Editor's Note: Michael Lewitt was one of the first analysts to call out Valeant in 2015, which just had its worst single day ever this week. His profit recommendations – which he first alerted us to less than six months ago – have paid off in the triple digits now, and he's already looking at his next big short. It's likely to unfold like this…
Valeant Pharmaceuticals International Inc. (NYSE: VRX) is the perfect example of everything that's wrong with the markets today.
In just one company, you find…
A risky, predatory, and destructive business model; extremely shady, allegedly illegal accounting and operating practices; $30 billion of debt on just $9 billion in the trailing 12 months; the most enthusiastic sell-side analysts money can buy; a huge number of investors who didn't realize they were exposed to this mess; and several hedge fund managers who should've known better…
Back in October 2015, when I realized how far and how fast this company's fall was going to be, I made the only recommendation I could in that situation:
Make a killing on Valeant's spectacular demise.
Now, Valeant is likely doomed as a company, and it's time to wind down this short-side profit play – with the gains we've had, there's no reason to chase it down any further. I’d like to see it fall further, personally, because it’s a disgusting company, but there’s no need to be greedy.
The very good news is there are plenty of other companies out there like it right now. In fact, I'm tracking one as I write this.
But… here's how we made as much as 700% as this stock crashed.
Valeant Was Rotten from the Start
Once upon a time, Valeant was among the fastest-growing pharmaceutical companies in the world. It more than doubled its revenue from 2012 to 2014, from $3.48 billion to $8.25 billion.
This attracted a lot of attention, not least of all from hedge fund rainmaker Bill Ackman (who took a $1 billion one-day loss on Tuesday, by the way), who took huge positions in the company.
Hedge funds weren't the only ones. Plenty of retail investors owned exchange-traded funds (ETFs) and mutual funds that were heavily invested in Valeant.
But from the start, it should have been obvious to everyone that Valeant's growth was anything but healthy. For one thing, this company was spending just 3% of its sales revenue on research (compared to 15% to 20% for pharma companies that are actually creating something).
This fast-growing company took advantage of every conceivable tax and legal loophole. For example, Valeant is based in Canada, but operates from New Jersey, which of course provides a tax advantage.
It issued junk bonds to acquire at least 33 other pharma companies. Once in control, they gutted the staff, then raised the prices on the drugs now in their portfolio.
Valeant's average annual drug price increase went from 21% in 2012 to an eye-watering 66% in 2015 – that's more than five times higher than its nearest rivals. Insurance companies and the government were left to pick up the difference.
These loathsome practices made Valeant's board filthy rich, and temporarily lined the pockets of its hedge fund devotees, while U.S. taxpayers and patients were left to pick up the bill for spiking healthcare costs.
Once politicians realized they could make some hay by publicly scolding and appearing to crack down on companies like Valeant, it was the beginning of the end.
On the day I reported all of this on Oct. 15, 2015, the government announced it was investigating Valeant in Massachusetts and New York because of its pricing practices.
The stock had already plunged 25% in the month before this, but news of the investigation sent the shares tumbling another 11.5%.
I predicted at the time that Valeant would trade down, from $170 to $100 – but even I didn't expect that to happen in two days.
But it certainly did, and we were about to make our first move…
How Valeant's Losses Became Our Gains
Barely two weeks later, on Oct. 30, 2015, Valeant was in deepening hot water.
The federal pricing investigation was bad enough, but it was about to get worse, thanks to a bombshell allegation of channel stuffing that had the company on the back foot.
Serious questions about the legality of Valeant's relationship with Philidor Rx Services LLC – a shadowy mail-order pharmacy through which the company sold some 7% of all its drugs. Unable to provide a good explanation for this relationship, Valeant quickly “threw in the towel” and severed its relationship with Philidor altogether.
And what a relationship it was… Philidor wasn’t just a business connection. Valeant had paid $100 million for an option to purchase the company, which it failed to disclose to investors. I regarded it as highly unlikely that Valeant’s famously “hands-on” chairman and CEO, J. Michael Pearson, was unaware of what was happening at Philidor.
Now, Valeant's "amen corner" on Wall Street, led by Bill Ackman, was still extremely vocal in its enthusiasm and confidence in the company, but those of us who hadn't drunk the Kool-Aid could tell that one of the biggest short opportunities of the year was just ahead.
I revised my price target for VRX shares all the way down to $50.
Now, shorting a stock is always the "pure play" to profit from a stock's decline, but that can be risky – there's no limit to how far a stock can rise, but your maximum upside on a short play is 100%. Not only that, but certain stocks can be hard to borrow, depending of course on your broker and the stock.
But my favorite way to take advantage of a situation like this is to buy put options. It's the most capital-efficient trade, and your potential losses are limited to what you paid for the option. They're also leveraged, which magnifies the potential profits.
So I recommended a speculative, long-dated options trade on Oct. 30 – VRX March 18 2016 $50 puts (VRX160318P00050000), for up to $4.50 – because I knew this stock had a lot further to fall. And after trading back up to $120, the shares plunged back below $100 as Valeant’s junk debt also sold off as a clear sign that creditors and banks were not happy with events.
Investors like us couldn't have been more thrilled, though.
The Profits Poured in Fast and Thick
Valeant continued to be a volatile “hot potato” into early 2016, as bad news piled up. The company announced a questionable plan to pay down its immense, $30 billion debt burden, and CEO Pearson came down with pneumonia and stepped aside.
I still think it’s poetic justice that a man who made his fortune ripping off the sick got taken down by illness himself. The only mistake he made was deciding to return to work in March, when things began to spin further out of control. When the company announced his return, it also said that it was withdrawing its 2016 earnings guidance and postponing a conference call with investors to discuss Q4 2015 results.
The changes at Valeant were not enough to convince anyone but the most enthusiastic apologists. The company’s leadership and debt payment plan had zero credibility.
The company’s business plan was no longer viable; Valeant’s stock price was so beaten down that it could no longer pull off the stock-for-stock acquisitions it depended on to perpetuate its phony growth model.
It couldn’t pull off mergers and acquisitions (M&A) with its cheap debt, either. The credit markets had started collapsing in late 2014 and by early 2016 were closed for business to all but the strongest companies – and Valeant is the opposite of a strong company. With its bonds selling off, its borrowing costs were too high to justify making new acquisitions. Instead, the company had to worry about how to service its existing $30 billion debt load.
Valeant was in "handwriting on the wall" territory, which for us meant another opportunity to profit.
So on Jan. 13, I recommended investors buy VRX June $50 puts. They were trading for $2.50 at the time, so there was plenty of upside left in the Valeant train wreck.
By March 8, the VRX March 18 $50 puts were trading at $6.10, which means readers who were following along better than doubled their money. I recommended investors consider selling the puts at $6.10, because they were close to expiring.
At that time, Valeant was trading at around $61.31, down from a 52-week high of $263. 81. The shares were getting battered, adding to our short-side profits, but there was still more excitement ahead.
Then on Tuesday, March 15, the ceiling fell in. Valeant announced that it wouldn’t be able to file its U.S. Securities and Exchange Commission 10-K forms, and might default on some of its debt obligations if it couldn’t get its act together and get them filed by the end of March.
That was the end of the line for many stockholders. Volume topped 71 million shares as sellers drove the stock down another 51% to just under $33.50. It was Valeant’s (and Bill Ackman’s) worst day ever.
On the other hand, the VRX June $50 puts are trading at around $20 as of this writing. Investors who paid up to $2.50 are looking at gains as high as 700%.
Needless to say, investors like Ackman who were on the "wrong" side of this trade are in a world of hurt. They may never recover. Valeant almost certainly won't.
But I'm already looking at the next big short opportunity…
This time, the play is one of the world's biggest (and most mismanaged) banks. It has about $60 trillion in risky derivatives on the books, and it's been battered on the rocks of the European banking crisis. I'm making more profit recommendations to my Sure Money readers, because when this bank goes over the cliff, it's likely to be much, much bigger than Valeant, and therefore so much more profitable. Click here to get my briefing on this bank and the recommendations I'm making to profit on its "Lehman Brothers moment." You'll get my Sure Money investor service, too.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.