Valeant Pharmaceuticals: Part IIIA: Corrections and amplifications on the Medicis restructuring charges

This post contains corrections and amplifications to and of the previous post - which is why it labelled Part IIIA. This is a series - it will help to start at the beginning. Here are the links: Part I, Part II and Part III.

Part III of this series went to the core of the issue.

As shown in Part II, Valeant Pharmaceuticals makes huge and increasing losses after very large restructuring and other one-off expenses. If the GAAP accounts are the beginning and end of the story then Valeant is headed for bankruptcy. It has large and increasing losses and $17 billion in debt.

If the restructuring and other one-off expenses are truly "one-off" then you believe the Valeant story. Profits net of these "one-offs" are large and rising. GAAP EPS (currently a loss) will rise explosively when one-off expenses go away. Consensus (guidance) earnings predictions have this explosive character.

If the restructuring charges are not "one-off" then Valeant is a Wizard-of-Oz type con on the markets where it looks really great if you ignore ordinary recurring expense because it is classified as non-recurring.

We need to work out - what - if any - of the literally billions of dollars of "one-off" expense is really ordinary expense in disguise...

Alas that is very hard to do - because - frankly - there is not enough disclosure as what is in the "one-off" bucket. So I do it with respect to only one merger - the Medicis Merger. That was the subject of Part III.

Comments on Part III

In Part III I assessed the restructuring charges with respect to the Medicis merger and whether they were plausibly one-off. I thought they were too large relative to both the employment base and balance sheet of Medicis to be plausible one-off charges. This leads me to the Wizard-of-Oz style conclusion but other people (see the debate in the comments) were willing to accept those restructuring charges as truly one-off.

I want to go through the issues raised both privately and in the public comments. Alas there are lots of deep-dives into difficult disclosures. I am going to try to make this as painless for both me and you as possible.

I stand by my conclusion though that is likely that one-off expenses are being dumped into the restructuring charges - and I show with a clear example of royalties paid to Galderma on an ongoing product (Sculptra). 

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Employee numbers at Medicis prior to the acquisition

One of the more damming allegations in the last post was that Valeant provided for employee termination costs payable to approximately 750 employees of the Company and Medicis who have been or will be terminated as a result of the Medicis acquisition. I noted that the last form 10-K of Medicis had 646 employees.

Several people asked whether the 646 employees was before or after Medicis merged with Graceway. Medicis purchased Graceway at a bankruptcy auction and the closed the deal as per 2 December 2011. So that number provided in 2012 should have included the Graceway personnel (about 200 I gather). There is some doubt as to whether it did include the Graceway personnel. The last 10-Q of Medicis talks about 770 employees not including R&D functions. There may have been 900 employees so firing 750 is - I guess - theoretically possible albeit extremely aggressive. Just working through the numbers it is likely that more than 100 of those fired were in sales - and many of the products were out of patent (which means competition). Losing the employee who visits the doctors office (when the competitor is doing so) is probably negative for sales - but that is the subject of future posts.

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The breakdown of acquisition costs in the 2013 form 10-K

There is a breakdown in the 2013 Form 10-K of the integration costs related to the Medicis acquisition. I quote:

We estimated that we will incur total costs of less than $250 million in connection with these cost-rationalization and integration initiatives, which were substantially completed by the end of 2013. However, certain costs may still be incurred in 2014. Since the acquisition date, total costs of $181.3 million (including (i) $109.2 million of restructuring expenses, (ii) $32.2 million of acquisition-related costs, which excludes $24.2 million of acquisition-related costs recognized in the fourth quarter of 2012 related to royalties to be paid to Galderma S.A. on sales of Sculptra®, and (iii) $39.9 million of integration expenses) have been incurred through December 31, 2013. The estimated costs primarily include: employee termination costs payable to approximately 750 employees of the Company and Medicis who have been terminated as a result of the Medicis Acquisition; IPR&D termination costs related to the transfer to other parties of product-development programs that did not align with our research and development model; costs to consolidate or close facilities and relocate employees; and contract termination and lease cancellation costs. These estimates do not include a charge of $77.3 million recognized and paid in the fourth quarter of 2012 related to the acceleration of unvested stock options, restricted stock awards, and share appreciation rights for Medicis employees that was triggered by the change in control.

This requires a little reading and comprehension - so lets break it the expenses actually incurred to date.

* 109.2 million of restructuring expense,
* 32.2 million of acquisition related costs
* a further 24.2 million of "acquisition-related costs recognized in the fourth quarter of 2012 related to royalties to be paid to Galderma S.A. on sales of Sculptra®," [I will get back to this.]
* a further $39.9 million of integration costs.

Also there are $77.3 million of acceleration of unvested stock options recognised and paid in the fourth quarter of 2012. That adds up to 205 million plus the additional $77.3 million which really looks like purchase consideration. Its a little shy of the $275 million originally suggested unless you include the purchase consideration.

Many people suggested my calculation as to whether this charge was silly should have allowed for substantial lease breaking costs and the like. There is a table in the form 10-K which dismisses that but which does not quite reconcile with the numbers above.

The following table summarizes the major components of restructuring costs incurred in connection with Medicis Acquisition-related initiatives through December 31, 2013:

		Employee Termination Costs								IPR&D Termination Costs				Contract Termination, Facility Closure and Other Costs
		Severance and Related Benefits				Share-Based Compensation(1)												Total
Balance, January 1, 2012		$	—			$	—			$	—			$	—			$	—
Costs incurred and/or charged to expense		85,253				77,329				—				370				162,952
Cash payments		(77,975		)		(77,329		)		—				(5		)		(155,309		)
Non-cash adjustments		4,073				—				—				(162		)		3,911
Balance, December 31, 2012		11,351				—				—				203				11,554
Costs incurred and/or charged to expense		20,039				—				—				3,550				23,589
Cash payments		(31,409		)		—				—				(3,575		)		(34,984		)
Non-cash adjustments		275				—				—				(178		)		97
Balance, December 31, 2013		$	256			$	—			$	—			$	—			$	256

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(1)	Relates to the acceleration of unvested stock options, restricted stock awards, and share appreciation rights for Medicis employees that was triggered by the change in control.

Whatever: contract termination is trivial - under $4 million in a very big restructuring pool.

More interesting though is what is not included in this table. We above calculated that $205 million of restructuring expenses were incurred plus the share based compensation, and this table contains less than $110 million of those expenses.

Acquisition-related costs recognized in the fourth quarter of 2012 related to royalties on sales of Sculptra

The mischief alleged in Post III is that ordinary expenses are being dumped in the restructuring budget meaning the GAAP earnings, not the GAAP earnings net of restructuring charges are the more accurate way of assessing this business.

There is a disclosure above I needed to read twice to understand. It says that they have categorized as a one-off expense related to the Medicis merger $24.2 million  royalties to be paid to Galderma S.A. on sales of Sculptra.

Sculptra came with the acquisition of Dermik Pharmaceuticals from Sanofi for $425 million - it is hard to see how these are restructuring expenses related to the Medicis merger. Sculptura was always subject to royalty payments to be made to Galderma. Those royalties were paid in advance as part of a legal settlement with Galderma. So - guess what? They classified them as a "one-off" expense.

Now this is clearly stretching it. The revenue from selling those pharmaceuticals is ordinary income. The expense associated with selling them is classified as "non recurring". This is a defining example of the mischief that I believe is happening at Valeant. The company is explaining away its losses (yes GAAP losses) by asking you to ignore certain expenses as "one-off" and those expenses include expenses necessary to sell drugs that they sell on an ongoing basis.

What are the other expenses?
As noted the table above includes only $105 million of $205 million of so called "one-off" expenses incurred. $24.2 million of the remainder was what I am pretty sure was ordinary recurring expenses (royalties on products they sell). Is the rest also mislabelled "one-off"? You can't tell as no information is provided.

The Trust Me story

Ultimately this is a trust-me story. In Valeant, and its CEO Mike Pearson we must trust.

The GAAP accounts for Valeant show large and increasing losses. They have $17 billion in debt.

If the GAAP accounts are the beginning and the end of the story then Valeant is headed to bankruptcy court.

Valeant's CEO and investor relations function want you to ignore the GAAP accounts. They classify quite literally billions of dollars of expense as "one-off" and ask you to ignore that expense and look at the earnings net of "one-off" expenses.

At no point does the auditor audit the statement that they are one-off expenses. You need to trust the management, the CEO and the information they give you. It is a trust me story.

This blog series has shown reasons for not trusting.

Part III demonstrated that the expenses associated with the Medicis merger were very large relative to the employee and capital bases of Medicis. This part made minor corrections (the employee base of Medicis was larger than indicated in Part III) but also demonstrated that the large expenses were not associated with breaking contracts or facility closure (as suggested by some of my critics).

Moreover this part showed some expenses classified as one-off (royalties) were likely to be recurring expenses and hence misclassified. That gives you reason to doubt the management when, more generally, they say you should assess Valeant net of billions of dollars of restructuring expenses.

In future posts I will more directly examine the credibility of Mike Pearson. Till then, happy reading and comments (positive and negative) are appreciated.

John