Five Lessons Big Pharma Should Learn From Valeant’s Collapse

Valeant Pharmaceuticals , long Wall Street’s favorite drug maker, has finally been brought low. On Tuesday a remarkably awkward earnings announcement—epitomized by a $600 million typo in the company’s financial guidance—revealed that sales will be more than $1 billlion lower than expected this year and that the company will fail to file its annual report on time, triggering notices of default from bondholders.

The stock crashed 50% to $34. That’s an 87% decrease since the stock peaked in August. Chief Executive Michael Pearson, the mastermind behind Valeant’s rise, has gone from being a billionaire to being worth $250 million. On Tuesday alone he lost $180 million.

Expect lots more discussion about Valeant’s accounting, which has been as transparent as a game of three-card monte. But there are other issues at stake, too. Valeant represented a strategy of not doing R&D, and of raising prices on existing drugs. Faced with Valeant’s status as the top-performing pharma stock, many drug company CEOs have been pressured by investors to be more like Mike. Now that Valeant stock is a smoldering wreck, what lessons should the rest of the $600 billion pharmaceutical business learn?

Well, there’s the Biblical one: “Pride goeth before a fall.” And then here are five more.

 Lesson 1: Drug companies waste too much money.

This was Pearson’s fundamental insight when he came from a career as a McKinsey consultant to run what was then a struggling generic maker called Biovail. He was right. When Pearson had this insight—about both R&D and marketing—the cost of inventing a new drug was ballooning to at least $2.5 billion, with some companies, like Pfizer PFE +1.83%, Sanofi and AstraZeneca , spending $7 billion in R&D budget for every medicine they got to market. As far as it goes, Pearson proved his point: You can invent drugs on the cheap (Valeant’s toenail fungus drug Jublia cost just $35 million, a third as much as a normal, inexpensive project), buy them from outside, and make the numbers work by firing people and cutting costs.

Lesson 2: Drug companies need to do R&D. They have a higher purpose.

Just because you can’t afford a Mercedes doesn’t mean you should buy a cheap, flimsy Yugo. Jublia may have been inexpensive to develop, but it’s also not a product on which you’d build a company, its $1,000-a-bottle price notwithstanding. Pearson’s insistence on frugality is part of what doomed him. So is his lack of a realization that companies that invent cures and lifesaving treatments matter to the public and lawmakers. Those that make toenail fungus drops don’t.

As I noted last year, Pearson’s strategy shined when drug R&D was at its absolute worst. But in the past few years it has turned around, and in this environment, not putting money into innovation was as much a mistake as pretending you can invent everything yourself. This was the difference between Actavis, now Allergan AGN +1.74%, and Valeant. The company had a Valeant-like strategy of growth by acquisition, but it also focused on spending money to develop drugs. That’s why Actavis was able to buy Allergan when Valeant failed, and it’s why the new company, renamed Allergan, is being bought by Pfizer for $160 billion.

Lesson 3: Big mergers are a sign of desperation. Always.

Valeant’s failure to buy Allergan is the most baffling part of the entire Valeant story. Companies don’t pledge $60 billion to buy rivals unless they are desperate. Pfizer failed to buy AstraZeneca, and it was only a matter of time before it went after Allergan. Merck bought Schering-Plough because both companies were suffering. And on and on, all the way through the graveyard of drug companies lost to time like Squibb, Ciba-Geigy, and Beecham Pharmaceuticals.

Fans of Valeant shares kept insisting that the attempt to buy Allergan was opportunistic, and that Valeant could quit any time it wanted to. But the reality was that Valeant was running out of small targets from which it could wring earnings. That’s how it ended up buying products like Sprout Pharmaceuticals’ marginally effective drug to boost women’s libido. The merger quest should have been a warning sign, but investors kept buying.

Lesson 4: You can always raise the price of a new drug, until you can’t raise the price on any of them.

Valeant succeeded in part based on the crass realization that drug prices are inelastic. If you charge more, most insurers will continue to pay, and patients will still take the drug. This is especially true when you use specialty pharmacies to help patients pay their copayments so they don’t worry about the cost. This was the purpose of Philidor, the sketchy pharmacy with which Valeant severed its relationship. But when the gravy train stops, it stops in total. One thing that has hurt Valeant is that government has made it vow to stop taking huge price increases. That should be a warning to big pharma in general.

Lesson 5: Sorry, if you want to invest in pharma, you need to actually invest in drugs.

Part of the appeal of Valeant and other specialty pharma companies has been the idea that you could avoid having to deal with all the kooky science and 90%+ failure rates of real drug discovery. This sales pitch has always been irresistible to investors. This has happened before. In the early 2000s, investors fell in love with an Irish company called Elan Pharmaceuticals that promised not only a bucket of innovative Alzheimer’s drugs, but a fast-growing business of making new formulations of old pills. But then it turned out that Elan’s stunning earnings came partly from a scheme in which its various subsidiaries took R&D spending off its books while adding profits.

It didn’t work then, and it doesn’t work now. Want the financial benefits of curing disease? You have to take the risk. Maybe the business of inventing medicines is more comprehensible, and safer, than byzantine accounting and pretend parsimony anyway. The rest of the drug industry needed a reminder to tighten its belt. But otherwise, following Valeant meant going in all the wrong directions.

21 – March – 2015