The first observation is that Valeant's CEO Mike Pearson and I agree on the basic accounting issue at Valeant. [We have different views on the end-result.]
At the moment Valeant is loss making and if you look at their GAAP cash flows versus $17 billion in debt Valeant looks like it is going bust. Valeant has asked you to look not at GAAP EPS but at non-GAAP "cash EPS" which is net of one-time charges. If you believe the one-time charge number represents true one-time charges then you believe the Valeant story. If however ordinary expenses are put in the one-time charge number then you do not believe the "cash EPS number".
Here is Mr Pearson, from yesterday talking about how the acquisition team might not be able to do many acquisitions whilst they are awaiting the outcome of the Allergan deal:
Mr Pearson: I think a bit of a silver lining in this in that [Valeant are] not doing any other significant acquisitions at this time, will mean that our financial statements will actually begin to really demonstrate that our one-time costs are really one-time costs. And that you'll begin to see that GAAP and non-GAAP EPS and organic growth. Everyone will see that the business model is working.
It is of course possible that some of the one time charges are in fact one-time and some are in fact ordinary expenses that are misclassified as one-off. In that case the truth lies somewhere between GAAP numbers (large and increasing losses) and the non-GAAP "cash EPS".
There were some definite one-time charges. $109.4 million of the expenses on the Medicis merger were to fund layoffs. Even if I were to quibble about redundancies at the edge I would be forced to admit that most of those were mostly indeed one-off. [They did take a lot of redundancies - probably too many as they admitted later in the call.] Adjusting EPS by these one-time charges appears reasonable.
However it appears that I was entirely right about the Scuptura/Galderma royalty as per Post IIIA.
Howard Schiller (CFO): And one last assertion that I would like to address relates to royalties on Sculptra. There had been statements that this royalty to Galderma was an obligation that existed when we acquired the product from Sanofi in December 2011 and that we subsequently prepaid this royalty and charged it off as an acquisition-related cost at the time of the Medicis acquisition. The fact is that when we acquired Sculptra from Sanofi, there was no royalty obligation to any third party. In the fall of 2012, Galderma sued to enjoin Valeant's acquisition of Medicis, and Valeant later entered into a settlement with Galderma to allow the acquisition to be completed. The settlement included $15 million in upfront payments and a 5% annual payment on worldwide sales to Sculptra. Because Valeant did not receive any additional rights associated with Restylane, Perlane or Sculptra, both the $15 million upfront payment and the fair value of the future payments of $24.2 million were recorded as acquisition-related costs during the fourth quarter 2012. Of the $24.2 million that was reported, $2.6 million has been paid to date. The royalty obligation will be eliminated upon the sale of the Valeant injectable aesthetics business to Galderma, and the remaining balance will be reversed as a credit to acquisition-related costs at close and will not be included in cash EPS.
Lets read this. Valeant believed that when we bought the product from Sanofi there were no royalty obligations to any third party. Galderma sued and Valeant settled for cash including an up-front payment of $15 million and annual royalties of 5%. Now if there were no royalty obligations then Valeant would not normally settle. [This suggests at a minimum Valeant does not have an adequate patent database and patent lawyers.]
Having settled Valeant charged to one-time expenses $15 million plus $24.2 million for future payments as a legal settlement. The $24.2 million was the present value of future royalties they might have to pay. Now as they sell Sculptura they record as continuing income all sales but the royalties on those sales get netted off the 24.2 million they recorded. This is more or less precisely the suggestion I made. Income goes through the cash-EPS number, and expenses associated with that income go through the one-off charge line.
Moreover they have not yet paid out much of this Sculptura royalty - they still have, on their balance sheet, a liability for over $20 million - the future value of Sculptura royalties. They will cancel that as part of the sale of the aesthetics assets to Galderma. [So now there will be non-cash proceeds of asset sales.]
One cockroach, how many more?
The excess redundancies at Medicis
Mike Pearson admitted in the conference call that redundancies in the sales force at Medicis were inappropriate. Talking about potential redundancies at Allergan:
Mike Pearson: We plan to keep -- one thing that we've learned in the Medicis and B+L acquisitions is don't touch the sales force, right? I think in Medicis, we did touch the sales force, and that was problematic for a period of time. Our sales force in dermatology now has been stable for a few quarters, and quite frankly, all of our promoted products in dermatology are growing. And so that was a lesson we learned.
This completely matches your intuition (if they sack roughly 100 percent of the staff with an acquired company they will sack sales staff and the sales will go down). It also matches the scuttlebutt I have heard (the Medicis acquisition was a mess with respect to sales and contact with dermatologists). However it is contrary to previous comments by Mike Pearson.
In the first quarter 2013 conference call they told us these brands were doing great (that is just after they sacked the sales force):
Mike Pearson: ...Again, the Medicis brands that -- let me go through againat some portion. You don't have a slide to take a look at, but as I go to the Medicis brands, Ziana and Solodyn are both performing at expectation. Zyclara is a little bit behind and the Dysport, Restylane and Perlane, which are the aesthetics brands are performing ahead of expectations. In terms of what's happening in the marketplace, pricing is largely staying the same. We did take a price increase on Restylane in the first quarter of about 10%.
In the second quarter of 2013 the products were doing great too:
Mike Pearson: I am pleased to report that our aesthetics franchise has its best quarter since Medicis launched its aesthetic products. In particular, Dysport had its best quarter ever and gained significant market share against BOTOX and Xeomin.
They were doing great as late as the first quarter of 2014.
Mike Pearson: In aesthetics, I know there were some comments based on some survey in terms of our share. Our injectable sales, which would include Dysport and our fillers in the first quarter in the United States, grew 15%. I think I heard somewhere that it was cited the market grew at 11%. So I'm not familiar with that survey, but that would suggest we're gaining share, not losing shares. So we had very strong performance on the aesthetics side, continuous strong performance.
These are again the Medicis products.
Mike Pearson then adds:
And that's before the impact of the extra 100 people we have now hired.
This is the sales force that was originally fired being replaced. They really did need to rehire a dermatology sales force.
This is strange. Sales were great and increased market share every quarter after the Medicis acquisition but Mike Pearson admits that it was a mistake to touch the sales force and they needed to rehire sales people.
I have tried and tried to square the circle but I can't. There remains one tantalizing possibility - and that is that they simply changed the definition of a sale (and hence reported growth where there was none). This is somewhat supported by SEC filings. The 2013 Form 10-K discloses:
In 2012, consistent with legacy Medicis’ historical approach, we recognized revenue on those products upon shipment from McKesson, our primary U.S. distributor of aesthetics products, to physicians. As part of our integration efforts, we implemented new strategies and business practices in the first quarter of 2013, particularly as they relate to rebate and discount programs for these aesthetics products. As a result of these changes, the criteria for revenue recognition are achieved upon shipment of these products to McKesson, and, therefore, we began, in the first quarter of 2013, recognizing revenue upon shipment of these products to McKesson.
This is such a bold change in revenue recognition that it raised questions from the SEC who asked Valeant about it in formal letters (filed on the SEC site). The question asked is below:
SEC Question: You disclose that you changed the revenue recognition procedure for several brands acquired in your business combination with Medicis to now recognize this revenue upon shipment to your distributor instead of when this distributor ships products to physicians. Please provide us your analysis supporting this change in revenue recognition. In your response, please tell us why management of Medicis delayed recognition and what has changed, including what additional information you have, to permit you to recognize revenue for these products earlier than under Medicis’ policy.
You can find the question and answer provided by the company at this link. For students of revenue-recognition accounting the answer is flat funny (disguised in turgid prose).
Anyway, it seems they reported market share growth in part by changing the definition of sales.
And then they hope to solve that problem long term by hiring 100 sales people to replace the ones they fired.
Finally I should note that I am going to Europe mostly to meet with companies that we are invested in or might invest in. We are also meeting some clients. The frequency of posts on Valeant and other matters is likely to slow down.