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

____________________________________

(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

Valeant Pharmaceuticals Part III: Assessing the one-off charges from the Medicis merger

In Part II of this series I explained how to look at Valeant Pharmaceutics GAAP and non-GAAP accounts. In particular I showed how the GAAP accounts show large and increasing losses which the company asks you to look through. Instead they prefer you look at earnings disregarding large and increasing "merger and restructuring charges", "asset writedowns" and "legal settlements".

This is a reasonable thing to do if you think these charges are (a) reasonable and (b) non-repeating.

If the "one-off charges" are not really "one-off" then the "non-GAAP" earnings (presented net of these charges) are a fraud on the gullible.

This is the central point of the series. It would be dead-easy to fake "earnings after one-offs" by putting ordinary expenses in the restructuring budget. I could make margins almost as large as I liked by telling you to ignore costs. Take an extreme example: if I called marketing expenses one-off (and put them in a bucket which I ignored) my margin would look much higher. Telling you to ignore those expenses of course is a sort of con - a Wizard of Oz trick where you tell people to "ignore those expenses by behind the curtain".

The "non-GAAP" earnings presented by Valeant however are not audited. GAAP accounting does not ignore the one-off expenses. The question is whether you - as an inventor - should ignore them like management encourages you to do.

The purpose of this post is to assess whether one-off charges as booked by Valeant are reasonable.

To assess reasonableness I looked at a few mergers where the acquired company had public accounts prior to the merger. It is against those accounts and that business said merger charges arise.

I start with the Medicis Pharmaceuticals merger.

Here, from Medicis's last filed annual report on Form 10-K here is the business description:

Medicis Pharmaceutical Corporation ... together with our wholly owned subsidiaries, is a leading independent speciality pharmaceutical company focusing primarily on helping patients attain a healthy and youthful appearance and self-image through the development and marketing in the United States (“U.S.”) and Canada of products for the treatment of dermatological and aesthetic conditions.  

Also according to that form 10-K Medicis had 646 full-time employees. No employees were subject to a collective bargaining agreement, and as seems obligatory in a 10-K they believed they had good relationships with their employees. 253 employees were in sales.

Medicis was acquired by Valeant during the year following these disclosures - and the deal closed in December 2012.

The Valeant form 10-K for the year ended December 2012 gives details on the merger including the restructuring charge. Our job in this post is to assess whether those charges are reasonable.

If they are reasonable then we can accept the "non-GAAP" earnings. If they are not reasonable then the "non-GAAP EPS" is a Wizard-of-Oz style con.

Here is what the 10K says about the charges.

Medicis Acquisition-Related Cost-Rationalization and Integration Initiatives 

The complementary nature of the Company and Medicis businesses has provided an opportunity to capture significant operating synergies from reductions in sales and marketing, general and administrative expenses, and research and development. In total, we have identified approximately $275 million of cost synergies on a run rate basis that we expect to achieve by the end of 2013. This amount does not include potential revenue synergies or the potential benefits of expanding the Company corporate structure to Medicis’s operations. 

We have implemented cost-rationalization and integration initiatives to capture operating synergies and generate cost savings across the Company. These measures included: 

We estimated that we will incur total costs in the range of up to $275 million in connection with these cost-rationalization and integration initiatives, which are expected to be substantially completed by the end of 2013. $85.6 million has been incurred as of December 31, 2012. These costs include: 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; 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.  

See note 6 of notes to consolidated financial statements in Item 15 of this Form 10-K for detailed information summarizing the major components of costs incurred in connection with our Medicis acquisition-related initiatives through December 31, 2012.

The first thing to note is the quote that says that the costs include "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".

This is a surprising number - at the last 10-K (admittedly released about nine months prior to the merger) Medicis only had 646 full time employees. The termination of 750 people looks aggressive. If the reserves for this are unreasonable the non-GAAP earnings are also unreasonable.

Providing for redundancies for 750 employees when you bought a business that only had 646 employees sounds like over-provision to me - but other people might have a different view and there were a large number of people fired. This article from the Phoenix Business Blog that 319 people were fired the day the merger closed and that they were paid two months pay in lieu of notice. Two months pay time 319 people gets nowhere near the $275 million provision in the above quote. We need to look elsewhere.

More generally we should compare the total charges disclosed or anticipated ($275 million) to the pre-acquisition balance sheet of Medicis. If for example the pre-acquisition balance sheet contained only $20 million in plant it would be unreasonable to write off $100 million. The excess write-off would create a cookie jar which could be used to fake non-GAAP earnings. Indeed that is the central allegation we are addressing.

Here is the final quarterly balance sheet for Medicis as an independent company:

Balance Sheet as of:	Q3 Sep-30-2012
Currency	USD
ASSETS
Cash And Equivalents	130.1
Short Term Investments	629.8
Total Cash & ST Investments	759.9
Accounts Receivable	145.8
Total Receivables	145.8
Inventory	34.9
Deferred Tax Assets, Curr.	73.5
Other Current Assets	54.5
Total Current Assets	1,068.6
Gross Property, Plant & Equipment	-
Accumulated Depreciation	-
Net Property, Plant & Equipment	32.5
Long-term Investments	12.8
Goodwill	202.7
Other Intangibles	452.6
Deferred Tax Assets, LT	59.0
Deferred Charges, LT	11.9
Other Long-Term Assets	23.7
Total Assets	1,863.8
LIABILITIES
Accounts Payable	77.4
Accrued Exp.	224.8
Curr. Port. of LT Debt	0.2
Curr. Income Taxes Payable	-
Unearned Revenue, Current	11.4
Other Current Liabilities	77.2
Total Current Liabilities	391.0
Long-Term Debt	594.7
Other Non-Current Liabilities	50.2
Total Liabilities	1,035.9
Common Stock	1.1
Additional Paid In Capital	851.3
Retained Earnings	571.1
Treasury Stock	(578.7)
Comprehensive Inc. and Other	(17.0)
Total Common Equity	827.8
Total Equity	827.8

The source is CapitalIQ but it checks against their last 10-Q. 

This balance sheet matches the final Form 10-Q for Medicis as an independent company.

Not all of these assets are subject to write-down or balance sheet adjustment on acquisition. For instance the cash and short-dated securities are almost certainly able to be converted to cash near par and hence money-good. No write-down there. It might be true that the accounts receivable are not entirely solid, but you would think they are mostly money-good, after all the customers before the merger were roughly the same people as the customers after the merger. And it doesn't make sense to write down the tax assets - after all Valeant is claiming that these are very profitable businesses after the merger - so former tax losses are probably money good.

Writing down intangibles is a wash and has no effect on Valeant's accounts. Valeant has to work out what each of the tangible assets is worth at acquisition, and using this new balance sheet and the price they acquired they deduce the goodwill to add to their own balance sheet. They could write-off some of the property plant and equipment. I guess at the same level they could provide some liabilities, eg they could have a provision for sacking staff. However the main liabilities (long term debt and the like) are not subject to much write-up either. [Looking at a balance sheet usually the debt is a solid number!]

So lets do a (im)plausibility check - lets imagine a write-off so large it is implausible (at least if the business was worth buying for $2.6 billion. Here goes:

Suppose - and this is very nasty, 

*. that half of the receiveables are bad 

*. and half of the inventory has to be written off, 

*. and the entire net property, plant and equipment needs to be written off. 

*. And further suppose they have to sack every one of the 646 full time employees and provide $200 thousand per employee (and suppose we provide this notwithstanding that the Phoenix Business Blog suggested that most those employees were paid only two months salary). That might give us the largest plausible provision. 

So the answer is $252 million which even with these extreme assumptions is not as much at the $275 million stated in the Valeant form 10-K.

The $275 million number looks like a porky to me. It sure as hell looks like the only way that you can get to that number is to dump ordinary expenses into the one-off bucket. And if you do that the "non-GAAP cash EPS" that the bulls in the company tout is rubbish.

The alternative hypothesis is that Medicis really was awful - and the receivables were bad, and the inventory did have to be written off, and the property and plant was useless because they moved all the manufacturing. And they were so efficient they got to sack 750 of their 646 staff.

Stranger things have happened in my investing travels. Maybe it is all reasonable after all.




John



Post script. Even Valeant managed to reduce the merger-charges. The 2013 form 10-K re-estimates the provision for this merger at $250 million and gives further break-up as per this paragraph:

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.

I wonder where in the P&L the difference between 250 million and $275 million appears. Whatever, both numbers seem very large to me.

So far the buy-case for Valeant looks weak.

However this is a single acquisition, Medicis, and the main products of that company Valeant are selling to Nestle. I would like to do this more generally but as a later post shows that becomes increasingly more difficult after the Medicis merger because the one-off charges are not sufficiently broken out by acquisition.



John

PPS. Someone on twitter is saying that - like the jobs - many of the restructuring expenses to do with the Medicis merger could have taken place in the pre-Medicis Valeant. I will try to address this in future posts.