Monday, June 30, 2014

The miserable circle of bad service: Telefonica edition

One of the puzzles of this world is why European phone revenues per customer are so low - and sustainably so. If there were any sign that these would rise then European telecom stocks would be a steal... but alas no sign...

Part of it is clearly usage. If you are French there is just a much narrower range of services on your phone for you to use. The average Frenchman with a smart phone uses less than a fifth the data of an American - and at least part of the reason has to be that there is less content in French.

Sitting in a cafe in Paris (even possibly a Starbucks) and seeing the usage you think that will change. The young speak English or at least use the net like Americans.

Data usage can't be all of it. Data speeds in most of Europe suck compared to the US or Telstra in Australia - and you will use the phone more if it delivers you information faster and more reliably. Better service costs more to provide - but average revenue per user is so much higher in America it more than pays for that.

But some of it has to be the special incompetence of European phone companies. They make Comcast look like customer friendly people. Truly.

I have an O2 [ie Telefonica] sim-card I use in Europe and with an Australian credit card it is simply impossible to top up. Telefonica are so obsessed with credit-card fraud risk (simply controllable by using PayPal for instance) that they refuse revenue opportunities. Fat ones from people who are price insensitive and need data everywhere.

There is a special place in hell for management of European phone companies - the people that will ensure that Europe disconnects itself from the new world. If you need a reason why Europe will lose in any new economy look no further.

Having spent thirty minutes unsuccessfully trying to top-up I am wishing for a new Spanish inquisition. Actually I am expecting one [if only so I can link the Monty Python sketch...]


Wednesday, June 18, 2014

Valeant Pharmaceuticals Part VII: First notes on the special conference call

Valeant Pharmaceuticals yesterday held its "facts-based" conference call. There were plausible denials of several things that have been suggested in this blog and one flat acceptance.

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".

Indeed I think that is the likely outcome and was consistent with the conference call. Again I will stick to the Medicis  merger.

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.

To quote:

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.

Tuesday, June 17, 2014

Valeant Pharmaceuticals Part VI: a first question on corporate jets

A simple question. Is any part of the four (?) corporate jets ever put into the one-off basket like royalties (which were continuing) for Galderma?

For reference - future post coming - this is the largest corporate jet. It is basically the fastest, longest range and most expensive corporate jet on the market. It is a Gulfstream 650...

PS: There were denials (plausible) of many of my assertions in the conference call. However they simply admitted the piece about the royalty paid to Galderma. They accrued a liability for ROYALTIES on Galderma and wrote that royalty off against current earnings thus raising the "cash EPS" during that period.

Given they are selling the product they are going to reverse the rest of that liability through the purchase price. [Simply they will not receive the whole purchase price in cash - some of it will be cancelling a liability they have accrued.]


Valeant Pharmaceuticals Part V: Share pledges

Today is the day of Valeant's "fact based" presentation. As I demonstrated in Part IV you need to verify "facts" presented by Valeant. Mr Pearson (the CEO) stated categorically that Valeant bought their debt down quite quickly after the Biovail merger. They did not.

So here is a "fact" that I would like clarified.

One of the great bull stories of Valeant is how the CEO, Mr J Michael Pearson, is a "hidden billionaire" who can't sell any of his stock until 2017.

Bill Ackman of Pershing Square, Valeant's partner in its campaign to buy Allergan, says:
“Now how is management compensated? This is one of the more unusual and leveraged shareholder aligned compensation packages we've ever seen. So the way it works for Mike and Howard, the CEO and the CFO of the company, if over the period of their long-term incentive compensation grant, which are typically long-term periods, the company's share price, the total return does not equal or exceed 15%, they get no long-term incentive compensation. If it's above 15%, they get 100% of their PSUs vest. If it's above 30% compounded, they get 200%. If it's 45% compounded, they get 300%. At 60%, they get 400% of their PSU grant. So that, again, focused on IRR on a long-term basis. And then it's not just that they get compensated, but they receive stock in the company that they can't sell. Mike owns 10.6 million shares. He's sort of a hidden billionaire. He can't sell this stock until 2017. So we like that long-term alignment and that leveraged compensation for performance.” [Source: Transcript of Investor Meeting dated April 22nd, 2014, Page 16 - however you can find an edited version in this SEC file.]
There are dozens of such statements and restrictions on selling shares apply to many senior managers. This is a key part of the bull case.

Mr Ackman's statement was made in a presentation filed the day after the proxy was filed. Just the day before Valeant disclosed that the CEO had pledged a quarter of a billion dollars worth of stock. See this quote:
Because of the expansive share ownership requirements applicable to Mr. Pearson, the Board has permitted Mr. Pearson to pledge certain of his shares. As of March 31, 2014, Mr. Pearson had pledged 2,028,516 shares, representing approximately 19% of his shares beneficially owned (including purchased shares, shares received in settlement of equity compensation awards, and shares underlying vested but undelivered awards and vested but unexercised options). In addition, the Valeant shares held by Mr. Pearson that are not subject to pledging arrangements far exceed the Company’s general share ownership guidelines (requiring executives to hold shares with a value equal to or greater than two times the combined amount of their base salary and target annual cash bonus). Notwithstanding the large number of un-pledged shares that Mr. Pearson continues to own, the Board, together with the Talent and Compensation Committee and the Nominating and Governance Committee, has committed to reducing the level of pledging generally at the Company in the future. Valeant has adopted a policy disallowing future pledges unless an exception is approved by the Board and will consider permitting Mr. Pearson to sell shares to reduce the level of pledging.

There are three key details: (a). Mr Pearson has been permitted to pledge over two million shares (more than a quarter of a billion dollars), (b) there is pledging throughout the company that the compensation committee is committed to reducing and (c) to that end Mr Pearson may be permitted to his shares.

Pledging has been used by several CEOs to effectively sell shares without fully disclosing the sales and sometimes in contravention of employment rules. ISS, a leading shareholder advisory service, has been targeting pledging and hedging of corporate stock as a governance issue for some time. Dodd Frank also made recommendations on the issue.

The proxy discloses that the pledge was made "in connection with loans used to fund tax and other obligations associated with vesting and delivery of equity incentive awards and purchases of Company shares". This seems unrealistic as most tax bills come only on the selling of those shares and a quarter of a billion dollars is a rather large pledge.

I have some questions:

Question 1: What sort of transaction has Mr Pearson pledged the shares for? An equity swap (which is a de-facto share sale)? Maybe a loan? The shares then will be sold if the stock goes down - and Mr Pearson gets to keep the cash. Or is it for something else?

Question 2: And under what circumstances will Mr Pearson be allowed to sell shares contrary to the employment contract detailed by Mr Ackman?

You can't tell from the disclosure but it is possible that Mr Pearson has - contrary to the myths around Valeant - taken a couple of hundred million dollars off the table. I have learned that statements by Mr Pearson (such as the statement about bringing debt down quite quickly) need to be verified. Mr Ackman almost certainly wrote his long presentation several days before the proxy was filed and probably did not learn about the pledge until after he wrote his presentation.

Question 3: The compensation committee is "committed to reducing the level of pledging generally at the Company". Which other executives have pledged shares, in what quantity, and are those pledges properly disclosed in public filings (especially in filings regarding executive compensation)?

The proxy also discloses that the company only adopted an "anti-pledging policy" in 2014. Moreover that "anti-pledging policy exempts existing margin and accounts and pledging accounts, which are permitted to continue until they expire, and allows the Board to make further exceptions to the policy when determined by the Board to be in the best interests of the Company".

Some will argue that I am being pedantic. A quarter of a billion dollars (the value of Mr Pearsons pledge) is small compared to the value that Mr Pearson has has created at Valeant - a company worth over 40 billion.

After all, what is a quarter of a billion dollars between friends?


Monday, June 16, 2014

Valeant Pharmaceuticals Part IV: Fact based discussions about the reduction of debt

Recent release: Valeant Pharmaceuticals International, Inc. (NYSE: VRX) (TSX: VRX) today announced that it will conduct a fact-based presentation to refute recent misleading assertions made by Allergan, Inc. (NYSE: AGN) and others, as well as answer additional investor questions, on June 17, 2014.

As stated: the presentation Valeant is making is "fact-based". The alternative is unthinkable.

However I want to ensure that prior to the presentation my readers know that you must physically check "facts" that Valeant and their management state. Let me demonstrate with a single seemingly irrefutable example:

Here is Mike Pearson, the CEO of Valeant talking about his strategy in the context of the (not-consummated) merger with Cephalon.

Michael Pearson, chairman and CEO of Valeant... by tvnportal

I have started the video at 4 minutes and 3 seconds. Mr Pearson is answering a question about their acquisition spree.

Interviewer: Now Mr Pearson, you have been on a little bit of a spending spree lately. I understand that you have made something like twenty acquisitions in the past three years and now we hear that Standard and Poors is putting you on a little bit of a watch because of your debt situation why do you think this is the right strategy for your company.
Mike Pearson: Well it has been the strategy ever since I got there. It is not a change in strategy. Its what we have been doing. We have successfully raised debt historically and we believe that we will be able to pay down the debt quite rapidly if we are able to consummate this transaction. We have done that in the past. When we merged with Biovail our debt actually went up and we brought it down quite quickly since that time and we plan to do the same with this. 

Now this is not a forward looking statement. And for an acquisitive finance-driven CEO its a number that he should not get wrong. Level of debt is a deterministic and audited number. A "fact based" number - or dare I say it - a "reality based" number.

Anyway the Biovail merger closed on the 27 September 2010 with the legacy Valeant shareholders being paid a special dividend.

Here - courtesy of Capital IQ - is the net debt (in millions of USD) for Valeant every quarter from June 2010 onwards. The June 2010 debt is the debt in legacy Biovail (which was later renamed Valeant).

Balance Sheet as of:Total Cash & ST InvestmentsTotal DebtNet Debt

Now Valeant bid for Cephalon in 2011 when this video was filmed.

In that period there is a single quarter when the net debt fell - and that was by less than 6 million dollars. Gross debt (ie before cash and short term investments) fell in that quarter by more but only at the cost of running down the cash balance. The falls are marked in red (one occurs after the period in question and is the result of selling shares for cash). [The other period in which debt fell it fell because of selling additional shares for cash which was used for the Bausch + Lomb acquisition.]

On the face of it - using the numbers above, the statement that they bought debt down quite quickly after the Biovail merger looks like a porky. But there is an alternative hypothesis - which is that Valeant management have a different view to me on what it means to bring debt down quite quickly. They might mean debt to net assets (but even that is problematic in a company with losses). They might mean debt to cash flow (except that has risen too though not quite as monotonically.)

So for the "fact based" presentation I ask only one thing of Valeant management. The "facts" need to be verifiable - in such a way when I have a different interpretation than you I can see the difference.


Friday, June 13, 2014

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). 


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.


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
Facility Closure
and Other Costs
Severance and
Related Benefits
Balance, January 1, 2012





Costs incurred and/or charged to expense





Cash payments

Non-cash adjustments




Balance, December 31, 2012





Costs incurred and/or charged to expense





Cash payments


Non-cash adjustments




Balance, December 31, 2013





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.


Thursday, June 12, 2014

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:
Cash And Equivalents
Short Term Investments
Total Cash & ST Investments
Accounts Receivable
Total Receivables
Deferred Tax Assets, Curr.
Other Current Assets
Total Current Assets
Gross Property, Plant & Equipment
Accumulated Depreciation
Net Property, Plant & Equipment
Long-term Investments
Other Intangibles
Deferred Tax Assets, LT
Deferred Charges, LT
Other Long-Term Assets
Total Assets
Accounts Payable
Accrued Exp.
Curr. Port. of LT Debt
Curr. Income Taxes Payable
Unearned Revenue, Current
Other Current Liabilities
Total Current Liabilities
Long-Term Debt
Other Non-Current Liabilities
Total Liabilities
Common Stock
Additional Paid In Capital
Retained Earnings
Treasury Stock
Comprehensive Inc. and Other
Total Common Equity
Total Equity

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.


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.


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.

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