP earnings was destined to implode if it stopped doing deals and triggered a mass exodus from its hedge fund hotel.

Needless to say, these Bubble Finance deformations have resulted from the lunatic cheap money and wealth effects levitation policies of the Fed. Financial repression and QE deeply subsidize corporate borrowing to fund financial engineering deals, reducing the after-tax cost of even sub-investment grade debt low single digit levels.

Likewise, ZIRP is the mother’s milk of Wall Street speculation; it enables hedge funds and other fast money traders to build-up positions in rocket ships like Valeant at virtually no cost through the options and dealer financing markets.

Indeed, as VRX’s market cap grew from $14 billion to $90 billion in just 36 months, it generated a daisy chain of rising “collateral” value that enabled leveraged speculators to chase its stock to an absurd height relative to the company’s GAAP financials.

During the 12 months ending in September, for example, VRX  generated only $2.54 billion of operating cash flow, but spent $14.3 billion of cash on CapEx, M&A deals and other investments.

Nor was that an aberration. During the 27 quarters since the end of 2008, VRX has generated a mere $7 billion in operating cash flow, but has consumed nearly $26 billion of cash on investments and deals.  Stated differently, it was a Wall Street Ponzi pure and simple.

(to be completed)

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