Bill Ackman's plan to fix Valeant is doomed

Valeant Pharmaceuticals is frozen.

Until the company replaces the two years worth of earnings numbers that it scrapped due to admitted accounting issues on Monday, its value could be considered a matter of conjecture.

This has led many analysts on Wall Street to throw up their hands in exasperation, to scrap their financial models and place a hold on their price targets. They will wait for the company - now with its once-celebrated CEO Michael Pearson on the way out - to produce fresh numbers until they can decide if the company is worth buying again.

But they shouldn't. What we already know for sure is that Valeant will never be what it once was - a money printing juggernaut that tirelessly bought up other drug companies, hiked up the prices of their products, and grew, and grew, and grew.

It's not just that the company has said it won't be that anymore. It can't because that old model is toxic even to Valeant's potential business partners, takeover targets, and customers. As Piper Jaffray's David Amsellem wrote Monday: "this is not a company that has friends in the broader pharmaceuticals space."

The question now is, can it even come close?

No.

Valeant, working as a normal drug company that spends money on research and development and does not price gouge or use debt-filled takeovers to grow, simply doesn't work.

And because of this, the only plan to turn things around - an asset sale proposed by Valeant's de facto leader Bill Ackman - is likely to fail as well.

Thomson Reuters

J. Michael Pearson, Chairman of the board and Chief Executive Officer of Valeant Pharmaceuticals International Inc., speaks during their annual general meeting in Laval, Quebec

The model is dead, long live the model

Valeant's old model is no more for two reasons - price and distribution. On the price front, regulators and government officials will no longer tolerate the price gouging that Valeant once engaged in. Politicians from Hillary Clinton to Sen. Clare McCaskill have vowed to go after the company for the practice.

On the distribution front, Valeant lost a major avenue when it was forced to shut down its mail order pharmacy, Philidor. Philidor was a call center dedicated to pushing almost exclusively Valeant products as aggressively as possible.

Investigators are now trying to determine whether or not its practices with insurers were illegal.

Valeant has pledged to stop relying on exorbitant price hikes. Instead, the company said it would make up the difference with volume.

"We've always had strong growth and volume growth, but the skeptics have said that it's all price," CEO Pearson said on CNBC while announcing a deal with its new partner Walgreens in December. "This will turn it all into volume."

But it took no time for flaws on that model to appear: Mizuho analysts wondered how much product Valeant was going to give away for free, and, unlike with Philidor, the drugs are being sold on consignment.

Also, Walgreens has its own reputation to consider and being a pusher for Valeant's $1000-per bottle toenail fungus treatment doesn't seem like it belongs at the "corner of happy and healthy."

But lets use our imaginations

Let's be generous, though, lets say that Valeant is capable of pushing out a great volume of drugs without the help of its Philidor call centers in Pennsylvania and Arizona. In other words, that it can survive pricing and distributing drugs like a normal drug company.

According to Bloomberg analyst Elizabeth Krutoholow, that still will not do. Without price hikes (some of which were around 500%) Valeant would lose 10% of its revenue.

Krutoholow figured that out by taking 17 of Valeant's top drugs (which account for almost 40% of sales) and calculating their revenue without the hikes.

She also calculated that its operating margin without price increases would be 7% instead of 24%.

Put this together with an increase in R&D spending to 13%, instead of the industry-low 3%, and Valeant would be losing money. A lot of money.

"If Valeant was operating more like a traditional specialty pharma company, it could have had a trailing 12-month (4Q15) loss of $2.44 rather than an adjusted EPS of $1.53. Ebit could have dropped to $606 million from $2.5 billion," Krutoholow wrote. "Valeant could have had an adjusted net loss of $842 million instead of net income of $527 million. As the company focuses on paying down debt and can no longer use price increases, earnings may see a similar effect in future quarters." [emphasis ours]

That isn't even to mention that there are serious problems ahead for two of Valeant's big drugs - Xifaxan and Jublia. Xifaxan faces competition from a generic set to come online soon. Jublia, which was a big Philidor drug, has seen its usefulness come into question. CVS Pharmacy will force patients to try a cheaper treatment before purchasing the $1,000 toe fungus drug.

What about Bill?

Krutoholow's model looks pretty grim, but hold the phone. Despite the fact that Valeant is sitting on over $30 billion in debt and, according to its agreement with creditors, can only sell 4% of its assets, Pershing Square's Bill Ackman - who has a 9% stake in the company - has a plan.

Here's what he told Valeant employees at a town hall on Monday night according Bloomberg:

Valeant has said publicly it would look at selling some non-core assets, but won't sell core businesses. What Ackman suggested was potentially selling a minority portion - perhaps between 10 and 20 percent - of Bausch & Lomb in an initial public offering, and using the cash to help pay down Valeant's debt. If that option was pursued, Valeant would retain control of Bausch & Lomb and hold onto the remainder of the company.

According to Ackman's own calculations last November, Bausch & Lomb is a healthy consumer eye care business that makes up 21% of Valeant sales. Valeant paid $8.9 million for the company back in 2013.

If Ackman spins off part of Bausch & Lomb (B&L), the question then becomes, is that a business worth buying? A stock worth buying?

It's hard to tell if we don't know Valeant's actual earnings for the last two years.

However, we do know that when Valeant and Ackman were in the middle of a very hostile takeover of Allergan Pharmaceuticals, one of the arguments Allergan used to fend off Valeant was that price hikes were masking what was really going on at B&L, and it wasn't good.

Going forward, Allergan's estimates saw B&L sales declining. If that's the case, that's not the most attractive public company, to say the least.

And without knowing what you're actually left with in terms of sales, you're taking a big punt on the future value of B&L or any asset that falls into Ackman's breakup plan.

Now you may be saying to yourself - how can we trust these numbers? Allergan was trying to avoid getting bought.

To that we say two things:

1. Allergan clearly dodged a bullet
2. Valeant is the one that's admitted to accounting irregularities and price gouging. It has also said that its revenue will decline significantly in 2016 compared to prior guidance.

Meanwhile Wall Street analysts wait for the next batch of numbers in order to try to piece together a picture they never really understood to begin with.

Well, actually some aren't waiting.

Here's Piper Jaffray's Amsellem again [emphasis ours]:

Putting the default risk aside, we still do not believe that there are any simple or nearer-term fixes purely from a business perspective in the context of tattered customer relationships, a clear leadership vacuum and very real question marks surrounding employee retention (pharmaceutical products, even higher-quality ones, do not simply manage themselves).

We do not believe VRX shares are investable.

Valeant has yet to respond to a request for comment on this story.