This spring, Charlie Munger held court at the annual shareholder meeting for the Daily Journal Corporation, a small newspaper company where he serves as chairman of the board. Someone asked him about Valeant, at that time one of the highest-flying stocks in the market. Munger didn’t mince words: “Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.”
Munger was alluding to one of the worst conglomerates ever assembled by Wall Street’s deal-making machine. And “the guy” in this case is McKinsey veteran J. Michael Pearson, who had built Valeant into a $90 billion pharmaceutical conglomerate virtually overnight. Pearson is no scientific wunderkind, nor did Valeant have any breakthrough drug hit the shelves during his tenure. Instead, the company’s rapid success could be chalked up to aggressive dealmaking of the sort we haven’t seen since the late 1990s heyday of Tyco and Dennis Kozlowski.
Over the past few weeks, Valeant (VRX) has been embroiled in the early stages of a scandal that now threatens to level the company and its largest shareholders should it spiral out of control. Short-sellers are alleging that the company has several pharmacies it controls that enable it to subvert prescription rules and “stuff the channel” with sales that never actually materialize. The company held a conference call last week to refute these claims, but the stock continues to crater as every new detail leads to additional questions.
As of this writing, Valeant has lost almost $50 billion in market cap since its stock price peaked this summer. Hedge fund manager and Valeant supporter Bill Ackman is said to be sitting on over $1.5 billion in losses from his firm’s position in the stock.
In a gruesome bit of irony, the Warren Buffett-endorsed Sequoia Fund is one of Valeant’s largest shareholders, with almost 30% of the fund’s assets tied up in the stock. Led by investment advisory firm Ruane, Cunniff & Goldfarb, which was founded by a disciple of Benjamin Graham, the Sequoia Fund issued an explanation to its investors as two of its board directors resigned.
Munger’s Valeant-ITT comparison shouldn’t be taken lightly. Over a period of nine years, Harold Geneen used his company International Telephone & Telegraph Corp to make more than 350 acquisitions in over 80 countries around the world. Sales exploded from $765 million in 1961 to over $17 billion in 1970, before the wheels started to come off. The empire was eventually revealed to be little more than a giant accounting trick that covered up the losses from one acquisition with the paper profits of the next one.
By the early 1970s, the wheels began to come off. Geneen and his monster became implicated in a million-dollar bribery scandal with the Nixon administration and charges that the firm attempted to undermine elections in Chile to further its business interests. You can see just how unflattering Munger’s analogy is when you look at the decades it took to unwind the ITT nightmare once the wheeling and dealing came to an end. The ITT scandal was one of several story lines that kept a lid on stock market enthusiasm and helped contribute to the secular bear market that paralyzed stocks until the early 1980s.
The Valeant saga has yet to fully play out, but investors are right to be skittish. The company cannot conceivably continue on its acquisition spree with its stock price in free-fall; what potential target would accept it as currency? In the meantime, Valeant is now encumbered with over $30 billion in long-term debt, equal to roughly five times the amount of shareholders’ equity.
The other leg to the Valeant story—its ability to continue raising the prices of the drugs it acquires—is also now on shaky ground. Presidential candidates on both sides are vocally expressing their disdain for the practice, and the issue has crossed into the mainstream. In the current politicized environment, it is inconceivable that Valeant and other drug companies will enjoy the same latitude to hike prices as it has over the last four years.
Whether or not investors are directly exposed to the maelstrom surrounding Valeant, we all have something at stake. Should it turn out that the company is guilty of more than just free-wheeling accounting, the impact on all U.S. stocks will be negative. Episodes surrounding the likes of Tyco, Enron, and Worldcom after the turn of the millennium fed into broader distrust of the stock market and helped prolong the bear market that had originally started with the dot-com bust. The same could be said about the many banking and trading scandals that were unearthed after the fall of Lehman.
Valeant’s epic share price decline may not affect your portfolio directly, but a reversal in overall market sentiment absolutely will. Let’s hope Charlie Munger’s assertion about “the guy being worse this time” turns out to be incorrect.
