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.



Anonymous said...

I think you're reading the Sculptura "one-off" wrong. They aren't including it in the Medicis deal, but excluding it from their estimated charge for Medicis. However, it does appear that they are taking a one-time charge for Sculptura, which does not explain your position that they are recognizing sales but not expenses. Casual observer here, so there could be an explanation for this one-off.

Anonymous said...

Also, could it be that the "one-time" expense is capturing solely the upfront royalty payment, and not the on-going royalty? Lastly, Galderma sold products to Medicis, so per the linked press release it looks like that may be how the two are linked??

Anonymous said...

I hope you also look at the capital structuring side & balance sheet, like these guys did.

Unknown said...


Please double-check your math regarding note 6 from the '13 K.

RX exp. - $109.2

Q4 '12 exp: $85,253 + 370 = $85,623
'13A exp: $20,039 + 3,550 = $23,589

Total RX expenses: $109,212

The table is only a break-out of the restructuring expenses as stated. Per the 2012 10-K, "Acquisition-related costs ($32.2mm) also include expenditures for advisory, legal, valuation, accounting and other similar services." Hardly an egregious amount for a +2bn acquisition.

Regarding your concern of the $24.2mm royalty figure (of the original $39.2mm settlement), the logical explanation for why it is included in the Medicis acquisition area of the 10-K is that Galderma makes products for Medicis. As a result of the acquisition, they were going to produce the brand for Valeant moving forward (this was incorrectly reported in a BW article circa Dec. 2012).

You must reconcile this statement from the 10-K press release in order to determine which figure was added-back.

Total Q4 RX exp - $55.4
Total RX (less total Galderma pmt) - $16.2
Total RX (less Galderma royalty pmt) - $31.2

"Restructuring, acquisition-related and other costs of $261.8 million represent costs related to the acquisitions of Medicis, internal Valeant restructuring and integration initiatives, iNova, Dermik, OraPharma, Sanitas, Visudyne and Swiss Herbal. These include $52.6 million related to acquisition costs, $98.2 million related to employee severance costs, $77.3 million of stock base compensation, $30.5 million related to integration consulting, duplicative labor, transition services, and other, and $3.2 million related to facility closure costs."

gv said...

My 2cts
I assume that the license contract between Qmed and Medicis for the distribution of Restylane, etc,contained a rule that approval was needed in case of a transfer or merger. Whether one can agree upon this in case of mergers will be subject to discussion I guess.
This idea emerged when I read that Galerma needed the approval of Medicis the moment they took over the Swedish Qmed.
Qmed objected right after the merger become public and filed a lawsuit. However the matter was resolved quickly with a meagre payment of 24,5 M. My guess is that at that very moment they already agreed to sell the business to Galderma but for tax reasons the transaction had to be delayed and obfuscated.

Anonymous said...

Do you have evidence that Valeant always paid royalties to Galderma for Sculptura?

The lawsuit resulted from Galderma vetoing the transfer of exclusive rights in North America to Restylane and Perlane from Medicis to Valeant - given that Sculptura is a direct competitor.

It would make sense if they agreed on a royalty to compensate Galderma for the added future competition.

If that's the background previous royalties are unlikely but the royalties might be recurring.

gv said...

An overal comment on Valeant's strategy which I detest.
They express existing unrealized wealth by taking and merging companies in a tax free way for the company not for the selling shareholder, they cut costs which eliminates or reduces future wealth creation within the company and optimize aggressively the tax structure. The whole strategy is one of asset-conversion not going concern.
One day Michael Pearson will stand on a hill and draw a dollar sign in the sky.

Anonymous said...

The majority of broker research paints a totally different picture on Valeant Pharmaceuticals. There is generally no mention of GAAP financials, it's almost as if they are analysing a different company.

Where the analysis totally breaks down is the comparison of Cash EPS to GAAP BPS. How can you compare ratios calculated using totally different accounting treatment?

Anonymous said...

John, I've followed your writings for quite some time but this is the first time I've written as your recent series of posts are pertinent to one of my investments (I own shares of Valeant through a significant investment in Sequoia Fund). Given it's their largest holding, I'm particularly interested in a contrary view on the company. As noted by some others, what is your view with respect to Cash Flow from and Operations? I've spent little time on this thus far but in looking at the most recet 10K and 10Qs, it seems this is tracking to ~$2 billion run rate CFO (~9x Total Debt, ~30x EBITDA). From a valuation perspective, this seems really high, but not necessarily indicative of financial stress.

As an aside, I recently read The Outsiders and Pearson's strategy seems to share many of the characteristics of a classic roll-up. Depending how he uses their stock, I imagine this could ultimately be accretive to longer term shareholders. That said, I'm typically weary of rapid growth through acquisitions because it offers many opportunities to dump recurring costs and hide the financial profile of the company. My two cents for what it's worth. As always, I appreciate your insights.

Anonymous said...

I'm a little confused. They said they would expense and spend 250MM-275MM but they actually spent/expensed much less. Is that a problem?

Anonymous said...

I think your animosity with Ackman might be clouding your judgement. The statement released by Valeant said this:

The Company has incurred to date $55.4 million of transaction costs directly related to the Medicis acquisition, which includes $39.2 million of expenses incurred with respect to an agreement with Galderma S.A (“Galderma”) which, among other things, includes an upfront payment and royalties to be paid to Galderma on sales of Sculptra®. The agreement also resolved all claims asserted in Galderma’s pending litigation related to the Company’s acquisition of Medicis. Acquisition-related costs also include expenditures for advisory, legal, valuation, accounting and other similar services. These costs have been expensed as acquisition-related costs.

Now I don't need to read that twice to get that there is an upfront payment and ongoing royalties. Reading into both this statement and announcement of the settlement (which you linked), I would guess that Galderma had some clause that allowed them to stop producing products for Medicis upon a change of control. So they probably used that leverage to extract a both an up-front payment from Valeant and ongoing royalties on Sculptra. But then this is just a guess on my part. A reader should not put any credibility in this guess. On the other hand the reading of the statement above seems rather clear to me. You can call them all liars, but you certainly haven't provided any damning evidence...I await Valeant Part IIIB.

Anonymous said...

John – I think you’re reading the Sculptra payment incorrectly (as noted by another commenter above). VRX acquired Sculptra through its purchase of Dermik. Medicis paid Galderma royalties on Restylane/Perlane, which are both facial fillers which compete with Sculptra. When VRX sought to acquire Medicis, Galderma sued for a couple reasons 1) the main reason is that Galderma wanted US rights to MRX’s Dysport (competitor to Botox. If you read the documents you’ll see the Galderma CEO was quite upset he wasn’t able to buy MRX), and 2) because Galderma thought there was a risk that VRX would favor their own filler Sculptra (for which they paid no royalties) over Restylane/Perlane where they paid royalties to Galderma. In settling the suit VRX made an upfront payment to Galderma, which they called a non-recurring expense. They are also paying a royalty to Galderma going forward, which they are expensing as incurred.

Anonymous said...

John - I'll be very interested to hear your thoughts on CEO Pearson's credibility. I'd note a couple things -- he owns 4.2M shares and hasn't sold any yet. The long-term equity compensation strategy is very well aligned with shareholders -- much more so than most other companies I have looked at.

50% of long-term comp is time-vested stock options that vest ratably over 4 years. the other 50% is performance units (PSUs) which only vest if the stock price returns 30% over 3 yrs (for the 2012 and earlier PSU grants the 3 yr return thresh-hold was 45%).

The reason i bring this up is that the VRX bull story requires a lot of faith in mgmt and when I look at their incentive comp I see a CEO who is giving us a reason to believe he cares about long-term investors. Put another way, if this was a house of cards, wouldn't Pearson be cashing out by now? Or wouldn't he have set up his compensation in a way that allowed him to take more money out on the way up. Obviously this doesn't prove that VRX isn't faking it, but it doesn't line up with a company/CEO who's looking to cash out before his stock blows up.

Anonymous said...

So Valeant is a smoke and mirrors headed for bankruptcy, just like Fairfax was, right John?

Jon S. said...

I think some of the anon comments are interesting. Is there evidence Dermik ever paid royalties to Galderma? I couldn't find anything but wasn't searching hard.

Superficially, Nestle/Galderma comes out of these deals looking pretty crafty, Valeant not so much.

On another note, I think generally speaking the liability accrued under GAAP.

Anonymous said...

John, Is the GAAP even right? They seem to take a long time to collect from customers while having very little in the way of deferred revenue.

Will you address this at some point?

Andy Feinberg said...

John--I was long Valeant for many years but now I'm short. My sense, though, is that the truth lies somewhere between GAAP and "cash EPS." Some months ago, when I was still long, CEO Pearson said he was determined that Valeant become one of the five most valuable pharma companies in the world. That made me queasy. What a stupid corporate goal. Unless the sole point of corporate governance is to increase senior management compensation. (Hmmm.)

The huge bid for Allergan, and the seemingly desperate attempt to acquire it no matter what the price, makes me think about the spasm of acquisitions Tyco made in the year before it was uncovered as a partial fraud. Tyco had to keep making more and more large deals to keep up the mirage of ever-increasing earnings and to enable cookie-jar accounting (and some looting as well). Tyco CEO Kozlowski was a crook and a liar, but the company wasn't a complete sham. It made a lot of money, just not nearly as much as it alleged to the SEC and shareholders. Many parts of Tyco are publicly traded today and are thriving.

It seems pretty clear that Valeant needs to acquire Allergan so it can show decent growth next year. If that statement is true, isn't that disturbing on its face? Why can't it show decent EPS gains from organic growth and the acquisitions it has already made?

I look forward to reading the rest of your series.

Andy F

Anonymous said...

It is interesting to read Valeant's glassdoor reviews from current and former employees

Anonymous said...

I think you're stretching a little too hard to turn this into a fraud, when it's really just a misunderstood company and at worst a business model primed for a re-rating when the acquisition pipeline runs dry. Not just this post, but all of them so far you seem to misread pretty clear statements and disclosures to keep your narrative intact.

Just from a high level, the first thing that should be addressed is this underlying assumption that GAAP accounting is the be-all end-all for every company. Ask any manager (and I certainly hope you're aware of this) if GAAP does the best job of representing their operating results and they will tell you it isn't perfect. Most investors have learned by now that things like acquisition-related amortization, especially when a very large number, completely hides the company's profitability because it has to be included in operations. Why should a crappy deal my predecessors did 10 years ago that's still rolling off my balance sheet wipe out half my earnings that investors will use to value my company? I say this because Valeant has a huge amount of this amortization, and it's one of the many shortcomings of GAAP accounting.

Also - and I don't mean this personally at all - but have you really followed Valeant long enough to be the authority on what sounds like an attempt at a very deep-dive on the entire company? (and apparently the credibility in later posts) Just from the confusion surrounding the Galderma royalty charges it's clear you aren't familiar with these acquisitions, so it's surprising you'd have such conviction on this, but perhaps I'm basing too much on just a few of these posts.

I'd be curious to hear your thoughts about why the company has been the top holding of such intense fundamental investors like Ruane Cunniff, who are known for the extensive diligence, field research, character/background analyses, and 7+ year holding periods on their core investments (they've owned Valeant since 2010 maybe?)... not to mention ValueAct Capital, who had been inside the boardroom for 5+ years and never once sold a share? I won't even mention the dozens of other distinguished funds (given, many are momentum chasers or piggybacking the work of the two just mentioned) that have all examined the *VERY* old accounting argument before taking a position. Do you think they're all just missing something?

These bear arguments, as well as the credibility ones I'm sure you'll be bringing up, are very old and stale by now. So hopefully it won't include any of the following that I'm sure have been passed on to you by now...

-Pearson's alleged alcoholism in the past (which would be irrelevant anyway, but superficially sounds bad enough that it can't be disagreed with)

-Overly aggressive tactics at McKinsey in solving certain client requests

-Mike's badass basketball court (okay this one was a joke)

Anyway, I hope this is just food for thought and rest assured it's not even aimed at you personally, but really all the blogs/journalists/others who've written about Valeant with a negative bias without having spoken to the real shareholders on a point-by-point basis.

Llyod Christmas said...

I believe that you've truly cracked the case wide-open on Valeant. Thanks for all your research!

Anonymous said...

Some people overly focus on the misunderstanding of the origin of the Sculptura royalties.

Valeant's opex for Sculptura increases by the royalty because of the Medicis acquisition. But that does not allow them to bury that increase as Medicis restructuring charge.

How else would you get a fair representation of the profitability of Sculptura.

Also wouldn't you have to clearly disclose whether the royalty is recurring to give investors a fair picture of the profitability of Sculptura?

One has to assume it recurs since the marketing disadvantage due to Sculptura which the royalty is presumably meant to address is not one time.

Anonymous said...

John, Wasn't Baupost a big holder of HPQ when you were short? The names buying or shorting something shouldn't matter. There are always great investors on both sides of the trade.

Anonymous said...

What a stupid corporate goal. Unless the sole point of corporate governance is to increase senior management compensation. (Hmmm.)

Agreed and I don't get Tyco vibes but I do get very bad Boston Scientific/Guidant flashbacks. At least BSX was bidding against JNJ. VRX is so desperate for Allergan, they were bidding against themselves

I am following the series with interest but think that ultimately it doesn't much matter if they are playing find the queen with their one-offs. A company that lives by acquisition deserves to have that expense counted as a cost of doing business. If they want to cut R&D and instead spend on acquisitions, fine but it's a cost of doing business and not a one-off.

Kodak went along for a decade "one-offing" restructuring costs. A better way to look at that was as a legitimate business expense and it eventually turned out to be a tell and a signal to keep your money off the table.

Where VRX will run aground is when their access to credit dries up --already dangerously high and set to go redline when Allergan goes through. Their rates are 6-7% fixed and LIBOR+2.5% . These are killer in a low interest rate environment. Interest expense eats up huge amount of operating income even of the non-GAAP variety.

When credit stops, organic growth becomes essential and it ain't there. More troublesome than even the non-GAAP accounting is their insistence that the market look at their profits sans generics and patent loss drugs. This is their business and that will be their growth and it won't be pretty. They are in low margin generics, aging patents and low margin consumer products. Good luck when the acquisition grind to a stop.

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