Valeant Pharmaceuticals Part XII: the rolling solvency calculation

I am short Various parts of the Valeant capital structure and long a few thousand put contracts.

This is a bet that is levered to terrible outcomes at Valeant. It is not quite a bet on insolvency - but it is a bet on financial stress.

It is a very non-consensus bet. Valeant is considered extremely profitable. Bill Ackman gave a presentation that explained just how profitable Valeant is compared to average pharmaceutical companies and the numbers are breathtaking.

If Bill Ackman's assertion is correct (and it may be) then my bet is guaranteed to lose money.

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That said the enormous profitability of Valeant is not evident in the audited accounts.

Valeant's audited accounts show large an increasing cumulative losses.

The difference between the GAAP earnings and Valeant's cash earnings estimates are large restructuring and other charges which Valeant management assert are one-off results of acquisitions.

The argument is that if the acquisitions stop these one-off expenses will also stop and so the GAAP earnings will rise to converge with the so-called "cash EPS".

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The problem with this argument is that the one-off costs which are more than 100 percent of profits are not audited in that no auditor asserts that they are truly "one off".

You have to take management's word for it.

Some of these costs I have managed to verify are truly one off. In one instance I have verified the reverse, however that one instance was trivially small.

So you are really left with management's word.

At the end Valeant is a "trust me" story. The sole question is do you trust management and in particular their estimate of non-recurring costs. If you do you see a well run company at ten times earnings.

If you don't trust management then alas the company becomes very hard to value because there is clearly some truth in the management assertion of "one-off costs" and the true underlying earnings are somewhere between GAAP EPS and management's "cash EPS". Alas that is an enormous gap.

If 80 percent of the one-off costs are truly one-off my short is also a bad idea. Valeant would not be trading at ten time true earnings - but it would not be expensive.

For my short to be right I need a substantial proportion of the one-off costs to actually be recurring.

Genuinely this is an assessment I can't make.

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Still against GAAP cash flows Valeant looks insolvent. GAAP cash flow from operations over the past four quarters sums $1.3 billion and net debt is about $16.8 billion. There is also some compulsory capital expenditures which need to be funded out of cash from operations.

Consider this against personal finances: someone with debt more than ten times their cash flow is not obviously refinanceable. A company is more refinanceable than the person because a person needs to hold a fair bit back just to eat. The company can dedicate most of its cash flow to servicing debt. But this is edge-of-refinanceable whatever you want to count.

On the pure GAAP numbers this company looks particularly difficult especially as much of their debt needs to be refinanced starting in 2017.

Linked here is a Google Spreadsheet with the quarterly numbers for Valeant (and legacy Biovail) going back to the March quarter of 2007. The raw numbers come from CapitalIQ. The first three pages of the spreadsheet are my calculations from the raw numbers. [You can reconstruct the data if you wish.]

In this table - from 2011 only - I have listed

(a). the GAAP cash from operations,
(b). the sum of the GAAP cash from ops over the last 4 quarters
(c). the net debt at the end of the quarter
(d). the net debt averaged over the last four quarters

and (e) a calculation of the average debt divided by the cash from operations over the last four quarters.

The last calculation in appropriate for an acquisitive company as it accounts for the rising cash flow given acquisitions.

For the Fiscal Period Ending	Cash from ops	Cash from ops - trailing four quarters	net debt	net debt - averaged last 4 Qs	Average annual debt/cash from ops
3 months
3 months Q1 Mar-31-2011	86.3	304.8	4,310.3	2,569.7	8.4
Restated 3 months Q2 Jun-30-2011	190.7	386.5	4,304.9	3,611.9	9.3
3 months Q3 Sep-30-2011	173.7	449.3	4,969.4	4,194.9	9.3
3 months Q4 Dec-31-2011	189.8	640.5	6,480.6	5,016.3	7.8
3 months Q1 Mar-31-2012	167.2	721.4	6,671.9	5,606.7	7.8
3 months Q2 Jun-30-2012	254.6	785.3	7,161.3	6,320.8	8.0
3 months Q3 Sep-30-2012	166.8	778.4	7,382.2	6,924.0	8.9
3 months Q4 Dec-31-2012	67.9	656.6	10,110.1	7,831.4	11.9
Restated 3 months Q1 Mar-31-2013	255.3	744.6	10,203.4	8,714.2	11.7
Restated 3 months Q2 Jun-30-2013	305.1	795.1	8,254.7	8,987.6	11.3
3 months Q3 Sep-30-2013	201.7	830.0	16,808.4	11,344.1	13.7
3 months Q4 Dec-31-2013	279.9	1,042.0	16,779.4	13,011.5	12.5
3 months Q1 Mar-31-2014	484.3	1,271.0	16,787.4	14,657.5	11.5
3 months Q2 Jun-30-2014	376.0	1,341.9	16,763.1	16,784.6	12.5

Note that debt is 12.5 times GAAP cash flow. On the GAAP numbers the company looks extraordinarily difficult.

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It is even worse when you consider the GAAP cash flow has to fund some stay-in-business capital expenditures. Valeant is known for cutting capital expenditures to a minimum so this is not a big consideration but here is another table with the GAAP cash flows less capital expenditure compared to average debt.

For the Fiscal Period Ending	Capital expenditure	Free cash (ie cash from ops less capex)	Free cash, trailing twelve months	net debt - averaged over last 4Qs	Average net debt/cash from ops
3 months
3 months Q1 Mar-31-2011	(21.5)	64.8	270.1	2,569.7	9.5
Restated 3 months Q2 Jun-30-2011	(12.5)	178.2	342.2	3,611.9	10.6
3 months Q3 Sep-30-2011	(9.6)	164.1	396.4	4,194.9	10.6
3 months Q4 Dec-31-2011	(15.0)	174.8	581.9	5,016.3	8.6
3 months Q1 Mar-31-2012	(11.1)	156.1	673.2	5,606.7	8.3
3 months Q2 Jun-30-2012	(13.6)	241.0	736.0	6,320.8	8.6
3 months Q3 Sep-30-2012	(57.1)	109.7	681.6	6,924.0	10.2
3 months Q4 Dec-31-2012	(25.9)	42.0	548.9	7,831.4	14.3
Restated 3 months Q1 Mar-31-2013	(14.0)	241.3	634.0	8,714.2	13.7
Restated 3 months Q2 Jun-30-2013	(12.8)	292.3	685.3	8,987.6	13.1
3 months Q3 Sep-30-2013	(24.9)	176.8	752.4	11,344.1	15.1
3 months Q4 Dec-31-2013	(63.6)	216.3	926.7	13,011.5	14.0
3 months Q1 Mar-31-2014	(58.1)	426.2	1,111.6	14,657.5	13.2
3 months Q2 Jun-30-2014	(113.5)	262.5	1,081.8	16,784.6	15.5

On this measure the average debt is now 15.5 times the available cash flows to service it. There is a word for that: stuffed.

In other words if you believe the GAAP numbers this company is so dead it is pushing up daisies.

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The company however should not be dead if what the management says is correct. The management have continuously asserted that there are (literally) billions of dollars of non-recurring costs and that when there are no more acquisitions the operating cash flow will rise by billions of dollars.

If that is the case then the solvency calculations above are entirely moot. All will be well for the company.

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Strangely the solvency measure deteriorated sharply lately - rolling average debt is now 15.5 times trailing twelve month available cash flow - and that is despite it being more than a year since the mega-acquisition of Baush + Lomb closed. The company has done many small deals since - but the plausibility of one-off costs associated with old mega-acquisitions is declining.

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If you believe management vis the one-off costs incurred by Valeant then the solvency measure above - average debt to trailing cash flows - is going to improve dramatically over time.

My plan: to continue updating this post until either (a) the cash flows improve as management guides or (b) the company loses all credibility and maybe dies.

The whole process could take years. I am patient. I hope my clients are too. And as always I could be entirely wrong.

John

Nuskin - an MLM with wonky accounts

Regular readers will know that I am not an unbridled fan of multi-level marketing schemes MLMs - but I don't think they are all evil either.

They do provide a service that is valuable - they provide community support for whatever product they are selling.

But they have a tendency to sell the business opportunity rather than the product. And they have a tendency to decentralized law avoidance - for instance selling snake-oil cures in breach of FDA regulations.

I wrote a post once about good-and-bad MLMs - where I went through Avon and Pampered Chef as mostly good MLMs and Nuskin as a business built on decentralized law avoidance.

Herbalife was a fair way up the Pampered Chef end of the scale.

Nuskin sells mostly vastly overpriced vitamin pills. This is a picture of some:

Nuskin is in the process of blowing up.

Nuskin's main product is overpriced and is sold under the ridiculous label of "lifepak nano" as if they contain nano-technology. The pills promise "enhanced molecular delivery" without an explanation of what that might be. The pills are maybe 50, maybe 100 times overpriced. And they have a bunch of claims for them. Look at the original post for the whole comical list but they do (falsely) promise the fountain of youth. Here is one claim:

Advanced anti-aging formula helps protect the body with key nutrients such as NanoCoQ10™ and nano carotenoids*

The asterisk - which I am sure the distributors ignore - is to say that the claim is not evaluated by the food and drug administration.

But lets get into the true snake-oil here.

NanoCoQ10 utilizes cutting-edge nanotechnology to deliver highly bioavailable coenzyme Q10 for potent cardiovascular and cognitive benefits.

There was no asterisk where I took that quote from!

It is gobbledygook - but suffice to say that Coenzyme_Q10 is synthesized in pretty well all tissues in the body. There is some evidence that it reduces some headaches - so I guess there are cognitive benefits - if poorly explained.

Anyway - I am not writing about the business model - which on my observation differs substantially from Herbalife - I am writing about the accounts. And those are disastrous.

Here is the balance sheet:

June 30, 2014			December 31, 2013
ASSETS
Current assets:
Cash and cash equivalents	$	219,501		$	525,153
Current investments		14,227			21,974
Accounts receivable		41,712			68,652
Inventories, net		389,650			339,669
Prepaid expenses and other		180,957			162,886
		846,047			1,118,334
Property and equipment, net		429,332			396,042
Goodwill		112,446			112,446
Other intangible assets, net		79,258			83,168
Other assets		136,531			111,072
Total assets	$	1,603,614		$	1,821,062
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	35,836		$	82,684
Accrued expenses		383,012			626,284
Current portion of debt		99,828			67,824
		518,676			776,792
Long-term debt		111,621			113,852
Other liabilities		81,559			71,799
Total liabilities		711,856			962,443
Commitments and contingencies (Note 9)
Stockholders' equity:
Class A common stock – 500 million shares authorized, $.001 par value, 90.6 million  shares issued		91			91
Additional paid-in capital		410,440			397,383
Treasury stock, at cost – 31.3 million and 31.6 million shares, respectively		(844,615)			(826,904)
Accumulated other comprehensive loss		(42,284)			(46,228)
Retained earnings		1,368,126			1,334,277
		891,758			858,619
Total liabilities and stockholders' equity	$	1,603,614		$	1,821,062

And here is the P&L:

		Three Months Ended						Six Months Ended
		June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
Revenue	$	650,027		$	671,328		$	1,321,088		$	1,212,633
Cost of sales		156,010			111,273			262,654			201,318
Gross profit		494,017			560,055			1,058,434			1,011,315
Operating expenses:
Selling expenses		283,575			297,170			596,676			530,264
General and administrative expenses		155,705			148,302			305,824			283,809
Total operating expenses		439,280			445,472			902,500			814,073
Operating income		54,737			114,583			155,934			197,242
Other income (expense), net		(21,119)			(1,187)			(38,627)			(1,075)
Income before provision for income taxes		33,618			113,396			117,307			196,167
Provision for income taxes		14,111			38,961			42,946			67,450
Net income	$	19,507		$	74,435		$	74,361		$	128,717

Now I want you to notice $389 million in inventory versus six months cost of goods sold of 263 million. It has about 270 days of inventory. By contrast Herbalife has about 50 days of inventory.

It looks like Herbalife is professionally run and Nuskin is not.

But I think it might be worse. Nuskin has $389 million of inventory and the inventory is mostly vitamin pills. Can you imagine what $389 million in vitamin pills sitting in warehouses at production cost looks like? It is kind of strange thinking just how much that is...

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But the asset padding at Nuskin continues. It has less than half the sales of Herbalife but has $429 million of property plant and equipment. Herbalife has $363 million and that is after Herbalife has built some large impressive plants.

By comparison Nuskin seems profligate with plant - but hey - I have never seen one of their factories. Maybe they are gold-plated.

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But the whole thing becomes worse on the cash flow line. Herbalife is massively cash generative - almost comically cash generative.

Nuskin is not.

Here is Nuskin's cash flow statement.

		Six Months Ended June 30,
	2014			2013
Cash flows from operating activities:
Net income	$	74,361		$	128,717
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		24,965			15,527
Foreign currency (gains)/losses		48,264			863
Stock-based compensation		13,726			11,411
Deferred taxes		3,871			(2,901)
Changes in operating assets and liabilities:
Accounts receivable		27,121			(24,647)
Inventories, net		(54,218)			(45,228)
Prepaid expenses and other		(31,157)			(25,515)
Other assets		(14,797)			(10,987)
Accounts payable		(46,503)			3,593
Accrued expenses		(233,532)			132,787
Other liabilities		3,034			5,237
Net cash provided by (used in) operating activities		(184,865)			188,857
Cash flows from investing activities:
Purchases of property and equipment		(57,136)			(82,515)
Proceeds of investment sales		22,011			9,701
Purchases of investments		(13,655)			(5,077)
Net cash used in investing activities		(48,780)			(77,891)

You might notice that 186 million of cash was used in operating activities and a further 49 million was used in investing activities.

The cash balance dropped from $525 to $220 million. And there is a bunch of long term debt as well. It has more cash than long term debt - so survival is at least possible. But they better turn around awfully fast.

With Nuskin we have to analyse in terms of survival which is far from guaranteed just on the accounts.

It is that bad.

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Now as readers know I am a bit of a Herbalife fan. When I visit Herbalife distributors I see people providing a real service. The real service is emotional and physical support during dieting. Some sell Herbalife and run fitness clubs. Sometimes it looks more like a café. Some sell Herbalife out of "spiritual healing massage centres". Where I live in Australia it is often the personal trainers who sell Herbalife on the side - and comment (favourably I guess) on the new svelte bodies in their charge.

But in all cases there is a support network for dieting behind successful sellers. The product is not just the shake - it is the support network that goes with it - and the support network fits into the culture from where it is from. In Queens they reflect low-wage Hispanic workers. In more middle class areas of Miami the clubs are larger and better appointed. In Sydney they are fitness obsessed and at the beach and with upper-middle class customers.

And it shows. Herbalife generates more cash every year. The cash flow statement tells the story. This is for six months:

	Six Months Ended
		June 30, 2014				June 30, 2013
		(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	194,160			$	262,035
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			44,776				42,310
Excess tax benefits from share-based payment arrangements			(6,693	)			(15	)
Share-based compensation expenses			23,398				15,253
Non-cash interest expense			19,021				1,295
Deferred income taxes			(7,838	)			(7,939	)
Inventory write-downs			12,373				10,448
Unrealized foreign exchange transaction loss (gain)			2,532				(44	)
Foreign exchange loss relating to Venezuela			86,108				15,116
Other			3,717				(674	)
Changes in operating assets and liabilities:
Receivables			(1,163	)			(312	)
Inventories			(2,409	)			(14,094	)
Prepaid expenses and other current assets			(50,669	)			(13,150	)
Other assets			(4,642	)			(534	)
Accounts payable			13,038				4,586
Royalty overrides			(12,113	)			(2,051	)
Accrued expenses and accrued compensation			16,661				43,761
Advance sales deposits			20,915				4,481
Income taxes			(8,158	)			(12,546	)
Deferred compensation plan liability			4,569				3,527
NET CASH PROVIDED BY OPERATING ACTIVITIES			347,583				351,453
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, plant and equipment			(105,482	)			(56,048	)
Proceeds from sale of property, plant and equipment			11				33
Investments in Venezuelan bonds			(7,588	)			—
NET CASH USED IN INVESTING ACTIVITIES			(113,059	)			(56,015	)

Note 348 million produced in operating cash flows, 113 million consumed in investing (but that includes the construction of the above-mentioned large and impressive factory). I suspect investing cash drain falls and Herbalife becomes even more cash generative.

The net free cash after six months is 234 million or 470 million annualized. I suspect it will be higher because the investing cash use should drop.

This does not look expensive versus market cap (or even market cap plus net debt).

Its a real business, providing real and valuable service to at least ten million people - and it is highly cash generative.

But hey - that was where I started. Not all MLMs are equal. And not all outcomes are equal either.

Billy Bob shorted the wrong MLM.




John

Disclosure: Long Herbalife, short a little Nuskin. I regret not having the Nuskin short on earlier. The balance sheet was always a little stretched - the inventory build in 2013 was insane - and the business model did not make sense - but the denouement is more rapid than I thought possible.

At least one person I talk to got that entirely right including timing both the long Herbalife and short Nuskin legs.