Valeant Pharmaceuticals is Volatile, Once Again
Valeant Pharmaceuticals International, Inc. (NYSE: VRX) has been a stock for traders rather than investors who are focused on the long term. Traders could have made money on both the long and short sides of the market while investors who believed the company would enjoy steady profits were deeply disappointed.
The chart below shows how the stock has performed over the past five years.
The stock’s rise and fall are both easily explained.
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As the stock price soared, Valeant pursued a business strategy that would prove to be unsustainable. The company’s original plan was to buy other pharmaceutical companies and cut costs by realizing synergies after the acquisition. This is a standard part of many business plans.
But, it turned out Valeant’s management had a twist to their plan, and this twist is where the trouble developed that sent the stock price plunging.
Valeant completed more than 50 acquisitions over the past few years. Most of the acquisitions added approved drugs with sales to the company’s portfolio. The company then boosted prices for those drugs increasing sales and providing cash flow to fund the costs of servicing debt.
However, one analyst noted that this model, “emphasized boosting drug prices, gutting research and development budgets, firing employees and lowering taxes through a merger that moved Valeant’s tax address to Canada.”
Higher drug prices caught the attention of regulators and the public, creating a firestorm for the company. Critics argued the price hikes were too large to be justified.
As one example, Valeant increased the price of a diabetes drug called Glumetza by about 800% in 2015, the year Valeant bought it. The company treatment used for cancerous skin conditions rose by 1,700% in six years after Valeant acquired the drug.
Valeant’s management heard the protests of its critics. The company’s CEO chose to defend his pricing decisions, claiming that just about anyone who needed Valeant’s drugs would receive them because patients were protected by insurance and financial assistance programs.
Company CEO J. Michael Pearson had reason to defend the policy. His compensation was tied to the stock price and he was optimistic about the company’s future. His most recent employment agreement was negotiated when Valeant’s stock was trading at about $140 a share.
Under that agreement, Pearson would receive up to 2.25 million shares if Valeant’s stock hit $1,068 by 2020. The fact that he signed the deal seems to indicate that he expected to be able to reach that goal.
Political Pressures Mount and the Stock Drops
By 2015, high drug prices had caught the attention of politicians. That year, headlines like “Democrats take aim at drug prices, prompting sharp drops in biotech stocks” became more and more common.
The lead to that story and others was similar, “Democratic lawmakers on Monday attacked “massive” price increases of two heart drugs by Canada’s Valeant, fueling a rout in drugmaker shares on worries of a government and insurer clampdown on U.S. drug prices.”
Valeant had become a political target that could no longer continue operating as it had in the past.
Despite the problems, some large investors were buying the stock, among them were billionaire hedge fund manager Bill Ackman who purchased shares for Pershing Square Capital Management.
Ackman ended up owning more than 27.2 million shares. His purchases were completed at an average cost of around $196 a share. Ackman finally sold at around $11 earlier this year.
The Bottom May Be In
Over the past month, investors have become more bullish on Valeant.
In part, the rally is driven by news.
Earlier this month, another billionaire hedge fund manager joined the company’s Board of Directors. John Paulson, the head of Paulson & Co., joined the Board. In a news release, Paulson sounded optimistic:
“The strategic plan to transform Valeant smartly focuses on rebuilding the company’s core franchises in ophthalmology, dermatology and gastroenterology while simultaneously using the proceeds from the sale of non-core assets and operating cash flow to de-lever the company. I am fully supportive of the strategy and leadership team at Valeant.”
As of March 31, the last available data in the SEC database, Paulson’s fund was the Valeant’s largest share holder with 19.4 million Valeant Pharmaceuticals shares worth about $265 million. Like Ackman, Paulson paid a high price for his shares, around $130, and has a large loss on his books.
Another piece of good news for the industry, according to some analysts, is that the rhetoric coming out of Washington, D.C. may be softening and severe price controls for drugs appear to be “officially off the table.”
What’s Next for VRX?
The stock has had a big rally, doubling off its April lows. As the chart below shows, the stock is now overbought and likely to pull back.
RSI, the Relative Strength Index, is shown at the bottom of the chart. This is a momentum indicator that is widely followed by technical analysts. They believe when RSI moves above 70, the stock price has moved up too quickly. They then look for a reversal in price.
In the chart, there is one other overbought signal in the RSI indicator. This occurred in May and the stock did subsequently pull back.
This indicates we are likely to see the price rise in VRX at least stall or potentially partly reverse. In the short term, a trade that benefits from a decline in VRX is more likely to be successful than a long trade in the stock.
Given this outlook, a bear put spread could be an ideal strategy. This strategy is useful when a trader is looking for a steady or declining stock price during the term of the options.
A bear put spread consists of buying one put and selling another put, at a lower strike, to offset part of the upfront cost. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics
The bearish outlook for VRX is a short term opinion. In the long run, this stock could recover significantly. That will be determined by management’s ability to manage the company’s debt and maintain sales and profits. A bear put spread can be used when a trader doesn’t have a long term opinion on the stock.
VRX closed Monday at $17.00, up 8.1%. The gain came after a report the company may be looking a swapping equity for some of its $29 billion in debt. If there is no follow through on the report, the stock could be vulnerable to a pull back.
It’s likely any pull back will be limited. With limited downside, selling a put can generate a profit. However, risk can be large when selling puts. To limit the risks, a second put can be bought.
For VRX, there are a number of options expiring in July. In cases like this, the monthly options, those expiring at the close on the third Friday of the month, usually have the highest liquidity and can be traded at the lowest possible cost.
Specifically, the July 21 $15.50 put can be sold for $0.47 and the July 21 $12.50 put can be bought for about $0.08. This generates income of $39 and risk is limited to $300, a 13% return on risk.
The maximum loss is experienced if VRX falls more than 26% to close below $12.50. The probability of that happening in just four weeks is small.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to follow this strategy.