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Image source: National Cancer Institute.

Oh how the mighty have fallen.

In August, Valeant Pharmaceuticals (NYSE:VRX), a drugmaker that's primarily grown its product portfolio through mergers and acquisitions, was riding high. It was valued at nearly $264 per share, or a valuation of close to $90 billion, and was well on its way to becoming one of the largest drugmakers on the planet in the coming years. Pershing Square's Bill Ackman, one of Valeant's top shareholders and biggest supporters, opined in May of last year that Valeant could finance $7 billion to $20 billion worth of acquisitions each year, using its positive cash flow and debt financing to make it happen.

Everything seemed too perfect. And it was.

Valeant's growing woes
The wheels, motor, and transmission have all since fallen off the Valeant bus, with shares recently off as much as 90% from their all-time highs set just months earlier.

Currently, the company finds itself under heavy scrutiny from U.S. lawmakers for its drug pricing practices. Valeant has been wildly successful at discovering minimally competitive therapeutic indications, scooping up the market share leader for that indication, and raising the price of the drugs it acquires without necessarily changing the formulation or manufacturing process. The Wall Street Journal pointed this out in April 2015 when it highlighted the 525% price hike for Nitropress and 212% price jump for Isuprel following their acquisition by Valeant. 

But it gets much worse.

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Image source: Flickr user TaxRebate.org.uk.

More recently, Valeant announced its preliminary fourth-quarter results and 2016 full-year guidance. The Q4 results weren't all that bad, but its guidance calls for $9.50 to $10.50 in full-year EPS and $11 billion to $11.2 billion in sales. Comparatively, Valeant's fiscal 2016 guidance from just a few months prior had called for $12.6 billion in sales and $13.50 in EPS at the midpoint.

Additionally, Valeant alluded in October to possible accounting issues, which often raise major red flags with investors. An internal audit discovered that $58 million in revenue had been incorrectly booked with drug distributor Philidor Rx Services, which Valeant no longer has a relationship with. Nonetheless, Valeant's management didn't feel comfortable signing off on its 2015 full-year report, and has thus delayed its filing.

Delaying its annual 10-K could come with serious consequences. Valeant has waded into $30.9 billion in debt, which has been its primary funding tool to fuel its acquisition binge. Should Valeant fail to file its annual report in a timely manner, some or all of Valeant's lenders could consider the company to be in breach of its debt covenants. If this were to happen, Valeant's debtors could demand faster repayment and cripple the company's M&A business model.

Finally, as icing on the cake, Valeant ousted its now-former CEO J. Michael Pearson just weeks after he returned from a two-month pneumonia-related absence. Some might view the change as beneficial since it means Bill Ackman will be taking an even more active role in Valeant's prospective turnaround, but it's another sign of the departure from normalcy at Valeant Pharmaceuticals since last summer.

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Image source: Flickr user StockMonkeys.com.

Here's what's really at stake if Valeant collapses
It's certainly not every day that Wall Street and investors witness a company that was nearly a megacap lose 90% of its value in just a few months. But the reality is that Valeant's woes could have implications far beyond just Valeant's stock.

At the heart of Valeant's woes is whether or not its business model can be justified by lawmakers. Acquiring and merging is a perfectly acceptable practice in the healthcare sector and other industries. What's being called into question is whether or not drugmakers have the ability/right to drastically increase the prices of acquired drugs without changing the formulations or manufacturing processes. In other words, the value of branded medication is currently on trial, whether you realize it or not.

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Image source: Mallinckrodt.

Valeant is certainly not the only company to find itself in the spotlight for its drug-pricing practices. Mallinckrodt (NYSE:MNK) relies heavily on Acthar Gel, an anti-inflammatory medicine acquired when it purchased Questcor Pharmaceuticals for $5.6 billion in 2014. Now priced at about $35,000 per vial, Acthar Gel's price has risen by more than 2,000% since 2005. But in Mallinckrodt's defense, Questcor was responsible for the majority of those price hikes.

Perhaps the most infamous example includes Turing Pharmaceuticals' acquisition of Daraprim, a rare disease drug designed to fight infections, and the subsequent price hike of nearly 5,500%. Pharma bad boy Martin Shkreli had been CEO of Turing Pharmaceuticals at the time of the purchase and price hike.

If lawmakers' proverbial foot comes down on Valeant, or a similar-modeled M&A pharma company, it could be bad news for all innovative drug developers, who could witness their margins in the U.S. shrink.

In a recent interview with Bloomberg, GlaxoSmithKline's U.S. pharmaceuticals president Jack Bailey presciently summed up what's currently at stake:

"The days of unfettered pricing are long gone."

Why drugmakers need pricing power
But as much as consumers and lawmakers may dislike the pricing practices of drugmakers, high prices and annual increases are needed for a number of reasons, and are also protected by a handful of systemic differences between the U.S. drug market and other drug markets around the globe.

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Image source: National Cancer Institute.

There are clear fundamental reasons why U.S. drug developers charge as much as they do for the drugs they develop. For one thing, pharmaceutical demand is higher in the U.S. than anywhere in the world. The standard of living in the U.S. is also higher than most other countries, and the U.S. has drug exclusivity that can last beyond a decade, which helps support branded-drug pricing.

Additionally, drug developers need to cover their costs to develop new therapies and bring them to market. Drug companies need to recoup more than just the costs to develop a drug that makes it to pharmacy shelves; they're recouping losses from hundreds of failed discovery and in-lab studies, as well as unsuccessful preclinical and clinical ventures. There are also legal costs designed to protect their patents and marketing costs to launch new drugs.

Finally, drugmakers use high prices in U.S. markets to subsidize their ability to bring branded medicines to emerging and underdeveloped markets.

If U.S. regulators clamp down on the pricing power of drug developers, we could see drugmakers moving their operations to overseas markets where the regulations are potentially less restrictive. It may also result in emerging and underdeveloped markets losing out on access to game-changing therapies.

Personally, I don't deny that 500% increases in drug prices without formulaic changes to products don't seem right. But I also freely admit that I don't see a quick solution since regulating free market pricing isn't going to be easy. I'd suggest investors pay very close attention to Valeant whether they're shareholders or not, because what happens at Valeant will likely have ramifications throughout the entire drug industry.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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