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.



Anonymous said...

Doesn't he just mean Net Debt to EBITDA -- or the metric most commonly used by creditors to judge appropriate leverage?

John Hempton said...

He might mean that but it also isn't true. Net debt to [GAAP] EBITDA never goes down.

The only measure that goes down is debt to their non-GAAP "cash EPS".

The first four posts gave you a reason to doubt the "cash EPS" number - but it is your call on that. Relative to "cash EPS" this company looks fine.

Relative to GAAP numbers it looks awful.


Anonymous said...

But John, there's no such thing as "GAAP EBITDA" since EBITDA is by definition a Non-GAAP number. When financing decisions are made by lenders, underwriters, investors -- they are relying on the company's guidance on what should be considered "EBITDA" i.e. recurring profits that are unaffected by decisions made in any given year.

By your definition -- on "GAAP numbers", most cable companies never made any money during the 1980s and 1990s, including TCI. Yet, lenders who lent to John Malone were no fools and neither were his shareholders.

I am certainly not presumptuous enough to inform you about the limitations of GAAP accounting, you are well aware. I can only point out that with this post you are not making a new point, you are just repeating a point made in an earlier post -- which is that you think the Non-GAAP EBITDA/EPS/whatever-definition-of-profit number that Valeant reports is misleading and/or wrong, unrepresentative of run-rate ongoing profits. If one believes that and one believes Michael Pearson, in his heart of hearts also knows that, then yes, the accusation made in this post has merit. If one does not agree with that initial assessment, then it's hard to see how this current allegation breaks any new ground.

Your fundamental issue with the company remains the same -- will this be true for all future posts? If so, as a regular reader and huge fan, I am quite disappointed. Evidence needs to accumulate for a strong argument, synonyms don't make your case more worthwhile.

John Hempton said...

I know EBITDA is not a GAAP defined number. But even if you take off STANDARD amortization of intangibles, interest and depreciation you get the result.

EBITDA is defined in their debt covenants (which I have read).


Anonymous said...

Why do you use legacy Biovail debt in the first quarter? Shouldn't you use legacy Valeant debt since that's what he's talking about? Surely, he is using debt/EBITDA (as stipulated in debt docs) as a measure of indebtedness and not absolute debt levels. Similarly, the current deal will "delever" Valeant on debt/EBITDA levels but not absolute, as they have talked about.

John Hempton said...

Much of the old Valeant shares were cashed out. The debt was raised by Biovail (the surviving entity) to largely pay a special dividend to Valeant (the assumed entity).

So its not unreasonable. Moreover the debt is the exact series off Capital IQ. I did not want to muck the series up.

And the only question that matters to the quote is the debt AFTER the Biovail merger which Mr Pearson says comes down quite quickly. It does not.


John Hempton said...

Much of the old Valeant shares were cashed out. The debt was raised by Biovail (the surviving entity) to largely pay a special dividend to Valeant (the assumed entity).

So its not unreasonable. Moreover the debt is the exact series off Capital IQ. I did not want to muck the series up.

And the only question that matters to the quote is the debt AFTER the Biovail merger which Mr Pearson says comes down quite quickly. It does not.


Martin L said...

Loving the series - just had a gander at the proxy statement for the 2014 annual meeting: Looks like the board waived the bonus targets linked to reducing debt to recognise the acquisition of Bausch but DID not back out the revenue it acquired with Bausch in deciding whether or not revenue growth targets had been met (without the $1.35 billion in acquired revenue from Bausch they would have missed the $5.1 billion revenue target by some distance).

Brian Chan said...

From the footnote of Sequoia Fund 2013 annual report.

(1) This is a tricky number to calculate. Not all of our companies have reported 2013 earnings, nor are they all on December fiscal calendars. Importantly, Valeant and several others point investors to “cash earnings” that exclude non-cash charges like intangibles amortization and do not conform with Generally Accepted Accounting Principles. While we’re proud that our portfolio in aggregate grew non-GAAP, cash earnings by 23%, there is estimating involved on our part to derive this figure. Plus, reasonable people can disagree about the merits of non-GAAP earnings.

Anonymous said...

Might the CEO be referring to the specific loan or bond issue taken on to close the Biovail merger?

Anonymous said...

I agree with a previous anon. You're logic is circular and completely dependent on your analysis of their cash EPS number, which so far has left us with no smoking gun. Time spent proving that Cash EPS is misleading would be time well spent. The rest of this is just filler (e.g. Botox).

Foolish Jordan said...

Did you see you got quoted in Dealbook?

Anonymous said...

One area you might want to explore is the veracity of his research into returns on investment Pearson calculated most pharma didn't make positive returns on investments and Valeant naturally did

What should be verified is that he used formulas that were fair to pharma as compared to Valeant

I suspect he used EBITDA/invested capital sans goodwill. This would neatly remove the big expenses Valeant has by acquiring their pipeline and products (amortization) and at the same time penalize pharma that has to expense R&D.Basically this gives Valeant drugs for free while not cutting pharma the same deal

Unfortunately, Valeant doesn't reveal their calculations or their numbers. They won't talk to me but somebody with a little more heft might be able to get the information

Woody said...

John, I have to agree with you here, and thanks for doing all the work. He quite clearly says "pay down the debt" and "brought it down". While he very well could have misspoken, in my career those terms can only be associated with one thing, lowering the aggregate amount of debt. You can not do either of the two things he mentions by raising your (GAAP or whatever...completely irrelevant here) EBITDA and thus lowering your ratios. Anyone who thinks that you could walk into a room and use the term "pay down debt" to describe increasing your EBITDA relative to your debt with a group of serious financial analysts is delusional.

At best, in my opinion, Mr. Pearson is guilty of being lazy in his choice of words. In any event, given that clearly the media is now paying attention to this blog, I'm assuming Mr. Pearson is paying attention now too, and perhaps he can, in a VERIFIABLE manner, explain exactly what he meant?

Since I assume Mr. Pearson is reading...I'd also like to complement him on the Duke themed basketball court in his office that he generously shared with the NYT. It definitely lends credibility to all the statements he's made about his company's frugality. What was that about a golf course again?

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