Valeant's 'Moneyball' approach to dealmaking

Is Valeant Pharmaceuticals CEO Mike Pearson the Billy Beane of pharma deals?

Beane, general manager of the Oakland A's and subject of Michael Lewis's 2003 book "Moneyball," seeks players that come at a discount because of perceived flaws that may make them less appealing to richer teams. Pearson said he takes a similar approach to drug company acquisitions.

"We've always, from the very beginning, looked for assets we believe have been under-appreciated," Pearson said in a telephone interview after the company announced its 11th deal of the year on Wednesday, of surgery company Synergetics. Put another way, he said, "most of the products, we say internally, have hair on them: i.e., it's not perfect."

Some companies may not want to take on the risk of a product with flaws. Enter Valeant, which scoops up assets at a discount.

"Other companies tend to be a little more conservative and don't want to take on the risk," Pearson said. "We try to identify this partly so we can get it at a good cost to us and where we can manage the downside, but also if they really work, there's huge upside."

Take one of the deals his company did last week: Tuesday, Valeant announced it was purchasing the rights to AstraZeneca's experimental psoriasis drug, brodalumab, for $100 million upfront and up to $345 million in payments tied to regulatory and sales goals. This was a drug dropped earlier this year by Amgen over concerns it may cause suicidal thoughts.

Where Amgen saw risk, Valeant saw opportunity.

"We were encouraged by a huge amount of our current customers in dermatology who knew the product, knew the data, who said this is the most efficacious drug out there in this class," Pearson said.

"It does have side effects; all drugs have side effects," Pearson continued. "We're not suggesting it's going to be a dominant drug in the category, but we do think there is a set of doctors and patients where this will be most appropriate treatment."

That's not an approach many drugmakers would take, said Bernstein analyst Ronny Gal.

"Their view is the pharma guys always want great drugs," Gal said in a telephone interview. "But there's room in the market for second-rate drugs. Not everybody's going to drive a Mercedes; you have to have a few Pintos on the road, too. They're buying the Pintos."

Valeant's acquisition strategy has long been rewarded by investors. The stock has risen 850 percent in the last five years, giving Valeant a market value of $77 billion. Its approach has been described as buy and burn, "buying mature products and cutting all the support under them," Gal said.

"The big bet Pearson brought to the financial market is this concept that you can cut a lot of costs from a drug company and the existing drugs will keep on selling," Gal said. "He made a ton of money that way."

Pearson applied that strategy to Dendreon. The once darling of the biotech industry declared bankruptcy late last year after failing to sell its prostate cancer drug, Provenge, profitably. Valeant bought it in February for $415 million.

"We right-sized the company," Pearson said. "Though it was a small company, it was being run with a big company mindset."

The first step was eliminating the costs associated with Dendreon being publicly traded: It no longer needed a chief financial officer, or heads of IT and investor relations, Pearson said. Then it came to reducing costs associated with manufacturing: eliminating senior management positions and a "big purchasing department, which we didn't need—we could use our own," Pearson said.

Valeant also identified contracts with some suppliers where it determined Dendreon had been overpaying, and found that an automated system for manufacturing was actually more expensive than paying people to do the work.

"They had about a 50 percent gross margin," Pearson said. "Our gross margins are now up into the high 60s, low 70s."

Valeant's stock is up 36 percent since the Dendreon acquisition was approved.

But a more recent deal didn't yield the same encouragement from investors. Last month, Valeant announced it was acquiring privately held Sprout Pharmaceuticals for $1 billion. The company makes the controversial female libido pill, Addyi, just approved by the Food and Drug Administration after two previous rejections. Valeant's stock sank 8 percent.

Pearson noted that the move coincided with the start of market volatility—the declined 3 percent that day. He said the company's biggest investors, including Bill Ackman's hedge fund Pershing Square, ValueAct Capital and T. Rowe Price, "thought the deal was great."

"They thought that the downside was limited and the upside was huge," Pearson said.

But for some hedge fund investors, "which tend not to be as long-term holders," the deal "didn't make as much sense to them," Pearson said. They questioned how much in expenses Valeant could take out of the business, he said.

Gal questioned whether these more recent deals signify a shift in strategy, and noted the stock's reaction to the Sprout acquisition may signal investors aren't on board.

"They're basically looking at business they can buy that could give them sea legs in terms of building branded businesses," Gal said. "There's a big shift going on. This company was an M&A house, and they would not take any drugs that would require building."

Gal attributed the change to two things: the likelihood interest rates will soon rise, making capital more expensive, and that Valeant has become so big that not many assets will make a difference in growing the business.

Valeant hasn't shied from bigger deals, though a recent target was loath to succumb to Valeant's steep cost-cutting strategy: Botox-maker Allergan ultimately was sold to competitor Actavis for $66 billion after a nasty-months long battle with Valeant (Actavis since changed its name to Allergan).

And Pearson said the company's deal strategy hasn't changed so much as the kinds of targets it can look at.

"With the launch of Jublia and Ultra contact lenses, people recognize we're quite capable of launching products," Pearson said, referring to a prescription toenail fungus product and a contact lens brand from Bausch + Lomb, which Valeant bought in 2013. "Whereas a few years ago, we wouldn't have been a natural potential partner, now we are."

Pearson said the company will continue to look at bigger deals. He said he looks at the recent market volatility as an opportunity.

"When volatility comes in, people tend to get more conservative," he said. "If there's downward pressure on price, there's pressure on investors to book some profits for the year."

As for what Valeant will look for, expect more Moneyball-type deals—though Pearson didn't agree with Gal's Ford Pinto analogy, noting the brand's troubled history.

"We're not willing to buy a Pinto, because we all know what happened to Pinto," Pearson said—it was initially recalled over safety issues with its gas tank. "But we're certainly quite comfortable buying a Chevrolet."