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.

Wednesday, June 11, 2014

Valeant Pharmaceuticals Part II: GAAP and non-GAAP accounts

In Part 1 I introduced Valeant Pharmaceuticals and its business model which is to acquire pharmaceutical companies, strip them of their research expense and earn very high gross margins on sales.

This has become a hugely successful stock, however you could not tell by looking at the GAAP accounts. Here is the P&L for the last five years, latest on the left, courtesy of Capital IQ

For the Fiscal Period Ending
12 months
12 months
12 months
12 months
12 months
12 months
Other Revenue
Total Revenue
Cost Of Goods Sold
Gross Profit
Selling General & Admin Exp.
R&D Exp.
Depreciation & Amort.
Amort. of Goodwill and Intangibles
Other Operating Expense/(Income)
Other Operating Exp., Total
Operating Income
Interest Expense
Interest and Invest. Income
Net Interest Exp.
Currency Exchange Gains (Loss)
Other Non-Operating Inc. (Exp.)
EBT Excl. Unusual Items
Merger & Related Restruct. Charges
Impairment of Goodwill
Gain (Loss) On Sale Of Invest.
Gain (Loss) On Sale Of Assets
Asset Writedown
In Process R&D Exp.
Legal Settlements
Other Unusual Items
EBT Incl. Unusual Items
Income Tax Expense
Earnings from Cont. Ops.
Earnings of Discontinued Ops.
Extraord. Item & Account. Change
Net Income to Company
Minority Int. in Earnings
Net Income

It is that net income line at the end that sort of gets you. There are losses in all years except 2011 and large and increasing cumulative losses. The $866 million loss in calendar 2013 is a surprising number.

The losses are not quite so bad on an EPS basis because of a massively increasing share count, but these are hardly typical of a company with such a rapidly increasing stock price.

The losses however are net of vast "merger and restructuring charges", "asset writedowns" and "legal settlements" - so called "one-offs".

In 2013 merger and related costs were $923 million, asset write-downs a further $783 million and legal settlements were $192.5 million. These amounts constitute well over 100 percent of the loss recorded.

Net of these costs earnings are going up very nicely. The company actively encourages you to look at it this way - and the market has adopted that guidance (as reflected in the stock price).

Moreover this is precisely how they present it in analyst conference calls. Here is a slide from the 4Q 2013 conference call:

Note that the cash EPS reported ($6.24 per share profit) is considerably more attractive than the GAAP EPS (a loss of $2.70 according to the press release or Capital IQ).

And herein is the rub. Do you want to believe the GAAP EPS (in which case this company is a loss-making disaster) or do you want to look through the GAAP EPS and see what management directs you to, their definition of "cash EPS"?

In other words do you believe in the GAAP accounts or some non-GAAP accounts?

There is another way of saying this. To believe in the GAAP accounts you need to believe that the "one-off" charges are reasonable and truly one-off. [They are truly vast - so this matters.]

There is a possibility that the whole Valeant exercise is something from the Wizard of Oz. Profits are going up nicely if you pay no attention to that man behind the curtain - the man being the large restructuring and one-time items.

It would be an awful for investors if Valeant made its ferociously profitable budgets by putting any unwanted expenses (recurring or otherwise) into the "one-off" bucket.

And this is where we will start our long examination of Valeant. We want to work out whether the one-off charges are reasonable (in which case this is a great company) or whether they are inflated (in which case this is a Wizard-of-Oz-style con-on-the-market).

Till next time.


Valeant Pharmaceuticals International: an extended look

Valeant Pharmaceuticals is the hottest stock in the hottest sector (pharmaceuticals and biotech). It also has the strangest business model: it acquires existing companies, strips them of most of their research and development and a large proportion of their other staff and extracts huge margins.

As John Gapper observed in the FT: if the entire industry adopted Valeant’s approach, drug discovery would grind to a halt.

Gapper's article (accurately) stated:
Valeant’s business model is as simple as its accounting and tax structure are complex. While at McKinsey, Mr Pearson [the Valeant CEO] concluded that the industry he advised was spendthrift, not only in the sums it spent on headquarters and staff but in its investment in drug discovery. Employing scientists to search for new drugs was a waste of money because they often failed.
When he got the chance to put his ideas into practice he cut Valeant’s research to 3 per cent of revenues – compared with about 19 per cent at big pharma companies – and acquired products by buying other companies with debt. Valeant has taken over more than 35 companies since 2008, including Bausch + Lomb, which it acquired for $8.7bn last year.
To the extent that the stock price does the analysis this has been an outrageous success. The market clearly thinks Mr Pearson has the goods. This is one of those charts that is so good it makes no sense to view it in anything other than log-scale. 

The market cap is now over $43 billion. If you add in the net debt the enterprise value approaches $60 billion. This is one of the largest companies in the space by enterprise value. Enterprise value is over ten times historic sales (though somewhat less than that relative to the current sales run-rate). Whatever: this is very highly valued.

I am however a disagreeable person. I don't look at charts much - and my skill sets are accounting and tax driven. So I am inclined to take the accounting (and hopefully tax) issues head on and thus assess Mr Pearson's achievement. 

Alas - and I stating this in advance - this will be one of the more complicated projects this blog has and I have little idea how many posts this will take. I might learn a few things along the way too. So with the next post I will start you on the journey proper. Hopefully, dear readers, this will be useful for you too.


PS: In the interests of disclosure I should let you know I have done enough work in advance to have a position here. Short. 

Monday, June 9, 2014

Just what Canada needs: more exposure to a resource/China driven economy

Tony Abbott - the Australian Prime Minister - is in Canada at the moment. The Australian press reports that he is meeting a whole lot of fund managers to encourage them to invest in Australia. To quote the Murdoch National Newspaper (The Australian):
Mr Abbott is due to meet leaders from Sun Life Financial, the Canadian Council of Chief Executives, the Ontario Teacher’s Pension Plan, Barrick Gold, Barclays Canada, Saputo and Cameco.
I want to be blunt. There are advantages in investing in your own country: you know it better. You are less likely to make mistakes.

And there are reasons to invest overseas: you can get exposure to industries and economic cycles that might not be available at home. You get diversification.

Also every now and again a foreign market can become very cheap (not everywhere is in a bull market simultaneously). Blind Freddy could make money buying the Korean market at the height of the Asian crisis.

None of these reasons apply to a Canadian investing in Australia. Australia most certainly is not cheap. Sydney makes London and New York seem inexpensive.

And Australia and Canada have about the most similar economies in the Western World. We are large land masses, rich in resources, with small population bases and currencies and economies driven by Chinese resource demand. A Canadian investor in Australia gets little diversification benefit.

At the risk of seeming unpatriotic I am going to give you some advice. If you are a Canadian investment leader and Tony Abbott is seeing you today keep it brief. Don't waste his time or yours.


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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.