Valeant Pharmaceuticals Part II: GAAP and non-GAAP accounts

In Part 1 I introduced Valeant Pharmaceuticals and its business model which is to acquire pharmaceutical companies, strip them of their research expense and earn very high gross margins on sales.

This has become a hugely successful stock, however you could not tell by looking at the GAAP accounts. Here is the P&L for the last five years, latest on the left, courtesy of Capital IQ. 

For the Fiscal Period Ending	LTM 12 months Mar-31-2014	12 months Dec-31-2013	Reclassified 12 months Dec-31-2012	Reclassified 12 months Dec-31-2011	Reclassified 12 months Dec-31-2010	Reclassified 12 months Dec-31-2009
Currency	USD	USD	USD	USD	USD	USD
Revenue	6,577.6	5,765.4	3,480.4	2,427.5	1,181.2	820.4
Other Revenue	5.6	-	-	-	-	-
Total Revenue	6,583.2	5,765.4	3,480.4	2,427.5	1,181.2	820.4
Cost Of Goods Sold	1,784.6	1,528.5	890.9	636.8	352.1	218.2
Gross Profit	4,798.6	4,236.9	2,589.5	1,790.6	829.2	602.3
Selling General & Admin Exp.	1,545.3	1,305.2	756.1	572.5	256.4	167.6
R&D Exp.	194.3	156.8	79.1	65.7	67.9	47.6
Depreciation & Amort.	-	-	-	-	-	-
Amort. of Goodwill and Intangibles	1,326.0	1,248.7	865.6	530.1	219.8	104.7
Other Operating Expense/(Income)	37.7	41.1	18.1	4.1	89.2	-
Other Operating Exp., Total	3,103.2	2,751.7	1,718.8	1,172.3	633.4	319.9
Operating Income	1,695.4	1,485.2	870.7	618.3	195.8	282.3
Interest Expense	(935.5)	(844.3)	(481.6)	(334.5)	(90.1)	(25.4)
Interest and Invest. Income	8.2	8.0	6.0	4.1	1.3	1.1
Net Interest Exp.	(927.3)	(836.3)	(475.6)	(330.4)	(88.8)	(24.3)
Currency Exchange Gains (Loss)	(24.3)	(9.5)	19.7	-	0.6	0.5
Other Non-Operating Inc. (Exp.)	-	-	-	7.5	-	-
EBT Excl. Unusual Items	743.9	639.5	414.8	295.3	107.6	258.5
Merger & Related Restruct. Charges	(969.5)	(923.7)	(501.8)	(170.8)	(253.3)	(35.6)
Impairment of Goodwill	-	-	(12.8)	-	-	-
Gain (Loss) On Sale Of Invest.	3.9	5.8	2.1	22.8	(5.6)	17.6
Gain (Loss) On Sale Of Assets	(10.2)	(10.2)	-	5.3	-	-
Asset Writedown	(734.9)	(783.2)	(212.9)	(132.9)	-	-
In Process R&D Exp.	(12.0)	-	-	-	-	(59.4)
Legal Settlements	(142.5)	(192.5)	(56.8)	(11.8)	(52.6)	(6.2)
Other Unusual Items	(133.6)	(50.2)	(26.8)	(25.9)	(32.4)	-
EBT Incl. Unusual Items	(1,254.9)	(1,314.5)	(394.2)	(18.0)	(236.3)	175.0
Income Tax Expense	(398.4)	(450.8)	(278.2)	(177.6)	(28.1)	(1.5)
Earnings from Cont. Ops.	(856.5)	(863.7)	(116.0)	159.6	(208.2)	176.5
Earnings of Discontinued Ops.	-	-	-	-	-	-
Extraord. Item & Account. Change	-	-	-	-	-	-
Net Income to Company	(856.5)	(863.7)	(116.0)	159.6	(208.2)	176.5
Minority Int. in Earnings	(4.8)	(2.5)	-	-	-	-
Net Income	(861.2)	(866.1)	(116.0)	159.6	(208.2)	176.5

It is that net income line at the end that sort of gets you. There are losses in all years except 2011 and large and increasing cumulative losses. The $866 million loss in calendar 2013 is a surprising number.

The losses are not quite so bad on an EPS basis because of a massively increasing share count, but these are hardly typical of a company with such a rapidly increasing stock price.

The losses however are net of vast "merger and restructuring charges", "asset writedowns" and "legal settlements" - so called "one-offs".

In 2013 merger and related costs were $923 million, asset write-downs a further $783 million and legal settlements were $192.5 million. These amounts constitute well over 100 percent of the loss recorded.

Net of these costs earnings are going up very nicely. The company actively encourages you to look at it this way - and the market has adopted that guidance (as reflected in the stock price).

Moreover this is precisely how they present it in analyst conference calls. Here is a slide from the 4Q 2013 conference call:

Note that the cash EPS reported ($6.24 per share profit) is considerably more attractive than the GAAP EPS (a loss of $2.70 according to the press release or Capital IQ).

And herein is the rub. Do you want to believe the GAAP EPS (in which case this company is a loss-making disaster) or do you want to look through the GAAP EPS and see what management directs you to, their definition of "cash EPS"?

In other words do you believe in the GAAP accounts or some non-GAAP accounts?

There is another way of saying this. To believe in the GAAP accounts you need to believe that the "one-off" charges are reasonable and truly one-off. [They are truly vast - so this matters.]

There is a possibility that the whole Valeant exercise is something from the Wizard of Oz. Profits are going up nicely if you pay no attention to that man behind the curtain - the man being the large restructuring and one-time items.

It would be an awful for investors if Valeant made its ferociously profitable budgets by putting any unwanted expenses (recurring or otherwise) into the "one-off" bucket.

And this is where we will start our long examination of Valeant. We want to work out whether the one-off charges are reasonable (in which case this is a great company) or whether they are inflated (in which case this is a Wizard-of-Oz-style con-on-the-market).

Till next time.





John

Valeant Pharmaceuticals International: an extended look

Valeant Pharmaceuticals is the hottest stock in the hottest sector (pharmaceuticals and biotech). It also has the strangest business model: it acquires existing companies, strips them of most of their research and development and a large proportion of their other staff and extracts huge margins.

As John Gapper observed in the FT: if the entire industry adopted Valeant’s approach, drug discovery would grind to a halt.

Gapper's article (accurately) stated:

Valeant’s business model is as simple as its accounting and tax structure are complex. While at McKinsey, Mr Pearson [the Valeant CEO] concluded that the industry he advised was spendthrift, not only in the sums it spent on headquarters and staff but in its investment in drug discovery. Employing scientists to search for new drugs was a waste of money because they often failed.

When he got the chance to put his ideas into practice he cut Valeant’s research to 3 per cent of revenues – compared with about 19 per cent at big pharma companies – and acquired products by buying other companies with debt. Valeant has taken over more than 35 companies since 2008, including Bausch + Lomb, which it acquired for $8.7bn last year.

To the extent that the stock price does the analysis this has been an outrageous success. The market clearly thinks Mr Pearson has the goods. This is one of those charts that is so good it makes no sense to view it in anything other than log-scale. 

The market cap is now over $43 billion. If you add in the net debt the enterprise value approaches $60 billion. This is one of the largest companies in the space by enterprise value. Enterprise value is over ten times historic sales (though somewhat less than that relative to the current sales run-rate). Whatever: this is very highly valued.

I am however a disagreeable person. I don't look at charts much - and my skill sets are accounting and tax driven. So I am inclined to take the accounting (and hopefully tax) issues head on and thus assess Mr Pearson's achievement. 

Alas - and I stating this in advance - this will be one of the more complicated projects this blog has and I have little idea how many posts this will take. I might learn a few things along the way too. So with the next post I will start you on the journey proper. Hopefully, dear readers, this will be useful for you too.

John

PS: In the interests of disclosure I should let you know I have done enough work in advance to have a position here. Short. 

Just what Canada needs: more exposure to a resource/China driven economy

Tony Abbott - the Australian Prime Minister - is in Canada at the moment. The Australian press reports that he is meeting a whole lot of fund managers to encourage them to invest in Australia. To quote the Murdoch National Newspaper (The Australian):

Mr Abbott is due to meet leaders from Sun Life Financial, the Canadian Council of Chief Executives, the Ontario Teacher’s Pension Plan, Barrick Gold, Barclays Canada, Saputo and Cameco.

I want to be blunt. There are advantages in investing in your own country: you know it better. You are less likely to make mistakes.

And there are reasons to invest overseas: you can get exposure to industries and economic cycles that might not be available at home. You get diversification.

Also every now and again a foreign market can become very cheap (not everywhere is in a bull market simultaneously). Blind Freddy could make money buying the Korean market at the height of the Asian crisis.

None of these reasons apply to a Canadian investing in Australia. Australia most certainly is not cheap. Sydney makes London and New York seem inexpensive.

And Australia and Canada have about the most similar economies in the Western World. We are large land masses, rich in resources, with small population bases and currencies and economies driven by Chinese resource demand. A Canadian investor in Australia gets little diversification benefit.

At the risk of seeming unpatriotic I am going to give you some advice. If you are a Canadian investment leader and Tony Abbott is seeing you today keep it brief. Don't waste his time or yours.





John

The lesson of today's New York Post Herbalife story

Today Michelle Celarier in the New York Post blew the cover of some fairly harmless anonymous blogger. You can read the story here and the blog here.

The lesson of this story is that the New York Post at an editorial level - and certainly at the Michelle Celarier level does not believe in anonymity.

Given that journalists rely on anonymous sources for stories this is career dangerous.

Michelle Celarier is now - as far as anyone who thinks journalists should protect anonymity is concerned - damaged goods.

It is so sad to see a journalist self-immolate in the pages of her own paper.




John



PS. For the record I have agreed with the anonymous blogger only sometimes.

The New York Times pile onto Insys

The New York Times picks up where this blog leaves off, piling onto Insys Therapeutics. To quote:

Interviews with several former Insys sales representatives suggest the company, based in Chandler, Ariz., has aggressively marketed the painkiller, including to physicians who did not treat many cancer patients and by paying its sales force higher commissions for selling higher doses of the drug. 

Under F.D.A. rules, manufacturers may market prescription drugs only for approved uses. But doctors may prescribe drugs as they see fit. Over the last decade, pharmaceutical companies have paid billions of dollars to settle claims that they encouraged doctors to use drugs for nonapproved treatments, or so-called off-label uses, to increase sales and profits. 

Drug-safety experts said the range of medical professionals who appeared to be prescribing Subsys was troubling, particularly given concerns about the widespread use — and abuse — of narcotic painkillers. In December, Insys disclosed that it had received a subpoena from the federal health department’s Office of the Inspector General for documents related to its sales and marketing practices. The company has said it is cooperating with the investigation.

Marketing the drug off-label is a criminal offence and as the drug has near substitutes it will not be much if any loss to consumers if this company were closed.

The Feds are clearly interested having indicted a doctor who was allegedly prescribing large quantities of the drug off-label.

Can somebody please explain to me why this company is trading at 21 times historic earnings and almost 7 times historic sales? Because I don't quite get it.





John

Insys Therapuetics issues a statement

Insys has issued a statement regarding their Subsys business...

Insys Therapeutics Issues Clarifying Statement


PHOENIX, AZ--(Marketwired - May 12, 2014) - Insys Therapeutics, Inc. (NASDAQ: INSY) today issued a clarifying statement regarding its Subsys® (fentanyl sublingual spray) product.

Insys takes patient safety very seriously and we are committed to working with physicians to help ensure the proper prescribing and use of our products.

In terms of our business, we have continually expanded our commercial organization since launch due to the success of Subsys in treating break through cancer pain in opioid tolerant cancer patients who are 18 years or older. As such, we have expanded our prescriber base and for 2014 year-to-date, no single physician has written more than 5% of total Subsys prescriptions.

Based on recent activity, we feel it is appropriate to summarize and address some of the important items regarding Subsys. Subsys is governed by the Transmucosal Immediate Release Fentanyl ("TIRF") Risk Evaluation and Mitigation Strategy ("REMS") Access program, which was approved and launched by the FDA in March 2012. lnsys began commercializing Subsys on March 26, 2012 after the implementation of this TIRF-REMS program.

This TIRF-REMS program is designed to ensure informed risk-benefit decisions before initiating treatment and appropriate use of TIRF medicines. The purpose of the TIRF-REMS program is to mitigate the risk of misuse, abuse, addiction, overdose and serious complications due to medication errors with the use of TIRF medicines. Subsys can only be prescribed after physicians have undergone training on the risks and benefits of such products and products can only be dispensed via pharmacies who are REMS enrolled. Additionally, all patients and physicians are required to sign a prescriber patient agreement form as part of this process. Insys continues to support the TIRF-REMS program that was co-developed with other participant companies. More information regarding the TIRF-REMS program can be found at www.tirfremsaccess.com.

Insys does not sell directly to physicians. lnsys only sells Subsys through DEA approved wholesalers who monitor and track prescribing activity for this TIRF class of drugs and all opioids. Insys remains committed to our compliance program and protocols in place that are designed to ensure our sales and marketing practices comply with applicable laws.

About Insys Therapeutics, Inc.
Insys Therapeutics is a specialty pharmaceutical company that develops and commercializes innovative products for supportive care of cancer and pain patients. Using its proprietary sublingual spray technology and its capability to develop pharmaceutical cannabinoids, the company addresses the clinical shortcomings of existing commercial products. The company currently markets two products, Subsys, which is sublingual Fentanyl spray for break through cancer pain, and a generic version of Dronabinol (THC) capsules. The company plans to file a New Drug Application (NDA) for an oral liquid formulation of Dronabinol in the second half of 2014 and believes it is a clinically superior product to current Dronabinol capsules. The company is developing a pipeline of sublingual sprays, as well as pharmaceutical CBD.

Forward-Looking Statements
This press release contains forward-looking statements including the statements related to plans to file a New Drug Application (NDA) for an oral liquid formulation of Dronabinol in the second half of 2014, the Company's belief that this oral liquid formulation of Dronabinol is a clinically superior product to current Dronabinol capsules and the Company's statement regard a pipeline of sublingual sprays, as well as pharmaceutical CBD. These forward-looking statements are based on management's expectations and assumptions as of the date of this press release, and actual results may differ materially from those in these forward-looking statements as a result of various factors, many of which are beyond our control. For a description of these risks facing the Company, please see the risk factors described in our filings with the United States Securities and Exchange Commission, including those factors discussed under the caption "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2013 and any subsequent updates that may occur in our Quarterly Reports on Form 10-Q. Forward-looking statements speak only as of the date of this press release and we undertake no obligation to update or revise these statements, except as may be required by law.

Contact:

Contact:

Lisa M. Wilson
President
In-Site Communications, Inc.
T: 212-452-2793
E: lwilson@insitecony.com


I will restrain myself to two things.

(a). They point out correctly they do not sell directly to doctors. No drug company does. Instead they educate doctors about the drug and hopefully the doctors write a script which is collected by the patients. This whole section elides the issue of how the incentive marketing scheme grates against the laws regarding off-label marketing and the like. It is the interaction between the incentive program and alleged off-label prescriptions by the indicted doctor that matter here.

(b). They observe that Subsys can only be prescribed under restrictive conditions... "Subsys can only be prescribed after physicians have undergone training on the risks and benefits of such products and products can only be dispensed via pharmacies who are REMS enrolled. Additionally, all patients and physicians are required to sign a prescriber patient agreement form as part of this process. Insys continues to support the TIRF-REMS program that was co-developed with other participant companies."

This does not match the alleged behaviour of the doctor in question who was allegedly prescribing narcotics for something that looked like carpels tunnel syndrome.


Just saying.




John