- Henry Acton
"It's a story about the delinquent society—and I use that phrase intentionally—that grew up around the company, and here I'm referring to the collusion of Enron's various advisors and financial intermediaries. And most importantly, Enron is a story about how fraud is often preceded by gross incompetence: where the primary source of that incompetence is inexperience, naiveté, an ends-justify-the-means attitude toward life, and so on. And most importantly, an inability to face reality when painful problems arise."
- Malcolm Salter on Enron
****A word of caution up front. This article spends a considerable amount of time discussing the rather complex biopharmaceutical pricing and promotional models as background to Nintai’s purchase and sale of Allergan plc. For those with little no interest in the esoteric debate of government regulatory power and corporate business ethics, I recommend passing on this article.****
On Tuesday, June 25 2019, Abbvie (ABBV) announced it acquiring Allergan plc (AGN) in a $63B deal. Allergan is a former holding in several of Nintai Investments individual portfolios. This article is an attempt to describe how Allergan became a very short-term busted investment for us. I will delve into some level of detail surrounding biopharmaceutical off-label promotional efforts and the current reimbursement model. These was essential components in our decision to eliminate Nintai’s entire position in Allergan.
Allergan: A Brief Investment Case
As an investment manager, my fiduciary responsibility is to maximize my clients’ returns within a risk framework best suited to their investment goals. Since we have a tendency to look for companies with great financial strength, a strong competitive moat, selling at a discount to intrinsic value we think the concept of safety is built into our investment selection process.
This focus on safety has held Nintai in good stead over the years. In addition to that, we tend to invest in areas where we feel we have a competitive edge in the nature of the business - its strategy, competitors, marketplace, product development, and regulatory requirements. As a former health consulting firm (with an internal investment fund) we have been quite comfortable investing in the space. Allergan was particularly well-placed. Having served on several life science advisory Boards and 7 of the top 10 biopharmaceuticals as clients, we felt a certain level of comfort investing in the company.
Allergan represented a strong investment opportunity. It is one of the largest specialty pharmaceutical manufacturers. It specializes in aesthetics, ophthalmology, women's health, gastrointestinal, and central nervous system products. In 2016, Allergan sold its generics and distribution segments to Teva (TEVA). A series of acquisitions and divestitures hid what we though were some great aspects of the firm. For instance nearly 30% of revenue was converted to free cash over the pasty 5 years. Free cash flow had grown by 13.5% annually over the same period. While the company had roughly $26B in debt, it generated $5B in free cash and had $13B in cash proceeds from the Teva sale. Its major products – regardless of news accounts – had little to no competition for the next several years with one – Botox – looking at label expansion in 9 new therapeutic categories. Last, it was trading at a 9.6 P/E ratio and at a 33% discount to our intrinsic value. What wasn’t to like? Nintai Investments purchased shares of Allergan into some of our clients’ portfolios at roughly $150/share in December 2018.
Safety and Ethics or Growth in Sales?
Shortly after purchasing our shares in the company, Allergan announced it was under investigation for both off-label promotions and Medicare fraud. Before I go into a description of both of these, let me say up front that I believe good, sound management is essential to long-term corporate growth. This includes outstanding capital allocation skills, deep industry experience, great personnel management, and high ethical standards. Much like a four-legged stool, it is nearly impossible to obtain good balance when missing a leg. Over time, we unfortunately found the company was missing the last leg – high ethical standards.
As a steward of my investors’ investments, my primary goal is to not permanently impair their capital. Next in line is to allocate such capital to achieve outperformance of the markets in a manner that meets an investor’s safety requirements. As an investment manager, sometimes these two will be in conflict. In Allergan’s case, it became clear the company’s stock might (and that’s the operative word - might) outperform the general markets. That said, management’s active pursuit of revenue growth and profitability through unethical and potentially illegal means puts such growth at risk. It also put my investors’ capital at risk. For me, there wasn’t much of a debate. If my ultimate goal is to preserve capital, then any activity that puts that at risk requires my direct and immediate action. Accordingly, we sold out of the entire position at roughly $135/share in January 2019. In roughly 30 days we lost 10% (not counting a miniscule dividend payment) on the investment.
As most of you know, it isn’t common for Nintai Investments to own a stock for only 30 days. It’s certainly not our preferred time of ownership. I thought it might be helpful - particularly for those interested in investing in the biopharmaceutical space - to better understand how we see the issues facing Allergan’s management and why such behavior is unacceptable.
The drug industry is highly regulated for good reason. Many treatment therapies can have profound metabolic actions inside the human body. For instance, some inhibitors may inhibit more than originally thought (see COX-2 inhibitor VIOXX) while other treatments may cause side effects that make it impracticable in the clinical setting (see many anti-psychotics and depressants in the teen population). Of course, there is also the possibility of addiction and abuse. For these reasons – and many more – the Food and Drug Administration (FDA) keeps a close eye on the therapeutic approval process, dosage strength, and safety data of each proposed drug.
Biopharmaceuticals are no different than any other publicly-traded company. They face pressure to meet quarterly earnings, show growth in revenue and profits, and assist their shareholders in meeting their financial goals. For these reasons, biopharmaceuticals are tempted to do one of two things (or both) to increase revenues beyond ethical (and sometimes legal) means. The first is off-label marketing. This is when companies promote drugs for treatments of diseases not approved by the FDA. The second is price manipulation whereby the company overcharges state and Federal programs. Not only are both of these against the law, they are also highly unethical. Pushing drugs to be used where no scientific study has demonstrated efficacy and safety can put real lives at risk. Overcharging Medicare means there is less of the pie to go around, meaning there are less drugs available or fewer patients covered.
Off-Label Drug Promotion
There are two major areas of potential ethical violations in the biopharmaceutical industry. The first is promoting drugs “off-label”. This means the company is promoting its drugs to physicians as a therapy for a disease outside of its approved therapeutic guidelines or label. For instance, a drug might have gone though an FDA-approved clinical trial process that shows efficacy in the treatment of rheumatoid arthritis. The FDA then approves a label – found in the drug packaging – that outlines exactly for which disease, at which state of the disease, at what dosage, and at which demographic group the drug has been approved for treatment. This is the legal extent to which the drug can be promoted.
However, over time anecdotal evidence may start to suggest this drug is helpful in treating shingles. At this point, the biopharmaceutical is faced with a dilemma. It can spend hundreds of millions of dollars in new studies to confirm the drug is efficacious in shingles, or it can - without FDA approval - promote the drug to physicians “off-label” as a therapy for shingles. In the latter case, the company face up to hundreds of millions of dollars in fines. That said, dependent upon the increase in revenue from off-label sales, some companies might simply build in the fines as a cost of doing business.
Abuses of this type range in their level of guilt. Some drugs are promoted and used off-label with common knowledge because we know they work. For instance, colchicine was approved on-label for gout, but was used off-label for years to fight the effects of familial Mediterranean fever. Other efforts have been far shadier in their ethics. For instance, in 2012 GlaxoSmithKline (GSK) faced criminal and civil charges failing to provide safety data (showing much higher risk than disclosed) along with kick-backs, and off-label promotion knowing the drug was highly risky in the off-label target patient group.
Drug Pricing and Reimbursements
A second major way of illegally increasing revenue is by overcharging both the Federal government and state governments through manipulation of agreed-to pricing agreements. After receiving FDA approval to begin marketing, promoting, and selling its product, the company develops an average wholesale price (AWP). This is a benchmark used for pricing and reimbursement of prescription drugs for both government and private payers. AWP is not a true representation of actual market prices for either generic or brand drug products. AWP is often been compared to the “list price” or “sticker price”, meaning it is an elevated drug price that is rarely what is actually paid. Pharmaceutical companies then sell their drugs to wholesalers (roughly 90% of drugs are sold this route). The price the wholesaler (companies such as AmerisourceBergen ((ABC)), or Cardinal Health ((CAH))) pays for the drug is called the Wholesale Acquisition Cost (WAC). The final step is getting drugs from the wholesalers to the patients. This is handled through several chain and local retail pharmacies as well as an increasing number of mail and specialty pharmacies. The retail pharmacy market in the US is largely dominated by chain pharmacies;. In 2014 the top three pharmacy chains (Walgreens Boots Alliance ((WBA)), CVS Health ((CVS)) and Rite Aid ((RAD))) accounted for over 75% of the market share.
This system might work well if insurers and pharmacy benefits managers (PBMs) weren’t thrown in there as well. Insurers entered the pharmaceutical market to use their market power to reduce the prices they pay for drugs. PBMs (such as ExpressScripts ((ESRX))) work on behalf of their clients to lower the prices paid for pharmaceuticals. They interact in the pharmaceutical market through two primary paths: price negotiation and formulary design. The first part of price negotiation is reducing the prices paid at the pharmacy through discounts. PBMs aggregate the purchasing power of multiple insurers and payers to negotiate better discounts with pharmacies than insurers could achieve on their own.
While discounts reduce the initial price paid at the pharmacy, rebates earn money back after drugs have been sold and consumed. Drug rebates are negotiated directly with manufacturers on brand medications by PBMs. They often total 10% or more of the price of branded drugs. Manufacturers pay rebates to earn access and to reward volume. Access means that a PBM lists a medication on their formulary as a “preferred” brand drug, meaning it costs less to the consumer and will be more likely to be prescribed by physicians. Volume rebates are additional rebates paid by the manufacturer if a PBM sells more of their brand drug than similar alternatives. A decade ago many PBMs provided their services for a nominal fee and earned most of their money through rebates., Today, most PBMs charge higher upfront fees and pass-thru rebate payments to the insurer.
Allergan: An Investment Gone Awry
Biopharmaceuticals have increasingly used the complexity and opaque nature of pricing to overcharge state and federal healthcare (particularly Medicare). Along with off-label promotion efforts, the fines have begun to reach breathtaking levels. In the last 10 years, the industry has paid over $15B (that’s with a B) in penalties and fees and signed over 115 consent decrees.
Shortly after purchasing the stock, Allergan joined the hallowed halls of biopharmaceuticals stretching the legal limits – until, with a hop and a skip – they crossed the ethical (and perhaps legal lines). At Nintai, we spent the following 3 months interviewing management, wholesalers, pharmacy benefit managers, pharmacists, and managed care formulary committee members surrounding the company’s products and services. After much deliberation and thought, we made the decision to divest the entire position from the portfolio.
We didn’t do it lightly. We recognized we were taking a permanent 10% loss on our investors’ capital. But overall we think it was the right thing to do – from both a portfolio management perspective as well as a position of who we like to partner with when it comes to our partners’ hard-earned capital.
If one were to boycott every biopharmaceutical for a violation related to product promotion and sales, frankly there wouldn’t be that much of population left to research. That said, there are violations where the rot starts at the head. Both off-label marketing and mispricing are two of these. From the CEO down, every major manager knows sales forecasts to the penny. When these numbers begin to either outperform or meet numbers designed with fraud in mind, then senior management has a choice. They can live with knowledge of such activity or they can blow the whistle, take their lumps, and clean up the organization. It is a sad commentary on today’s business ethics that many choose the former course of action.
Do I regret seeing the company being acquired at a 28% premium to its price the day before the announcement? Sure. I hate losing. I equally hate not winning – and Allergan represents both of those in Nintai’s investment experience. But I’m happier knowing that both the Nintai team and our investment partners could sleep well at night – both from an ethical standpoint as well as a risk standpoint.