Bill Ackman's favorite company is turning on him

Valeant, Bill Ackman's biggest holding, seems to be straying from his vision of its business model.

On Monday morning, the embattled pharmaceutical company reported a stellar third-quarter earnings beat with revenue up 36% from this time last year.

The stock then proceeded to fall almost 8%.

That added to a sharp fall in the share price that began with government inquiries into the company's pricing and business model last month.

It was that model that Valeant CEO Michael Pearson walked away from on the earnings call following the release.

He said that Valeant will increase its spending on research and development, potentially buy back stock, perhaps spin off one of its entities with a growth model dependent on pricing increases, and attempt to cap price increases at 10% of realized revenue. It will also engage in fewer acquisitions.

He said: "During my 23 years at McKinsey, we found that companies that were successful over long periods of time had one thing in common. They were willing to move in and out of geographic and business areas over time, and they have modified and changed their strategy as the environment changed. We plan to be one of these companies."

Later he told an analyst on the call: "I do think given that environment, the pricing that pharmaceutical companies will take in the future will be more modest, and we built that into our forecast for next year."

The problem with all of that is that these changes don't jive with hedge fund billionaire Ackman's view of the company. He's been Valeant's most ardent supporter.

Valeant is his fund's largest holding and he is the company's third-largest shareholder. When the stock got hammered in September, so did Ackman's hedge fund, Pershing Square.

Sometimes, two friends just drift apart.

Bill Ackman and Pershing Square declined to comment for this story.

The Feds are here

Over the last month, the government has started paying fresh attention to the pharmaceutical industry and how it raises prices. It is concerned that companies are using the cost of R&D as an excuse to exorbitantly raise the prices of drugs.

Of the big pharmaceutical companies, Valeant has been hit the hardest in this controversy in part because it spends so little on R&D compared to its peers: only 3% of revenue. Democrats in the US House of Representatives signed a letter requesting that the company be subpoenaed and its CEO brought to Washington, DC, to testify.

US Sen. Claire McCaskill (D-Missouri) went one better and, in her capacity as head of the Senate Investigations Committee, asked the company to specifically respond to price increases in two of its drugs.

Her office did not receive a response until last week, when Valeant received federal subpoenas from US attorneys in New York and Massachusetts. After that, Valeant sent the senator a letter trying to explain its business model and the reasoning behind the price increases in the drugs McCaskill brought up.

But that wasn't enough for the senator.

"It appears obvious to me that Valeant has been anything but responsive or transparent - it refused to take any action until served with federal subpoenas, and is still refusing to provide answers to many of the questions I've asked," McCaskill said in a release following Valeant's letter. "I look forward to continuing my investigation of drug pricing and plan to further explore Valeant's inadequate response."

Woof.

Uncle?

Given all this drama, it's no surprise that Valeant's conference call was well-attended by analysts across Wall Street. They listened as CEO Michael Pearson announced that the company was going to change its business model to one more palatable to the company's government critics.

It said it would tweak a business model that, until last month, had sent the stock soaring around 115% over the last two years. This is a model Wall Street doesn't necessarily want to change.

Here's what Bill Ackman said he liked about the business model at a Bloomberg conference earlier this month.

"Valeant doesn't pay dividends, so it's no cash leaving the system," Ackman said. "And it's not buying back stock, right. So they generate a lot of cash flow. Where does it go? Well, they spend about 3% of revenues on R&D."

Ackman continued: "They spend money building plants to make pharmaceuticals. They pay their employees. Valeant believes that they are not good at drug development, i.e., or really coming up with new molecules and taking them all the way to the approval process. That's a - has been historically a very low-return business."

That low-return business, though, is what Pearson said Valeant is headed for on Monday's earnings call.

A Catch-22

If Valeant changes its business model, Wall Street will continue to punish the stock. If it doesn't, the federal government will continue to be dissatisfied with the company, and the stock will pay the price for that as well.

What's more, many of the changes Pearson discussed are going to take a load of cold hard cash.

"Now let me shift to some modifications to our strategy," Pearson explained on the call. "First, our Neuro and Other portfolio, which is dependent on price, will represent approximately 10% of our revenues in 2016, and will continue to shrink as a percentage of the company. We have and are seriously considering spinning off or selling this piece of our business.

"Second, due to our increasing success in internal R&D, especially in the areas of dermatology, contact lenses, surgical and OTC products, internal R&D will become more of a focus. Third, if our stock price remains at current levels, share repurchases will be seriously considered."

Pearson didn't have specific numbers for how much the company's R&D would increase, but in third-quarter 2015 it was around $100 million. For 2016, he threw around a quarterly increase to around $300 million to $400 million, but said those projections wouldn't come out until the budget was finalized in January 2016.

That's a lot of balls in the air

Part of the reason Pearson would want to spend cash on stock buybacks is because Valeant can't really use its stock to buy other companies until its price-to-earnings ratio improves. It has to use cash.

But with the cash it has on hand, it can't do deals big enough to make a positive impact on its earnings.

"I don't think there's any acquisition right now that would earn the return of buying back Valeant shares," he said. "So, that will also be part of the consideration."

At the same time, though, Valeant has to think about paying down debt. It has a lot, and it promised to draw down at least $562 million in debt next year.

"I do want to re-emphasize that our commitment to reducing our leverage is first and foremost, so we will make sure we do get under four times. But that still leaves a lot of cash to either do deals or deploy," Pearson said.

The further Valeant's stock price falls, the more cash it will have to deploy to boost its share price, which in turn will put it in a position to make acquisitions again.

What this stock needs now is stability, which is hard with the government on its back. Getting the government off its back, though, means walking back from a business model investors love. That brings volatility, too.

For now, it seems Valeant can do no right.