Why the fall of a pharmaceutical giant might be really encouraging

Does the fall of Valeant Pharmaceuticals mean the universe is a just place after all?

"Pharma bro" Martin Shkreli may have become infamous for buying up established drugs and then hiking their prices through the roof. But it was Valeant Pharmaceuticals that really pioneered the business model. Of the 19 drugs whose prices rose the fastest in 2015, half belonged to them.

Now Valeant is in crisis. And there are basically two stories we can tell about its rise and fall.

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Time will determine which story is right. But both begin in 2008, when Michael Pearson became Valeant's CEO. Up until that point, the drug company's business model was rather typical: pump lots of money into research and development, then profit from the discoveries that hit it big. The trouble is, from the standpoint of investors, this model is not terribly attractive. It's hard to profit from inventing new drugs. Lots of research just doesn't pan out, and even when it does, there's a lot of government tests and approval to get through.

So Pearson, egged on by some activist shareholders, struck on a different strategy: Valeant would leave the hard work of trying to create new drugs to the other suckers. Instead, it would just buy up companies whose drugs had already made it through the regulatory gauntlet and were being sold on the market, and then profit by jacking up their prices. Lay-offs for big portions of the workforce at the acquired companies were usually involved as well.

So Valeant went on a company-buying and cost-cutting spree, while its investment in research and development fell to almost nothing. And for a while, at least by Wall Street metrics, it worked: By mid-2015, Valeant's stock price had increased from around $10 a share when Pearson started to a peak of $263.

Then the bottom fell out. Valeant's stock price collapsed in late 2015, wiping out around two-thirds of the gains it had made since 2008. Dismal earnings reports arrived, and its stock price nose-dived again, wiping out much of what remained. All told, it's now down to about $26 a share, and Valeant recently announced Pearson's departure.

There appear to be a few precipitating events in this spectacular fall.

First off, Martin Shkreli's shenanigans ramped up public scrutiny on Valeant-style pharmaceutical business models, increasing political pressure on the company.

Second, and probably much more critically, Valeant's relationship with a distributor named Philidor came undone. One key difficulty with price-gouging brand-name drugs like this is that cheap alternative generics usually exist. So a price-gouger like Valeant needs to avoid competition with those generics. That's where Philidor came in: It was a mail-order pharmacy that sold its wares straight from doctors' offices, and as it turned out Valeant was its only customer. The idea was that patients would directly mail-order whichever of Valeant's drugs the doctor prescribed, and avoid ever setting foot inside a pharmacy or going through their insurer, where they might be exposed to other generic options. The insurer simply picked up its portion of the tab afterwards.

But this relationship with Philidor also involved a lot of complicated and opaque accounting that investors couldn't make heads or tails of. It's not clear (yet) that anything illegal was done, but a series of research bombshells hit Valeant's reputation hard and sent investors scurrying for the exits. It cut ties with Philidor, and recently struck a new distribution deal with Walgreens.

Finally, the company also ran up a fair amount of debt.

This is where the two possible stories I mentioned come in.

The first story is that Valeant shows there's justice in the world. That interpretation was laid out pretty well by James Surowiecki in The New Yorker: Rather like a ponzi scheme, Valeant's business strategy was never viable in any fundamental sense. Instead, it had to forever stay ahead of its own unsustainable nature by perpetually buying up new drugs and trying out ever-more elaborate accounting methods. "Valeant has been less like a drug company than like a super-aggressive hedge fund that just happened to specialize in pharmaceuticals," Surowiecki wrote. "It made money not by providing economic value to customers but by financial engineering and by gaming the system." Eventually, Valeant stumbled, and reality caught up with it.

The second story comes from Steven Davidoff Solomon at The New York Times. His interpretation is that there's actually nothing that conclusively shows the collapse — or at least the full extent of the collapse — in Valeant's stock price was justified by any fundamental realities. It's worth remembering here that the stock market is not the real economy. It's just an arena for a small slice of the population to buy and sell stocks and financial instruments to maximize their personal returns. And investors are as susceptible to groupthink, social pressure, and panic as anyone.

By Solomon's reckoning, Valeant's accounting may be opaque, but there's no reason to think it's like Enron's: The company remains profitable — and thus valuable to investors — in real terms. "The drugs in its current stable of products are priced where they are and still sell," Solomon pointed out. Lastly, Valeant's debt overhang of $30 billion is hardly ideal, but it is manageable.

While Solomon might not put it this way, the implication of his interpretation is that maybe it's not such a just world after all: Just because business practices are immoral doesn't mean they can't keep reaping profits and satisfying investors in perpetuity. Valeant is suffering nothing more than "a crisis of confidence."

But perhaps even this second story contains a ray of hope. Even if a set of morally deplorable business practices are perfectly profitable and sustainable from a cold-eyed economic perspective, they can still be shut down if enough public pressure and outrage builds.

The question now is, once investors realize they fled Valeant for purely social reasons, will they return?