Canada's Valeant Pharmaceuticals (NYSE:BHC) is a good example of what can be done when a company chooses to go its own way and zig while others zag. In an industry that had becoming increasingly skittish about mergers and acquisitions as a growth driver, Valeant has done about 60 deals in the last six years. In an industry that is increasingly spinning off divisions and focusing on "core operations, Valeant management is willing to go wherever opportunity takes them – prescription drugs, devices, OTC, and branded generics.
The potential merits of Valeant's approach certainly have not gone unnoticed, as the shares have nearly doubled over the past year. Valeant's uncommonly aggressive use of leverage does add some risk to the story, but the company has used its balance sheet to build very sizable franchises in dermatology, eye care, and aesthetics, and the opportunity to launch a "merger of equals" and leverage better operating and tax efficiency could propel the shares further.
Eye care – A crown jewel in need of a new setting
The 2013 deal for Bausch & Lomb was the company's largest deal to date (nearly $9 billion) and a relatively risky one. There are precious few real franchises in eye care (Johnson & Johnson (NYSE:JNJ), Novartis (NYSE:NVS), Cooper, Abbott, Allergan (UNKNOWN:AGN.DL), and Santen), but Bauch & Lomb's prior owners hadn't really done a great job of maintaining the business. Underinvestment in new product development had led to the company sliding back in contact lenses, drugs, and devices, and compromised the company's growth potential.
Now Valeant is working to bring a sleeping giant back to its feet. Johnson & Johnson and Novartis likely have about two-thirds of the market for contact lenses (with Bausch & Lomb fourth at about 10% share), but the new Ultra line should help the company regain some lost ground. Likewise in the drug space, where the company has lacked a presence in glaucoma (which represents about one-third of the market for ophthalmology drugs) but where latanoprostene bunod could change things if the Phase III read-out later this year is positive.
As time goes on, I think Valeant's broad approach will serve it well in this market. Johnson & Johnson is strong in contact lens, but has no real presence in drugs or devices, while Abbott is only involved in devices and Allergan is only involved in drug development. While Santen does compete in both drugs and devices, it is really only strong in Japan, leaving Novartis and Valeant as the only comprehensive global eye care franchises.
Dermatology and aesthetics more than a pretty face
Valeant will likely generate more than one-third of its revenue in 2014 from its dermatology and aesthetics businesses, and these are potential fortresses in the making. Insurance companies have gotten better about covering dermatological treatments (it used to be much more of a self-pay market), but it's not an area where most Big Pharma companies concentrate much effort or attention.
Novartis and GlaxoSmithKline are really the only sizable publicly traded pharmaceuticals with a strong dermatology presence and many others treat it as more of a side business, lumping it in with their primary care sales efforts.
This gives Valeant a lot of opportunities to grow. First, the company has a large dedicated sales force, meaning that its reps can spend considerably more time with dermatologists and really market their products. Second, it makes Valeant a strong potential partner – a biotech working on dermatology drugs knows that this is one of the strongest sales forces in the business and one of the best chances of maximizing value. It also gives Valeant strong operating leverage – the company can buy other dermatology businesses/products, even at a higher multiple, and strip out a large percentage of the operating costs and simply leverage those products through its existing operations.
Another large deal may be coming
Valeant has not been shy about doing deals, nor telegraphing its intention that it would like to do another Bausch & Lomb-sized deal in 2014, or even a potential merger of equals. Management has laid out the bold target of running a $150 billion (market cap) business by 2016, and the company's convoluted tax structure (headquartered in Canada, but with IP and other assets held in low-tax jurisdictions) is a tremendous asset in deal-making – with an exceptionally low tax rate, Valeant can generate significant synergy just from running acquired assets through lower-tax jurisdictions.
Unlike so many Big Pharma companies that have been shedding "non-core" assets, Valeant is not particularly worried about owning a diverse collection of assets – about 40% of 2014 sales will likely come from branded prescription drugs, with roughly 20% each from devices, OTC products, and generic/branded generics.
With that flexibility, numerous companies could be potential partners in a large-scale merger. Allergan would bring some clear synergies in eye care and aesthetics, though also likely some antitrust worries. Teva would greatly expand the company's generic business and international exposure, while Mylan could be synergistic through the tax inversion that Valeant could offer.
I have two other favored candidates, though, that the sell-side doesn't seem to be as focused on – Galderma, the world's second-largest dermatology franchise (a joint venture between Nestle and L'Oreal) and Aspen Pharmacare, a leading pharmaceutical company in Sub-Saharan Africa and Asia-Pacific. Neither of these two would fit the "merger of equals" criteria, but they would be about double the size of the Bausch & Lomb deal and offer a good match for existing Valeant strength in dermatology and emerging markets, respectively.
The bottom line
With more than $49 a share in net debt, Valeant cannot afford to stumble. On a more positive note, eye care and dermatology are less "rough and tumble" than more competitive areas of health care and Valeant has uncommonly low exposure to patent expirations over the next few years. With just mid-single digit revenue growth (excluding the Bausch & Lomb "step up" and any future large deals), Valeant looks a little undervalued today and significantly more so when considering the growth and operating leverage of a deal for a company like Allergan, Galderma, or Aspen.
It can be emotionally challenging to buy a stock that has already had a big run. In the case of Valeant, though, I wouldn't sleep on management's ability to identify defensible profitable niches and leverage its operating advantages to greater effect.