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Wall Street Financial Engineering At Work - How Valeant Got Vaporized

Tyler Durden's picture




 

Submitted by David Stockman via Contra Corner blog,

If you need evidence that Wall Street is a financial time bomb waiting for ignition look no further than the recent meltdown of Valeant Pharmaceuticals (VRX). In round terms, its market cap of $90 billion on August 5th has suddenly become the embodiment of that proverbial sucking sound to the south, having plunged by nearly two-thirds to only $34 billion by Friday’s close.

VRX Chart

 

No, Valeant was not caught selling poison or torturing cats during the last 90 days. What is was doing for the past six years is aggressively pursuing every one of the financial engineering strategies that are worshipped and rewarded in the Wall Street casino.

Indeed, Valeant’s evolution during that period arose straight out of financial engineering central. That is, it was a creature of Goldman Sachs and the various dealers, underwriters, hedge funds and consulting firms which ply the Bubble Finance trade.

At the end of the day, the latter have turned the C-suites of corporate America into gambling dens by attracting, selecting and rewarding company wrecking speculators and debt-crazed buccaneers to the top corporate jobs.

In this case, the principal agent of destruction was a former M&A focussed McKinsey & Co consultant, Michael Pearson, who became CEO in 2008.

Pearson had apparently spent a career in the Dennis Kozlowski/Tyco school of corporate strategy. That is, advising clients to buy, not build; to slash staff and R&D spending, not invest; to set ridiculously ambitious “bigness” goals such as taking this tiny Canadian pharma specialist from its $800 million of sales to a goal of $20 billion practically overnight; to finance this 25X expansion with proceeds from Wall Street underwriters, not internally generated cash. He even replicated the Tyco strategy of moving the corporate HQ to Bermuda to slash its tax rate.

Pearson’s confederate in this scorched earth corporate “roll-up” enterprise was Howard Schiller, a 24-year veteran of Goldman Sachs, who became CFO in 2011, and soon completed the conversion of Valeant into a financial engineering machine.

During their tenure, Pearson and Schiller spent about $40 billion on some 150 acquisitions. And exactly what common expertise and value added leverage did these far flung acquisitions in contact lenses, ophthalmological therapies, dermatology, cosmeceuticals, anti-aging creams, Botox equivalents, acne fighters and much more bring to the table?

Well, what they brought was an opportunity to slash thousands of jobs, eliminate R&D, fund massive amounts of goodwill and intangible assets with cheap debt and, most especially, to fill Valeant’s purchase accounting cooking jars with fulsome amounts of reserves that can henceforth be used to cause inconvenient integration costs to disappear, as needed.

Indeed, Valeant not only failed to acquire any significant pharmacuetical synergies, but actually went in the opposite direction. That is, it has militantly eschewed investment in drug research and development in an industry who’s very purpose is the development of new drugs and therapies.

Yet the alternative strategy they peddled to the occupants of the hedge fund hotel that became increasingly crowded with VRX punters as its shares soared skyward was downright nonsensical and economically vapid. It could only have thrived during the late stages of a Bubble Finance mania.

In essence, Pearson and Schiller claimed that the rest of the industry was infinitely stupid, and that tens of billions of market cap could be created instantly by the simple expedient of buying companies with seasoned drugs and then jacking up prices, often by orders of magnitude.

In fact, Valeant has acquired a reputation for ferociously raising prices. In one year alone the company jacked-up the price of 81% of the drugs in its portfolio by an average of 66%.

The point here is not to echo the Hillary Chorus in favor of government drug price controls. Quite the contrary. Despite a crony capitalist inspired patent regime and the endless legal obstacles thrown up by the Big Pharma cartel, the drug market is not immune to the laws of economics.

Raise the price of drugs radically enough and you will attract competitors into the market with new formulations that circumvent the patent; or get greedy enough and generics will swamp you on the patent’s expiration.

Nor does that truth completely exempt even small volume or so-called orphan drugs. In those instances, it takes massive price gains to move the aggregate revenue needle. That is, exactly the kind of egregious increases that stir a political firestorm among users and providers and bring the Hillary brigade charging toward the TV cameras.

Accordingly, Martin Shkreli’s 5000% increase in the price of Daraprim went dark even faster than his company Twitter account.

Stated differently, what seasoned industry executives know that may have escaped the attention of 32-year Wall Street hot shots like Shkreli, or the spreadsheet jockeys who congregate in the hedge fund hotels, is that massive, wanton, overnight price escalation is not a business strategy that builds sustainable value and reinforces brand equity; it’s a scalping tactic that works in the casino, but not the real world.

At the same time, Pearson and Schiller slashed staff and chopped down R&D spending to a comically low 3% of sales. That compares to an industry norm of 12% to 18%.

Finally, this Wall Street witches brew was stirred together in pro forma financials that assumed these predatory price hikes would be permanent and that these back-of-the-envelope cost savings would be immediately realized in full.

The resulting profit projections, of course, had virtually nothing to do with the company’s actual results, but they did conform to sell-side hockey sticks like a hand-in-glove.

As the New York Times noted in an piece over the weekend:

Looking at Valeant’s real earnings compared with its make-believe ones exposes an enormous gulf. Under generally accepted accounting principles, the company earned $912.2 million in 2014. But Valeant’s preferred calculation showed “cash” earnings of $2.85 billion last year. That gap is far wider than at other pharmaceutical companies presenting adjusted figures.

Needless to say, it did not take long to turn Valeant into a veritable debt-mule. Its debt outstanding rose from $400 million in 2009 to $31 billion at present, and that’s the rub.

To wit, Valeant has been a veritable cash burning machine during its Wall Street driven M&A spree. So it has no possibility of making ends meet under a continuation of the maniacal M&A campaign crafted by the Wall Street wise guys.

Indeed, its demise is a near certainty. On the one hand, it was destined to blow-up if it kept “growing” via debt-fueled M&A. Contrariwise, its peak stock market value at 100X GAAP earnings was destined to implode if it stopped doing deals and triggered a mass exodus by the punters who inhabited VRX’s hedge fund hotel.

It goes without saying, of course, that these Bubble Finance deformations have resulted from the lunatic cheap money and wealth effects levitation policies of the Fed. Financial repression and QE deeply subsidize corporate borrowing to fund financial engineering deals, thereby reducing the after-tax cost of even sub-investment grade debt to low single digit levels.

Likewise, ZIRP is the mother’s milk of Wall Street speculation. It enables hedge funds and other fast money traders to build-up positions in rocket ships like Valeant at virtually no cost through the options and dealer financing markets.

Indeed, as VRX’s market cap grew from $14 billion to $90 billion in just 36 months, it generated a daisy chain of rising “collateral” value that enabled leveraged speculators to chase its stock to an ever more absurd height relative to the company’s GAAP financials.

During the 12 months ending in September, for example, VRX  generated only $2.54 billion of operating cash flow, but spent $14.3 billion of cash on CapEx, M&A deals and other investments.

Nor was that an aberration. During the 27 quarters since the end of 2008, VRX has generated a mere $7 billion in operating cash flow, but has consumed nearly $26 billion of cash on investments and deals. Stated differently, it was a Wall Street Ponzi pure and simple.

Likewise, during that 27 quarter period, which roughly tracks Pearson’s tenure, the company has posted rapidly rising sales—-with the top line growing from $757 million in 2008 to $10 billion in its most recent LTM report.

But it has been an absolutely profitless prosperity—–not unlike the typical financial engineering driven roll-up. Thus, over this 27 quarter period as a whole, sales totaled just under $30 billion, but its cumulative net income amounted to a miniscule $130 million.

That’s right. Over the last seven years, Valeant’s GAAP profits have amounted to just 0.4% of sales. 

So why did Valeant’s market cap soar from $1.2 billion, when Pearson arrived in 2008, to the recent peak of $90 billion during a period when the company has generated hardly a dime of profits?

It was just another case of Wall Street financial engineering and speculative hype at work. The entire story has been based on pro forma, ex-items forward looking Wall Street hockey sticks, and not the least those published by Goldman Sachs.

Yet there is no mystery as to why these financial engineering scams happen over and again in financial markets which have been corrupted and disabled by the Fed and other central banks.

Namely, because the deal fees from financial engineering are so lucrative; and because the checks and balance of a healthy free market in finance——such as short-sellers, heavy hedging expense and meaningful carry costs for debt financed speculations—–have been destroyed by the central banks.

Thus, a few years ago Valeant’s predecessor company was a backwater player on the Toronto stock exchange, but in the last three years it has become the fifth largest payer of investment banker fees on Wall Street.

In fact, thanks to its rapid acquisition-driven and debt-financed expansion Valeant’s investment banking fees have totaled $500 million since 2012. This means that only General Electric Co, Allergan Plc., AT&T Inc. and Dell Inc have paid more, according to data from Freeman and Co.

Needless to say, financial engineering scams like Tyco and Valeant would never happen in an honest free market. Short sellers would shut them down long before they reach egregious levels of over-valuation; and the cost of honest downside market insurance (i.e. S&P 500 puts) and market driven carry cost would dramatically reduce the profitability of speculation and the amount of punters and capital in the casino.

In today’s broken markets and corrupt regime of central bank driven crony capitalism, however, bubbles inflate in individual securities, as well as in broad sectors (e.g. biotech, social media and junk bonds) and the market as a whole, until they reach egregious, self-correcting extremes. Then they violently implode, creating immense waves of collateral damage in the process.

Recall that Tyco’s market cap dropped from $125 billion to $25 billion during just the final six months before Kozlowski was finally forced out in June 2002. Likewise, during the last 90 days nearly $250 billion has evaporated from the 150 companies in the NADAQ biotech index.

Viewed in the larger context, therefore, Valeant’s $55 billion implosion in recent weeks is just a preliminary tremor. On a worldwide basis, the mother of all financial bubbles is just beginning to fracture.

Accordingly, in the US alone there is probably another $15 trillion of bottled air waiting to be released. Perhaps then the American people will learn that Yellen & Co have actually been in the un-wealth effects business for way too long.

 

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Mon, 11/02/2015 - 17:37 | 6741081 Bob-Ross-Yo
Bob-Ross-Yo's picture

AIG next in line

Mon, 11/02/2015 - 17:43 | 6741097 NoDebt
NoDebt's picture

I should be embarassed but I still like reading Stockman's stuff, even though I rarely learn anything I didn't know before (other than a new vocabulary word or two).

Maybe it's all the easy-to-digest, bite-sized 2 sentence paragraphs he uses.  Go on, look at it.  See what I mean?  Betcha never noticed that before, but he does it a lot.

 

Mon, 11/02/2015 - 17:48 | 6741131 Rainman
Rainman's picture

Sarbanes-Oxley was a hoax ... they're all in on it.

 

Tue, 11/03/2015 - 04:05 | 6743078 explosivo
explosivo's picture

It was just another regulation designed to drive the small enterprise competition from taking away any loot from the corporatocracy. 

Tue, 11/03/2015 - 11:43 | 6743951 TheABaum
TheABaum's picture

Regulation as a barrier to entry. 

Tue, 11/03/2015 - 11:41 | 6743943 TheABaum
TheABaum's picture

Sox IS Accounting fraud. The sole requirement for the majority of the board of the PCAOB is that they are unqualified. 

Mon, 11/02/2015 - 18:00 | 6741184 Government need...
Government needs you to pay taxes's picture

This company is like an inveterate gambler who has recently acquired a meth addiction but thinks his new prostitution gig will enable him to save enough to retire in 10 years so he can then focus on rehab.

Mon, 11/02/2015 - 18:04 | 6741204 TheABaum
TheABaum's picture

Imagine if you shorted it at the peak...

Mon, 11/02/2015 - 18:33 | 6741339 Cosmicserpent
Cosmicserpent's picture

NO, imagine shorting it now, as it goes to Enron and Tyco levels. I mean fuck imagining it. Just fucking short it now.

Mon, 11/02/2015 - 18:53 | 6741474 stant
stant's picture

I think it's time to buy Lee Mon Bros, and some crack

Mon, 11/02/2015 - 18:54 | 6741480 SMC
SMC's picture

"...in the US alone there is probably another $15 trillion of bottled air waiting to be released."

A very optimistic estimate.

Mon, 11/02/2015 - 19:55 | 6741785 malek
malek's picture

Meltdown?
Wake me when it's a wipeout.

Mon, 11/02/2015 - 20:03 | 6741818 khakuda
khakuda's picture

The damage the Fed has done to the economy over the past 20 years is mind boggling. Even more mind boggling is that only about one half of 1% of the population at most understands what's going on.

Tue, 11/03/2015 - 00:27 | 6742844 herkomilchen
herkomilchen's picture

It's a fantastic scam because the scammers have systematically deployed propaganda brainwashing all their victims into not perceiving it as a scam, but instead perceiving it as beneficial so they cheer it being done to them.   Absolutely brilliant.

Mon, 11/02/2015 - 20:10 | 6741857 acetinker
acetinker's picture

My idea won't be too popular 'round here I s'pose,  but the right thing to do might just be to outlaw the casino.

What if those more 'successful' among us were limited to investing in neighbors, friends and family, instead of the fkn thieves on wall street?

Would that be a bad thing?  I, obviously don't think so.

Mon, 11/02/2015 - 21:05 | 6742071 Colonel Walter ...
Colonel Walter E Kurtz's picture

Maybe not outlaw, but how about maybe taxing the casino income more and the actual labor income less. That would be the first step into getting some balance back into the equation. (Why again does Warren Buffet' secretary pay more in taxes than the Oracle himself?)

I personally would prefer just simplifying the whole tax system, but that is not going to happen until everything completely resets so the in the meantime adjusting the tax rates is a possibility.

 

Mon, 11/02/2015 - 21:29 | 6742160 acetinker
acetinker's picture

Well, Col. Kurtz, I'm all with ya' on simple.  There should be no tax on labor- ever.  That's just slavery, pretending not to be.

If, and it's a big if, gov't. is justified in levying taxes at all, they would be based on consumption.

You buy a 12-pack?  A maximum tax (about 3%) goes to gov't.

You buy a yacht?  A maximum tax (about 3%) goes to gov't.

I know that gov't can't survive on such a paltry sum- and I say oh well!

Tue, 11/03/2015 - 00:24 | 6742831 herkomilchen
herkomilchen's picture

Wrong solution.  Just remove all regulation whatsoever, step back, and let free market forces take over.

No barriers to entry and unlimited freedom to innovate -> ferocious competition amoung  countless new entrants vying for customer dollars -> exchange behaviors that maximize sales on a sustainable basis-> pristine behavior and reputation building delivering what traders most covet and will pay for: transparency, honesty, trust, efficiency.

Any exchanges caught behaving badly would stay in business as long as a restaurant caught serving tainted food.  Markets would return to trading on value and value alone because that's all traders want to trade on.  The basis of competition would switch from legally granted position of privilege to quality of information about the health of traded companies as measured by actual revenues and profits.

Your idea to limit yourself to trading only with friends and family is as smart and cost effective as requiring people who want steak raise their own cows.  Specialization of labor and centralization of markets offers efficiency improvements and value creation opportunities at massive scale.  They are what elevated humanity's productivity up out of the subsistence level of peasants growing their own food, making their own clothes, trading with friends and family only.  Outlawing efficiency is, well really dumb, and does not come close to addressing the reason why we now have casinos instead of markets.

Tue, 11/03/2015 - 18:41 | 6746179 RMolineaux
RMolineaux's picture

Herk  -  If you remove all regulation, who would catch and punish the "restaurant serving tainted food?"  I was not aware that traders are all so virtuous that they are only interested in true values.  What about the short-sellers, inside information dealers and high frequency artists.

Mon, 11/02/2015 - 21:20 | 6742123 RMolineaux
RMolineaux's picture

I would like Stockman to explain to me how short-selling contributes to a healthy, balanced stock market and prevents valuations from reaching astronomic levels.  In fact, short-selling is a price manipulation scheme in which artificial volatility is introduced for the benefit of speculators and at the cost of long term investors.  Nothing more, nothing less.  The short-sellers goal is to borrow stock that would not otherwise be for sale, sell it to drive down the price, and then buy it back at that lower price and pocket the difference.  By buying back the stock, the speculator helps to restore the price to the level it was at before the operation began.  This manipulation is most easily done by insiders or those who have quick access to the market, and to the detriment of outsiders without quick access.    

Tue, 11/03/2015 - 00:25 | 6742842 damicol
damicol's picture

You could not be more wrong.

Short sellers are the only thing that can keep a market in balance.

Wall Street has no interest in seeing price falls, investors are nt interested in buying declining stocks, in fact everything is done to ensure upward momentum because it is in every parasite involved to scalp fees from that scenario.

When the short seller is effectively excluded who can base his judgement on what he believes the fundamentals are by making it costless for the sharks on Wall Street to manipulate stocks higher by complex financial engineering, precisely like Valeant, then the bubbles grow unchallenged.

That is effectively fraud, and the short sellers are those who see through it and drive the stock to its real valuations.

I never ever go long, in fact I only ever short stock and never ever look for stock that anyone tells me will reach the stars or even be a good buy.

Why would I buy a stock that already being flogged to death and every idiot wanting a piece and bidding it higher.

I look at those stocks where that has already happened and the muppets are fully invested. GAAP earnings, motives, risks, averages of PE over the long term is all that matters to me and when anything gets too far out of line it means its is either a scam in the making, or a bubble and the dumb money is all over it.

Time to sell, and sell short and levered in the case of crap like Valeant.

I have no obligation to st4op shorting to let stock rip when I see it as overvalued garbage, than a long has an obligation to stop buying because it drives sock to absurd levels thus creating dangers o  a stock I might wan to own but is now overpriced.

I build short positions like others build a portfolio, watching for chances, a new high for  unicorn, even taking a profit on corrections but ready to short again if the price goes back up again, because a unicorn is a unicorn is a unicorn.

And unicorns do not exist in the real world.

 

If a market is not based on its fundamental valuations and that valuation is determined up or down by the quality and ability of its management, then that stock can never be trusted as true store of wealth.

Right now this market is a short sellers dream, as virtually every stock holding up NASDAQ and S&P and DOW is a fraud as far as real fundamental valuations are concerned.

Unicorns by the hundreds, fad socks, media and IT stocks that never earn a penny, cash burners, every one of them in aggregate are a scam screaming to be shorted.

Because if the are not shorted and shorted often and forcefully when they deserve it they only cause bigger losses down the line.

No one ever shorts great well managed companies run with an eagle eye on costs and the bottom line and a management that looks long tern, is cautious, keeps debt low and prospects high by judicious capex and investments.

If you want to know what to put in your portfolio, then look no further than those companies where shorts are so low as be almost invisible.

But on the other hand, as shorts have been crushed by the Fed, watch them come roaring back if the Fed so much as farts in the opposite direction its going.

Wall St wants to make its profits flogging me unicorns, I want to make profits flogging  Wall St crap short.

 

 

 

 

 

Tue, 11/03/2015 - 08:20 | 6743253 Calculus99
Calculus99's picture

Nice post Dam, thanks for taking the time to write it. I leant a lot. Interesting strategy you've got.

Tue, 11/03/2015 - 10:52 | 6743718 morongobill
morongobill's picture

Really clear strategy and the reason for it. Your piece here should be featured at the top of Zerohedge. Excellent take on things. Wish I could upvote it a hundred times!

Sun, 11/08/2015 - 16:32 | 6762836 RMolineaux
RMolineaux's picture

Your comment is the standard PR used by the short-selling community to try to put a positive face on their gambling activities.  Tell me - is there anything incorrect or improper in my description of the mechanics of short selling as laid out in my above comment ?   If so, please advise me so you can complete my "education."

Mon, 11/02/2015 - 23:28 | 6742688 chisler
chisler's picture

If you keep paying more money for the same thing and that item does not: produce a better profit, increase in size or pack more punch, what can you say when you get squashed. That is the greed market.

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