In this week's episode of Industry Focus: Healthcare, Michael Douglass and Todd Campbell delve into the interesting places where Valeant Pharmaceuticals (NYSE:BHC) and GW Pharmaceuticals (NASDAQ:GWPH) fit into the healthcare investing puzzle.
First, the company you're probably getting sick of hearing about -- what's happening with Valeant today, how they got to this dire point, and how investors want to look at their future potential.
Then, a completely different story -- cannabinoid company GW Pharmaceuticals, and how their windfall phase 3 trial results might end up costing them. Also, they look at the new and very weird space of the cannabis market, and how investors should approach it.
A full transcript follows the video.
This podcast was recorded on March 23, 2016.
Michael Douglass: Healthcare: a study in contrasts. This is Industry Focus.
Hi, Fools! Healthcare analyst Michael Douglass here today with regular Industry Focus contributor Todd Campbell. I'm filling in for Kristine Harjes because she is just getting back from vacation, and we've got a great show for you today. Todd, welcome back!
Todd Campbell: I'm glad to be here and it's good to be talking to you again, Michael. It's been a little while since you've been here on the show.
Douglass: Yeah. They decided to pull me off the bench as a sub, so I'll take that. Also the sports metaphors will end right there because unfortunately I don't know the second base line from the free throw line, but I hear there's a difference and maybe they're even about different teams. I'm not sure. Anyway. Today we decided, Todd and I were talking about the show beforehand, and we decided to kind of ask about a pair of companies, how should I think about them right now.
Let's start with Valeant Pharmaceuticals. How should I think about Valeant Pharmaceuticals? Valeant has been in the news a lot, and I mean there's just been a ton going on with this company. Its market cap has kind of collapsed compared to where it was a year or two years ago. It's down just a massive percentage, and it's been name-checked in Congress. Prescription drug pricing has been name-checked on the presidential campaigns, and so there's just a lot going on with this company. Todd, let's go ahead and go through the history, kind of how we got to this place, and then we'll answer the question how to think about Valeant today. Sound good?
Campbell: Absolutely. That sounds great. I think that most of our listeners have probably heard Kristine and I chat a little bit about Valeant in the past, maybe you've read some of the stuff that we have up on Fool.com, but to give a little bit of quick background for people who may not be as familiar with the story, Valeant Pharmaceuticals has built itself up into a major pharmaceutical player by using a strategy that involves buying existing medications, repricing them higher, and then relaunching them. That strategy as you can imagine has come under a tremendous amount of fire in the past year following revelations, I guess you could say, stemming from now infamous Martin Shkreli's Turing Pharmaceuticals' bid to buy or acquisition of Daraprim, a sixty year-old drug to which they increased the price by 5000%. Valeant didn't go as far as that.
Douglass: Not quite that far, but ...
Campbell: No, but they are being held accountable for what some people think is an egregious price hike on two heart disease drugs that Valeant had acquired early in 2015. Those two drugs Valeant increased the price on by 537% and 237% respectively after they bought them, so as you can imagine, that kind of put them under the microscope as media attention and politicians and payers all started to swarm and say, "This isn't fair. These price increases are ridiculous."
Douglass: But wait, there's more.
Campbell: Yeah. There is more and what's happening is--
Douglass: Valeant really has been sort of the opposite of the gift that keeps on giving, right? It has just been the story that just keeps getting worse.
Campbell: The scrutiny that got, the light that got shined if you will on Valeant led to the discovery that Valeant had been relying on a specialty pharmacy known as Philidor to fulfill some of its prescriptions to patients. Philidor was basically substituting wherever possible Valeant's more expensive branded drugs instead of lower cost generics.
In an internal review that Valeant conducted determined that they probably shouldn't have been using Philidor the way they were, so they've since gotten rid of that relationship, but there's been all sorts of other things that have come out since then, including some concerns that maybe the accounting practices at the company are suspect. There could be a restatement, relatively minor, but still a restatement of revenue from 2014 into 2015. All sorts of questions basically being raised that ultimately now have led to the departure, soon departure if you will, of their CEO, and I guess you'd say the brain behind this whole buy, reprice, relaunch strategy, Michael Pearson.
Douglass: Yeah. I think this point has to be emphasized. When people talk about investing and they talk about companies, you will often hear people talking about valuation, you will often hear them talking about growth prospects, you will often hear them talking about the mergers and acquisitions strategy. These are all things that fundamental investors talk about and think about. What that really comes down to, what all three of those really come down to is leadership and company culture, at least in my mind. Because if you have a leadership that is very good at allocating capital, then you're going to have a better mergers and acquisitions strategy.
If you've got a leadership that is really smart about finding new opportunities for growth and then scaling them, then you're going to have hopefully great growth opportunities, and hopefully good stability for the company. And so for the person, Michael Pearson, who has been so key to so many investing thesis around Valeant to leave and to have apparently, at least potentially contributed to a lot of these internal issues, that really calls into question that investing thesis.
Campbell: Yeah. When things were great, things were great. Now things are not great, and of course he's being held accountable for that. The board is going to find a new CEO. That board is going to put someone new in place and hopefully they'll be able to get their arms around what needs to happen to right the ship if you will, but the challenges are big. Whoever comes in has been saddled with a mountainous level of debt because Pearson was so acquisitive. One of the other things we should always remind investors of is that there are two ways that companies report their financials. They report them on a gap basis and they report them on a non-gap basis.
A non-gap or an adjusted basis oftentimes in situations where companies are very acquisitive may not be the best way to look at the company, because it's very hard to figure out all of the moving pieces and how these acquisitions are flowing through to the bottom line. If you look at it on a gap basis, Valeant has been losing money. If you look at it on a non-gap basis, they're making money. That's something for investors to keep in mind with highly acquisitive companies, is to make sure that you're considering both the gap and the non-gap and taking the non-gap results with a little bit of a grain of salt.
Douglass: Yeah, or at least understanding how they came to it. When you think about how a Valeant or another company calculates it, I mean usually adjusted earnings are they're zeroing out things like one-time expenses which are often acquisition expenses, but really the key thing there is just to know the fine print and to know what they're zeroing out, why they're zeroing it out, and sort of building that into your own sort of thought process around the company. That's always a little bit of a struggle I think with everything because often adjusted earnings do give you a better sense of the company from the people who know it best. At the same time it does create this possibility that you're getting too different stories, and you really need to reconcile them together.
Campbell: I absolutely agree with that. That's why, again, with acquisition friendly companies especially, you know you and I talked a little bit about the onset, about trying to figure out how you should think about Valeant as we go forward. I think that, as investors, we have to temper our enthusiasm. This speaks right to what we were just talking about. If you look at it on a non-gap basis, shares are undeniably cheap. Even though they've revised down their guidance and now think that they're only going to make, I think it's between 9.50 and 10.50 in earnings per share on an adjusted basis in 2016. Now you're talking about a P/E ratio on a forward basis like less than 3. The first thing you think of is, "Wow. Screaming bargain," right? But you really should probably look more or think more about this company as a potential turnaround candidate rather than say an investment that's already in its turnaround.
Douglass: Yeah. I think that's a very good point. Really in a lot of ways they've kind of hit with the departure of the leadership, and with all these revelations, they're certainly in a rough spot right now. What will be interesting to see is what they do from here. Of course, the first step of that is getting that 10-K filed which they need to do by April 29th I want to say.
Campbell: Yeah. They plan on doing it by April 29th. This is really important because they owe $30.9 billion, and they only got $1.4 billion on the books. If debt holders say, "Hey. Listen you didn't file, which means you broke a covenant on these loans and we're going to [...] now say that you're in default." Then there could be quite a cash crunch that develops at the company because of that. Yeah. You got to get those things filed and they got to be right the first time.
Douglass: Absolutely. Thinking about future leadership of the company, I think what's going to be very interesting is you've got activist-investor Bill Ackman has a 9% stake in Valeant. Ackman is joining the board. He's got two board seats now for Pershing Square. You've got to think that he's going to be pretty active in terms of helping name new leadership and mold the company's future.
Campbell: Got to get an insider in there that really knows what they're doing and has very strong relationships with payers, because if you're not using Philidor anymore and you're launching new distribution models, you need to have somebody who has got vast experience in being able to manage relationships with payers, so I think having an industry, you know former CEO of a major pharmaceutical company come in, would certainly restore some confidence. Again, that restoring confidence, that's got to start from the top. It's going to be top-down, and that's one of the reasons that I think they ...
Think about this company as a potential turnaround, not one that's quite in it yet, but that could be involved in a turnaround soon.
Douglass: Right. Absolutely. I think that's very fair and I am very happy to continue to watch Valeant and this story develop from the sidelines.
Todd, let's hop on over to GW Pharmaceuticals. Really kind of the, in some ways, kind of the opposite story, right? A big marijuana breakthrough for this cannabinoid company. Why don't you go ahead and give us the background?
Campbell: This is a huge breakthrough, and I'm going to say that it's a much needed breakthrough. If you go back to 2013, 2014, everybody was thinking medical marijuana is the wave of the future. You've got 23 states that have approved medical marijuana possession in some form. You've got states like Colorado and California that allow dispensaries to dispense certain strains of marijuana that can be used to treat various maladies. You've got all of this momentum, yet there's still a big gap between the anecdotal evidence of marijuana helping patients and the scientifically proven evidence of marijuana helping patients.
Douglass: Right, which of course brings us through to this breakthrough.
Campbell: Yeah. Last year GW Pharmaceuticals fell short on three very important trials that were studying marijuana's use in cancer pain. They also stumbled in a trial that was evaluating marijuana's use in schizophrenia patients. It was very, very important to be able to show investors and everybody in the community, all the marijuana advocates, that yes, you can take marijuana and marijuana can help in some indications. What happened at GW Pharmaceuticals last week, is they said, "Yes. We have shown in one phase three, which is a late stage trial, that patients with a certain type of childhood onset epilepsy can see the number of seizures they suffer every month reduced significantly, by 39%, by taking a purified version of CBD, which is a cannabinoid that is found in the marijuana plant."
Again, this isn't a test that's basically giving them marijuana and telling them to smoke it. It's a medically derived therapy that's coming from the marijuana plants chemical cannabinoids and being applied in this setting.
Douglass: Yeah. By comparison, folks receiving a placebo only saw an 11% improvement in the number of seizures so that's a pretty big difference. There's a second trial readout in the second half of this year, and then they've got a number of other potential readouts in the coming years.
Campbell: Yeah. Epilepsy, especially childhood onset epilepsy like Dravet syndrome, which this trial was conducted in, Lennox-Gastaut syndrome. Sorry.
Douglass: Say that three times fast.
Campbell: Yeah. Those trials are ... There's a significant unmet need. These are debilitating disease for patients and neither of these are very adequately controlled by existing anticonvulsants that are on the market, so the thinking here is that, "Okay, if we succeed in the first Dravet syndrome trial, and we can put up good results in two other phase three trials in Lennox-Gastaut syndrome, then maybe we can file for FDA approval at some point maybe by the end of this year." If they have fast track status on the Dravet syndrome indication, so theoretically you could have GW Pharmaceuticals launching its first marijuana derived epilepsy drug in 2017.
Douglass: In the U.S. Yeah.
Campbell: In the U.S.
Douglass: Yeah. That would be potentially huge. Of course these patient populations are fairly small.
Campbell: Right. Again, this goes to what we were talking about before which is trying to figure out how should I think about this company, and how should I think about this development at the company. There are only 5400 patients in the United States with Dravet syndrome. If you slap a $16,000 price tag, which is basically what the company gets for their other marijuana drug which is available in Europe called Sativex, on that, you're really only talking about an annualized sales pace of I think it's like $86 million.
Douglass: Round it to a hundred.
Campbell: GW Pharmaceuticals has a $1.8 billion market cap.
Douglass: Yeah. Which is reflecting, and it's interesting about GW because usually when you see a market cap like that and an immediate drug that doesn't have enormous sales potential, it seems, at least based on some of these initial indications, you are thinking, OK, follow on indications, or are you thinking there must be something else in the pipeline that looks really, really good? Interestingly with GW it doesn't really seem to be the case with either. There doesn't appear to be that much commercial opportunity at least in the next few years for the company.
Campbell: You could make the argument and model that this could theoretically be a drug that generates, if you include the LGS indication, somewhere between $100-200 million, but that's a estimate, and we all know that whenever we make assumptions on what the peak sales forecast of a drug are, we run into a lot of trouble, so you got to reign that expectation in and probably low ball rather than high ball that. The other thing that investors should bear in mind is that if GW Pharmaceuticals is proving that CBD helps epileptics, some amount of their market share may go to the dispensaries in these states that are selling extracts that are high in CBD.
They could end up competing against dispensaries which probably are going to be cheaper. It'll be interesting to see how that dynamic plays out, and then of course there's also the risk that this indicates or I should say fuels R&D efforts at competitors, and then you've got a number of different competing therapies that hit the market. Good for patients, but not necessarily good for investors.
Douglass: Yeah. That's what's been interesting about the marijuana market is it's just so weird. I mean because you have this bifurcation where it's a controlled substance, but in some cases some states are supporting it. The FDA is doing this stuff with GW and with competitors like Insys looking at CBD compounds, and there's a lot of uncertainty and especially given GW's market cap and what at least the initial sales look like. For me this is clearly still a stay away story. Really interesting. Really exciting. They'll hopefully be able to find something that makes life better for these patients with Dravet syndrome and some of these other indications that we're talking about, but not an investment necessarily that we're interested in jumping on.
Campbell: A big win for patients, but maybe not as big a win for investors from this moment forward.
Douglass: Yeah. That makes sense. All right, well Todd, that's good stuff. Thanks for walking me through this and hopefully our listeners. Hopefully you all enjoyed it.
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Also, as always, important to remember that here at The Motley Fool we don't believe people should buy or sell stocks just based on what they hear. Todd and I may have positions in companies that we've discussed, although I don't think you and I do this week, given how bearish we are on them. The Motley Fool may have recs for or against companies that we mentioned, so always, always, always do your own due diligence. Do not buy yourself something just based on what you hear. It's the right way to invest. It's the smart way to invest, and here's to happy returns. Thanks everyone and Fool on!