Nobody expected much of a second act from Biovail Corp. after CEO Eugene Melnyk exited the company for good in 2007, leaving a trail of disgruntled shareholders and litigants in his wake. But just look at it now.
The Canadian drug company has a new name—Valeant Pharmaceuticals International Inc.—a soaring stock price and one of the best-paid CEOs in Canada, Michael Pearson. From out of nowhere, Pearson has built Valeant into by far the largest publicly traded Canadian-based drug company, sporting a $20-billion (Canadian) market capitalization. Following a flurry of acquisitions, Valeant is on track to top $4.4 billion in revenue this year (currency in U.S. dollars unless otherwise noted). And Pearson is just getting warmed up: Valeant sales will top $10 billion "in the foreseeable future," he says.
How did Pearson transform one of corporate Canada's favourite punching bags into a high-flying investor darling? Part of the explanation is that he has erased the Biovail of old. But he has replaced it with a deal-driven, pseudo-Canadian company that has become too big to ignore—and created a whole new set of concerns for investors to contend with.
It's enough for a company to have one scandalous entrepreneur in its past; Valeant has two. The company, based in Montreal, is the product of the 2010 merger of Biovail and California-based Valeant. If Canadian investors think there's no topping Melnyk's foibles, they clearly haven't met Milan Panic, the man who founded Valeant's predecessor company.
Panic's story is extraordinary: Having been a teenage Nazi-resister during the Second World War, he defected from Communist-era Yugoslavia to the West in 1955 while travelling as a member of his native country's Olympic cycling team. Five years later, he started a pharmaceutical company in his garage in Orange County with all of $200. The company, ICN, grew, along with Panic's wealth and connections. As his homeland was disintegrating in 1992, Serbian president Slobodan Milosevic invited Panic to become prime minister of Yugoslavia; he accepted. "He is a buccaneer, a two-fisted guy...an American success story," former California governor Jerry Brown, one of several former politicians on ICN's board, said of Panic (pronounced pah-nich) in 1992.
The fine print on Panic's biography is less flattering. Thanks to a falling-out with Milosevic, Panic's political career was over in just six months. And his business legacy is checkered. ICN discovered a new compound, ribavirin, in the 1970s, that to Panic represented the pharmaceutical holy grail—a billion-dollar, blockbuster drug. Panic claimed it would successfully treat a range of serious illnesses, but the U.S. Food and Drug Administration was unconvinced, approving ribavirin in 1985 only to treat a rare respiratory ailment in children. That didn't stop Panic from declaring in 1987 that ribavirin could slow the progression of AIDS, a claim that regulators flatly rejected and that resulted in a $600,000 fine (but no admission of guilt). In 1994, the FDA denied approval to market ribavirin as a stand-alone hepatitis C treatment. ICN didn't pass this news on to shareholders for months—and not until after Panic had sold $1.24 million worth of stock. The company's poor disclosure netted it a $5.6-million fine. The FDA did finally approve ribavirin to treat hepatitis C in 1998, but only in combination with another drug.
ICN had better luck abroad: Several countries, starting with Mexico in 1975, approved ribavirin to treat a range of ailments, from the flu to herpes. That led the company to expand globally, including the purchase of 75% of Yugoslavia's largest drug maker in 1991—a deal that tied a significant part of the company's business to the country just in time for its bloody breakup and the economically damaging sanctions that followed. The subsequent Serbian regime, headed by Panic's enemy Milosevic, in early 1999 forcefully seized control of ICN's assets, prompting a drawn-out but ultimately successful lawsuit by Panic.
There were other distractions, including a 1977 settlement with the U.S. Securities and Exchange Commission over allegedly misleading financial forecasts. Most embarrassing, however, was a spate of sexual harassment suits by former female employees against Panic in the 1990s, including one from a former secretary who bore his illegitimate son. ICN's board painted Panic as an innocent victim of extortion bids and loaned him millions of dollars to settle one of at least four lawsuits. To outsiders, it looked like one more perk from a compliant board—like the luxury pieds-à-terre and corporate jets at the CEO's disposal.
ICN's chronic underperformance persuaded shareholders they should toss Panic out; after several attempts, they finally succeeded in 2002. "Nutty is probably the right word" to describe the Panic era, says Mason Morfit, a Valeant director whose firm, ValueAct Capital, owns 5.5% of Valeant stock. "It was frightening and entertaining at the same time."
(Panic, now in his early 80s, is still in the business, heading a biomedical operation he bought from ICN in 2003; he has a young son with his latest wife, an opera singer nearly 40 years his junior.)
With Panic gone, successor Robert O'Leary dismantled much of the company and renamed it Valeant. It focused on developing neurology drugs and branded generics, a strategy that continued after O'Leary, in ailing health, handed the reins to one of his recruits, Tim Tyson, in January, 2005 (O'Leary died less than two years later).
But in the post-Panic regime, Valeant still lost money for five years straight. When Morfit joined the board in 2007, "it was my first peek under the covers as to how much progress we were making," he says. "It was evident we were not on the right track. In fact, we were going the opposite way."
As Valeant was struggling to redefine itself, Biovail was heading into its own crisis. Entrepreneur Eugene Melnyk had turned the fledgling company into a success by applying its patented time-release technology to create once-daily formulations of popular drugs that previously had to be taken multiple times a day. Biovail's first hit was Tiazac, an angina treatment approved by the FDA in 1995. It helped make Melnyk a jet-setting billionaire, with racehorses and a spread in Barbados.
But Biovail had many detractors who were suspicious of its accounting and financial performance. A litigious Melnyk battled back, but a traffic accident near Chicago in October, 2003, changed everything. Eight people were killed, and one truckload of Wellbutrin XL pills, Biovail's new one-a-day version of an established antidepressant, was damaged. Melnyk and Biovail claimed that $10 million to $20 million worth of pills were involved, affecting quarterly earnings. Shareholders and regulators suspected he was using the tragedy as cover for Biovail's shortcomings. The following year, Biovail admitted that just $5 million worth of pills were lost, plunging the company into years of regulatory investigations and shareholder lawsuits. By the time the smoke had cleared, Melnyk was gone and Biovail was out more than $200 million in legal expenses, settlement costs and penalties, net of insurance.
Melnyk fought back against his former company in two largely unsuccessful proxy battles, then sold most of his stake. Biovail moved on. New CEO Bill Wells slashed the dividend and refashioned Biovail as a conventional pharmaceutical firm, developing drugs to treat disorders of the central nervous system. But it was something else Biovail had that would soon lead to a marriage between the houses of Panic and Melnyk.
In 2002, Panic's successor, Robert O'Leary, put in a call to Robert Ingram, a former CEO of pharmaceutical giant Glaxo Wellcome (now GlaxoSmithKline). O'Leary wanted advice: Who should he hire to be his right-hand man to fix ICN? "I said to him...'You've got a shitty company,'" Ingram recalls. Nevertheless, Ingram recommended a former Glaxo executive, Tim Tyson, who joined ICN in October, 2002.
Before long, Tyson and O'Leary wanted Ingram's help again—as a board member. Ingram was reluctant to join but felt he couldn't let them down. Ingram eventually became chairman of ICN/Valeant.
In 2007, the board felt it was time to call in another outsider to fix Valeant. Ingram again had someone in mind: Mike Pearson, head of the global pharmaceutical practice at consultants McKinsey & Co. He'd hired Pearson for several projects at Glaxo and had been consistently impressed by his insight and his drive to deliver results. Most of all, he appreciated Pearson's "brutal" honesty. "When you're CEO, people want to tell you good news," Ingram says. "Mike would come in and tell me things that other people were reluctant to tell me."
Pearson, a native of London, Ontario, was at the peak of his consulting career. He'd come from a lower-middle-class background—his father was a phone installer—and the family had to make financial sacrifices to send Pearson to prestigious Duke University. Pearson excelled, playing on the hockey team, earning math and engineering degrees and gaining entry into the elite academic Phi Beta Kappa Society. After earning an MBA on full scholarship from the University of Virginia, he joined McKinsey, working his way up the ranks to become a board member and one of its top-paid professionals.
Pearson had never heard of Valeant before Ingram's call, but agreed to a consulting contract in mid-2007. A few weeks later, he delivered his findings. "Your current strategy is not only not working, it doesn't have much of a chance to be successful," he told directors. "And with that," recalls Ingram, "he laid out the strategy we now follow."
Like other smaller pharma companies, Pearson told the board, Valeant was trying to be all things in all regions, stretching itself too thin. It wanted to be like free-spending Big Pharma and develop blockbuster drugs, but had limited resources. Not that the complacent drug giants were great role models: Industry productivity was flatlining as the number of innovative drugs coming to market levelled off. Several blockbuster drugs were approaching the end of their patent protection. Cash-strapped governments were under pressure to curtail rising health-care costs. The industry's best days appeared to be drawing to a close.
Valeant, Pearson said, should focus only on geographical and therapeutic areas that had good long-term growth prospects, and where it wouldn't run into intense competition from Big Pharma. Valeant shouldn't be in Western Europe (low growth) or India or China (too much competition), or any other market where it lacked critical mass, which described the majority of countries where it operated. Despite its past restructuring efforts, Valeant was unwieldy, selling 370 treatments in 2,200 versions via a global supply chain of 85 third-party suppliers.
Pearson saw little potential in Valeant's cardiovascular, infectious disease and gastrointestinal therapies. Instead, he thought the company's medicine cabinet should be full of products like its cache of dermatological treatments. It was a corner of the market where Big Pharma was less prevalent, where there was big demand and no one-size-fits-all solution. Best of all, payers were primarily not governments but motivated consumers and private benefits plans. Valeant would have a brighter future selling acne cream and other drugs that matched its profile than trying to cure cancer.
Pearson's next suggestion was even more daring: Cut research and development spending, the heart of most drug firms, to the bone. "We had a premise that most R&D didn't give good return to shareholders," says Pearson. Instead, the company should favour M&A over R&D, buying established treatments that made enough money to matter, but not enough to attract the interest of Big Pharma or generic drug makers. A drug that sold between $10 million and $200 million a year was ideal, and there were a lot of companies working in that range that Valeant could buy, slashing costs with every purchase. As for those promising drugs it had in development, Pearson said, Valeant should strike partnerships with major drug companies that would take them to market, paying Valeant royalties and fees.
The board liked Pearson's prescription; finding management slow to implement it, the board asked Pearson back for an even bigger assignment: to take a deeper dive into the business. This time he brought a team of McKinseyites, who embedded themselves in the operation around the globe, and recruited board members to take an active role in the extensive review.
The more time they spent with their favourite consultant, the more the directors became convinced he should lead the company. Pearson may not come off as polished as CNBC-friendly CEOs—he can be an awkward speaker—but his strengths were evident to directors. "[His]leadership style wasn't a cult of personality or a force of will—though he's extremely willful—but one where the decision making was going to be based on facts, which was a breath of fresh air," says Morfit. "He felt like a much better fit for what we needed to do." (The company amicably parted ways with Tyson.)
Pearson started as CEO at Valeant in February, 2008, and quickly put his plan into action. He sold far-flung operations and focused on the company's business in North America and a handful of overseas markets; slimmed down its portfolio to focus on dermatology and branded generics; and struck an agreement with GlaxoSmithKline to develop and commercialize Valeant's epilepsy drug, retigabine. The R&D budget dropped 11% to $87 million in 2008, and by another 50% in 2009 (it's now at less than 5% of sales). That fall, Pearson made the first of many acquisitions.
Biovail was in his sights early on. It was about the same size as Valeant (2009 revenues of $820 million to Valeant's $830 million), and had a bloated cost structure and a big R&D budget. But it had something else as well: It wasn't based in the United States.
In fact, merging with a non-American drug company—or more precisely, engineering a reverse takeover whereby Valeant would be folded into the foreign entity but retain Pearson and his plan—"was certainly a key part of the strategy," says Ingram. Freed from the limits of the U.S. taxation regime, a foreign-based Valeant would be able to take advantage of the more flexible and tax-lowering rules in a country like Canada that allowed companies to move their intellectual property and profit centres to low-tax jurisdictions and then repatriate their profits without further taxation. Biovail had practically made an art form out of this practice, using a Barbados-domiciled subsidiary to cut its taxes.
The merger fell apart twice over Biovail's objections to Valeant's terms, but finally came together in June, 2010, with Pearson as CEO and Wells as non-executive chairman. Under a carefully constructed deal, Biovail shareholders got 50.5% of the combined company, while Valeant shareholders got 49.5% and a $16.77-per-share dividend, making the Canadian company the acquirer. But the company took on Valeant's name, indicating which partner really drove the deal. Wells and other Biovail executives were gone less than three months after the merger closed in September, 2010. The company uprooted the headquarters from Mississauga to Montreal (thanks to Quebec government incentives), but the brain trust largely works out of New Jersey offices near Pearson's home.
It's hard to see what else attracted Pearson to Biovail besides its tax structure. Biovail's key products—neurological treatments including Wellbutrin XL—faced generic competition and declining sales. Last June, Pearson told investors and analysts the merger "led to a mix of revenue that we did not particularly like." Even before the merger, "we felt [Biovail] was not making wise investments in research, that its products were not performing nearly as well as people had hoped," Ingram says. As Valeant has continued to bulk up, its overall share of revenues from its less profitable neurological treatments inherited from Biovail has shrivelled—but its overall cash tax rate has collapsed, to less than 5%. "If it wasn't for this tax structure, it's doubtful that Biovail shareholders would have been rescued by Valeant from a future of steadily declining legacy profits," forensic accounting firm Veritas Investment Research said in a note shortly after the deal closed.
Pearson spends the vast majority of his time on the road (he's entitled in some cases to fly his family on the corporate jet). So, on a typical day in November, he's in Denver, telling investors about his latest acquisition, dermatology specialist Medicis Pharmaceutical Corp. Earlier this week, he was in Scottsdale, Arizona, where Medicis is based, putting the finishing touches on the $2.6-billion purchase, but also scoping out another target, one of between 25 and 50 potential deals he's eyeing. Asked how many acquisitions he's done since joining Valeant in 2008, Pearson gruffly replies, "I don't know, 50, 60, 70, somewhere in that range." (The official number is 57.)
Pearson takes pride in getting deals done fast. Due diligence happens "very quickly"—Medicis took just 10 days—and he doesn't use investment bankers (but then again, CFO Howard Schiller formerly ran investment banking at Goldman Sachs). Valeant, Pearson says, pays "low prices" and targets a 20% return on investments. Pearson is against selling stock to finance deals, so he has been tapping eager credit markets instead: Following the Medicis deal, Valeant's debt is a staggering $11 billion—up more than threefold from two years ago, amounting to a highly levered 4.2 times earnings before interest, taxes, depreciation and amortization (EBITDA).
Pearson's strategy means that Valeant is in a state of perpetual change: All that dealmaking is necessarily attended by constant restructuring and shifts in focus. (Online industry bulletin boards are full of anonymous, vitriolic comments about Pearson and the company's ruthless rationalization of sales and research jobs.) After initially zeroing in on dermatology and generics and the North American market, Valeant has since bought into oral care, podiatry and vision treatment, but its offerings also include sports nutrition products, supplements and cosmetics. The company sells treatments for gum disease and athlete's foot, as well as over-the-counter Cold-FX. It has expanded into Southeast Asia and South Africa, and has also continued to sell the rights to commercialize drugs in its pipeline. The Medicis deal brings the focus back to dermatology: Medicis's biggest sellers include acne medicines and wrinkle-reducing injections.
It may be the work of a strategist rather than a maverick entrepreneur, but Valeant is still following the plot line of industry consolidators that grow rapidly on debt—stories that often don't end well. Even Pearson's supporters are a bit unnerved. "We believe in the strategy and believe in Mike and have for a long period of time," says Taymour Tamaddon of T. Rowe Price, one of Valeant's largest shareholders. "It obviously gets harder as you get bigger and that's not lost on anyone."
One knock against acquisition machines is that with so many moving parts, it's difficult to determine their true profitability, as Moody's Investors Service cautioned about Valeant last September. "It's very hard to see the earnings power of the underlying business," says Dimitry Khmelnitsky, an analyst with Veritas. Adds Tamaddon: "It's definitely the hardest company that I follow to model."
To guide investors, Valeant has fashioned three customized measurements: organic growth, adjusted cash flow from operations and cash earnings per share. As with any non-GAAP measure, however, Valeant's metrics are subjective—even problematic, says Khmelnitsky. For example, the company has changed the way it reports organic growth—that is, growth from its existing business rather than acquisitions—three times in the past two years, after investors asked how sales were faring both for products it had been selling for more than a year and its newly acquired products. But Khmelnitsky did his own calculations to determine organic growth. He excluded all acquisitions unless they had been part of the Valeant portfolio for at least a year. The result only tallied to 6% for the fourth quarter of fiscal 2011, not the 10% management reported (and just 4% in the first quarter of 2012, not 11%). "Valeant's organic revenue growth disclosures thus far have been piecemeal, inconsistent and confusing," Khmelnitsky wrote in a research note last July. (He says the company's disclosure has since improved.)
Tamaddon sees things slightly differently: While he wasn't happy with the original organic growth calculations, "to [Pearson's] credit, now we get both definitions, every quarter. Most companies I know of would have told me to go pound sand" rather than broaden disclosure, he says.
The problem with Valeant's adjusted cash flow and earnings numbers, says Khmelnitsky, is that they selectively include items that improve those measures "but don't count items that reduce [them]." For example, the company has counted one-time investment and acquisition gains in its calculations while excluding acquisition-related costs or losses on divestitures. It includes the tax benefits when employees exercise stock options, but excludes related dilution costs and withholding taxes paid. The way Valeant accounts for licensing agreements has had the effect of increasing revenues without recording related costs, Khmelnitsky says. In the first quarter of 2012, the company reported cash earnings per share of $1.14, which was 17 cents ahead of analyst estimates. But when Khmelnitsky adjusted the numbers for one-time foreign exchange and divestiture gains and royalty payments to a foreign company, he came up with cash EPS that was 16 cents below analyst estimates
There are other issues. After stating in a 2011 annual report that results "historically...have not been materially impacted" by seasonality, Pearson told an investor conference last June "we are a seasonal company and if you just take our guidance and divide it by four…it does not reflect what our underlying business works at." In fact, Khmelnistsky notes that Valeant made 60% of its cash earnings in the second half of the year—and that there was a more than 30% drop from the fourth quarter of 2011 to the first quarter of 2012.
There is also confusion about Valeant's dermatology drug Zovirax. Prescription data collected by research firm IMS suggests its sales declined in the third quarter of 2012 on a year-to-year basis; the company reported they increased sharply. Pearson's explanation: The data doesn't cover all channels, such as Walmart. Meanwhile, Bank of America/Merrill Lynch analyst Gregg Gilbert warned in a recent note that Valeant's dermatological organic sales growth resulted from sharp price increases, which "we don't see...as sustainable." In addition, 20% of revenues are from drugs that could face generic rivals within the next decade, Gilbert estimated.
Pearson and his team haven't bristled at the questions but instead have invited an open discussion about their numbers, unlike other companies that have threatened lawsuits in response to Veritas's criticisms. Valeant has even changed some accounting practices to assuage critics. "We know that we're a complicated story," CFO Schiller acknowledged to investors last June.
Pearson says, "We feel very, very comfortable with our accounting. In fact, we're probably more conservative than many other companies." Valeant's disclosures, he says, go well beyond its peers. Investors are free to do their own calculations based on the information the company provides, he says. But that's something even large investors struggle with, and is likely beyond most retail investors.
Even if Pearson can neutralize the accounting debate, however, the question persists—how long can he keep up the acquisitions? "Maybe the most legitimate question of our strategy is, 'How long is the runway? How many opportunities are out there?'" says Ingram. "I can tell you globally there are so many small and mid-sized companies that can benefit from this strategy—as long as you can execute it."
Pearson notes that Valeant revenues are now roughly eight times larger than when he joined the firm five years ago, once one accounts for divestitures. Does he think it can grow by another eight times in the next five years? "We probably won't," he says. "But we're certainly going to try to."
PEARSON'S TAKEOFF: FROM LOW-PROFILE CONSULTANT TO ONE OF CANADA'S BEST-PAID CEOS
Valeant Pharmaceuticals International Inc. chairman and CEO Michael Pearson was one of the most richly rewarded executives of a Canadian-listed company in 2011, earning compensation valued at $36.7 million (all currency in U.S. dollars). He has also accumulated a pile of equity, bringing the value of his stake at the end of January to a stunning $300 million after just five years—not including the additional $200 million worth of unrealized pretax gains from his fully vested stock options.
This doesn't seem to bother shareholders. In fact, one of the company's largest investors designed Pearson's pay plan, and he says it's doing what it's supposed to do: richly rewarding the CEO when shareholders do well—but denying him if they don't.
Pearson is paid $1.75 million in base salary, but it's the long-term incentives that really count. Factoring out dividends related to Valeant's merger with Biovail Corp. in 2010, Pearson earned $23 million in 2011.
Of that, 80% was in the form of stock or option rewards, whereas the median for S&P 500 CEOs is about 50%. That, says Steven Kaplan of the University of Chicago's Booth School of Business, keeps Pearson's interests aligned with those of shareholders. "If the stock goes up, he does well, and if the stock goes down, he does much less well."
The key feature of Pearson's pay package is a grant of 120,000 "performance share units," which turn into common shares when they vest. But they only vest if Pearson delivers a 15% compound annual return over three years. If he doesn't, the PSUs are worthless. If he delivers 30%, he'll get twice the original allotment of PSUs. At 45%, he gets three times, and at 60%, four times. "Everybody told me and him we were crazy to do that, because it's such a high bar in an era when stocks aren't performing," says director Mason Morfit, former chairman of the board's compensation committee, and the main architect of the pay plan. "Most people would prefer to take the risk out of their compensation plan."
Pearson is contractually bound to hold on to the vesting equity until the end of his term as CEO. That is supposed to deter him from making short-term moves to goose the stock: But, of course, it does nothing to protect shareholders if the company's high-risk, debt-fuelled growth strategy hits turbulence.
It's an approach that makes Pearson more like the boss of a firm owned by private equity, not public investors: Private-equity investors like their CEOs to have skin in the game (Pearson bought $5 million worth of Valeant stock when he joined in 2008) and their backs to the wall, working hard to create value and getting rich if they do.
Other boards are "curious and intrigued" by Valeant's approach, says Canadian compensation adviser Georges Soaré. But, he adds, "I haven't seen too many that have an appetite to go down this road."