Tuesday, March 15, 2016

How to judge Valeant in 2016

Here is a slide from Valeant Investor Day conference call in December 2015. You can find the original at this link.

Only a few months ago they stated that this was how they should be measured in 2016.

Today there will be another call.

I wonder what has changed?


Monday, March 14, 2016

Questions for the Valeant conference call

Valeant is planning to have a conference call to "discuss preliminary fourth quarter 2015 financial results and update 2016 financial guidance".

It is "preliminary" because numbers have not been audited yet. I expect an audit statement to be coming. I have never had a major problem with Valeant's GAAP numbers (which are terrible). My objection to their numbers is largely to the non-GAAP earnings that they promulgate widely and which are widely quoted by analysts.

I suspect ultimately their auditor may not have major problems with the GAAP numbers (other than certifying that Valeant is a going concern). The GAAP numbers don't smell wrong.

In that vein I  have only main question.
Can you break down your guidance for non-GAAP "cash EPS" into your estimated GAAP earnings and your budgeted non-recurring or non-cash expenses (such as restructuring expenses or amortisation) that I should ignore for the purposes of your GAAP EPS?
I ask this because Valeant non-GAAP numbers ("cash EPS") bear only minimal resemblance to the numbers in the accounts. Some of the difference between GAAP EPS and "cash EPS" is clearly justified. Some less obviously.

But from the outside it looks like business divisions can make their non-GAAP numbers by producing reasonable enough GAAP numbers and then marking any inconvenient expenses as "non-recurring". If a budget for non-recurring expenses is published this will help vouch for the integrity of non-GAAP numbers.

There is a follow on question: given the GAAP numbers are "messy" some covenants will be broken.
Can we have a list of broken debt covenants and a list of the consequences of those breaches? To my understanding the main consequences are restrictions on further borrowings and cash-traps for the benefit of debt holders if businesses are sold. However the documents are extensive - and there may be issues I am unaware of.

Thanks in advance


Sunday, March 13, 2016

The LA Times explores Valeant's business model

The LA Times has a savage little article on herpes (or cold sore) topical medication. In Australia you can buy small tubes of Zovirax topical medication for about $15 over the counter.

In America it is somewhat more complicated - and an insurance company winds up paying about $2500.


Go read it.

After the exposure of Philidor (which was a device to deceive insurance payers) it can't be long until Valeant gets total payment kick-back.

The end is nigh.


Tuesday, March 8, 2016

Being punished for doing the obvious: Peabody Energy Corp edition

It is no secret that US coal companies are financially stretched.

But Peabody Energy is particularly stretched.

Here - courtesy Thomson Reuters - is a price chart for the 6% coupon Peabody debt due November 2018. Its a large issue with almost 2 billion at face value outstanding.

The price is 3. That is 3 cents in the dollar.

The yield to maturity is 266 percent.

If Peabody survives without a restructure this piece of debt will make you over thirty times your money.

Obviously the debt market thinks that Peabody is dead. Dead parrot dead.

Go tell that to the equity market.

This is Peabody stock yesterday courtesy Yahoo Finance.

Yes the stock was up 40 percent.

And if the company survives it is vanishingly unlikely to be a thirty bagger.

So it is kind of obvious that you should be long the debt, short the equity. It is very hard to construct a scenario where you lose.

Except that it was darn obvious 100 percent ago in the trade.

So here is what happened. Some wise-cracking hedge fund put on the trade, long the debt, short the equity. Can't lose except that they did lose.

They are getting smashed.

The debt has come down rapidly from 25 to 3 wiping out the long side of that transaction. The equity has doubled.

And our hapless manager - having been perfectly rational - is left nursing some sore losses.


A general comment

This is happening all over the energy complex at the moment. Debt and equity markets disagree and the disagreement has got wider and wider.

There will be some very bruised arbitrage managers this week.

Very bruised indeed.


PS. Disclosure in order. We have a few of these trades on in tiny size. We are down low-single-digits this month. We are not enjoying it. But we are enjoying it far more than the soon-to-be-out-of-work manager who decided to put the Peabody trade on.


If you can't be ethical at least do a well-executed cover up (a comment on Commonwealth Bank of Australia)

Commonwealth Bank of Australia (CBA) last year faced a devastating expose of their financial planning business by Four Corners. Four Corners is the premier current affairs program of the ABC*. You can find that program here.


After the travesty detailed by Four Corners CBA promised to be the "ethical bank".

Today Four Corners was back with an expose as to how CBA has systematically denied insurance claims for trauma and other medical maladies. This was through their business arm called CommInsure.

You can find that program here.]


Amongst the allegations: medical files just disappear from their system.

I guess CommInsure is in the business of making things disappear. Here is a photo of their twitter account (https://twitter.com/CommInsure)

Yeah - the Twitter account disappeared too. Looks like another cover-up albeit badly executed.

Maybe the Twitter account was never there - but searching @CommInsure on Twitter gives a fairly consistent history of reluctance to pay claims. This is an extract from the timeline well before the Four Corners episode.

And another:

The whole stream is littered with claims complaints. If the senior brass did not know this is wilful ignorance.


PS. All this is indicative of a "make the numbers or else" management style. Head office claims ignorance of what happens in the periphery even though it is obvious to those that look.

Head office also claims their mortgage underwriting is good. I suspect someone should actually go take a look. (But that is a story for future blog posts and future episodes of Four Corners.)

*For non-Australians think of the ABC as the Australian version of the BBC. You will not be far wrong.

Monday, March 7, 2016

A comment on negative gearing in the Australian property market

This blog only infrequently wades into Australian politics - but the negative gearing debate has large economic and financial market implications. Moreover I am going to express an opinion moderately contrary to my self interest. Financially I would love the Labor Party policy to abolish negative gearing to be implemented (I am short Australian banks). But intellectually I think the Labor Party is mostly talking nonsense.

Background for non-Australians

In Australia you can deduct losses that you might make in renting a house against your ordinary (wages) income. This includes interest losses.

This is widely thought of as a tax incentive or even a tax rort. The aggregate amount of losses taken against tax is about 1% of GDP which is - to be blunt - a very large number. Negative gearing is widespread and part of our culture.

Moreover it is widely considered to be beneficial to have tax losses. I have had taxi drivers patiently explain that it is better not to pay principal on loans to buy investment properties (ie buy-to-let properties) because you want to keep the tax deductions as large as possible.

The Labor Party has promised to "abolish negative gearing". This has been a policy agenda for fringe groups (notably affordable housing activists) for some time.

Is negative gearing even a tax concession?

I sometimes express my view that negative gearing is not a tax concession and I am howled down by the consensus in this country. [This is despite doing an honours thesis on tax policy and working for five years in the Tax Policy Division of the Australian Treasury.]

But lets lay out the argument.

Imagine I have two business enterprises. One works well and the other one fails.

One makes $120. The other loses $100. My net gain is $20. If the tax rate is 30% I will pay $6 tax on on the net gain.

Now suppose that I can't deduct the losses against the profits. Then my loss will cost me $100. But my gain will be taxed at 30% and I will gain only $84 after tax. I will be $16 out of pocket.

If you do not allow losses to be taken against profits then you introduce an incentive against risk taking. Quarantining losses is expensive from a tax-policy perspective. Taken to its limit quarantining is a tax policy against innovation. [The benchmark for the taxation system is one that does not discriminate in taxation by how you make your income. Its a benchmark which implies tax policy should not in the benchmark case "pick winners".]

There is a case for quarantining losses - and it is done all over the place in tax policy - but almost everywhere the case for quarantining is anti-avoidance.  The most famous example is that offshore losses tend to be quarantined against offshore income. The reasons are (a) the offshore losses are hard to audit and (b) the offshore income that it is quarantined against might not have hit the domestic tax base anyway.

Risks from not quarantining

If you do not quarantine losses you can wind up with completely anomalous situations. For example Australian once had a 150 percent R&D tax concession. If something were certified as R&D all inputs to the process were entitled to a 150 percent tax deduction. Then some enterprising minerals processing company did some tweaking of their processing technology. It was legitimate R&D whilst they were measuring the efficiency of their processes. All inputs to that process (ie the minerals they bought) were deductible at 150%. The output only taxable at 100 percent.

They bought say $10 million of minerals, processed them and sold $11 million worth of metals. But they got a net tax deduction of $4 million even though the activity was profitable and the real amount spent on R&D (ie the amount spent tweaking equipment) was tiny.

Done on this scale the concession could - and did - produce tax losses for the mining company in the hundreds of millions of dollars. There was almost no limit to how large the tax losses could be.

If these losses were not quarantined somehow they could erode the entire corporate tax base.

But the issue here was a "clever avoidance scheme", not that quarantining is of a benefit in itself.

And if you take the typical negative gearing case in Australia (a doctor or middle-income professional) buys a property and makes a real loss it is pretty hard to see how this is a "clever avoidance scheme". Its just a loss.

And real losses are normally deductible.

Countries that ban negative gearing

It is commonly asserted that other countries do not allow negative gearing - and that is true. In some countries capital income is always and everywhere quarantined from wages income. (Scandinavia is a key example where taxes on wages can be much higher than taxes on capital and quarantining is enforced against all businesses not just property investment.)

It seems the Australian Treasury agrees with my view that negative gearing is not a tax concession

The Australian Treasury (for foreigners the main economic policy advice department of the Australian Government) publishes a "Tax Expenditure Statement" which estimates how much various tax concessions cost on the basis that money spent via a tax expenditure is economically similar to money a government might spend directly if it taxed the income and then gave it back through grants or similar.

The tax expenditure statement gives a list of major tax concessions and lists two big housing related expenditures. First the imputed rent that you might receive owing your own house is not taxed even though it might conceptually be thought of as part of your income. Second the capital gains you might make selling your primary residence is not taxed (though it would be taxed if it were an investment property).

They do not list negative gearing as a tax expenditure. The list of big tax expenditures can be found on page 8 of the Tax Expenditure Statement.

But everyone thinks that negative gearing is a concession

Its pretty clear the view that negative gearing is not a tax concession is a minority view in Australia (though it is a view held fairly widely by senior tax people I have known and seems to be held by the Commonwealth Treasury).

The general consensus that negative gearing is a tax concession and that the smart money should and do take advantage of it.

And you find negative gearing all over the income spectrum including some high income earners (but very few mega-high income earners).

I find negative gearing intellectually amusing. It is not a tax concession but after much marketing by the Property Council, various spruikers and the otherwise ill informed negative gearing has been in part responsible for pushing house prices in Australia to ridiculous levels.

People will not only make investments when you give them a real tax concession - they will do so when they think they are getting a concession even if they are not. [We have likewise observed that it is easier to defraud people if they think they are getting a tax concession - witness forestry schemes in Australia.]

Implementing the Labor Party no-negative-gearing pledge

The Labor Party is careful not to ban negative gearing for existing property investments. If they did there would be squeals about retrospectivity. Also there would be dumping of property on the market by people who were no longer entitled to their tax concessions.

But they do plan to ban negative gearing prospectively. So I will throw up a simple example that shows the implementation difficulties.

Imagine a house that is positively geared. Rent is $800 a week and all outgoings are $700 a week.

But the tenant trashes it. (This happens, not often but it happens.) There is $10,000 worth of maintenance.

The landlord is out-of-pocket. Even after than $5000 net rent they collect in the year they are out of pocket.

Does the Labour Party have an argument for quarantining that loss that is not an argument for quarantining all business income against wages income? If so I have not heard it.


PS. I am not averse generally to the Scandinavian idea of income quarantining. However in that case all income from capital is separate for tax purposes from income from wages. I have not heard a good case for selective quarantining that is not an anti-avoidance case.

Thursday, February 25, 2016

The amazing Zatarra Research piece on Wirecard

Zatarra Research - a seemingly anonymous outfit I had never heard of - have put out an amazing report on Wirecard - a reverse merger German listed financial services company with a large market cap.

You can find the report here...


Wirecard has long struck me as suspect - and I have maintained a short for years (yes, literally for years).

I have tried to verify the assets purchased by Wirecard that became corporate goodwill and I could not verify. Indeed I could not even confirm existence of some businesses they purchased.

Generally I follow the advice of Ronald Reagan: trust but verify.

In this case I could not verify Wirecard's assets but I have not verified Zatarra's claims...

So this post links an unverified report of a seemingly unverifiable company...

Even after the down-draft today I am showing decent losses on the position. Not all shorts work out...


(Hat-tip to Dan McCrum who has also been sceptical of Wirecard.)

Thursday, February 11, 2016

Valeant - links

There are two blog posts (both anonymous) that you must read to understand the Valeant bear case. The first is an old one - by AZ Value:


The second is recent - going through cash needs this year. Valeant will be in acute financial stress at some point this year.



Wednesday, February 3, 2016

Mr Ackman, I forgive you. Mike fooled almost everybody...

Bill Ackman gave a presentation on Valeant (NYSE:VRX) and its relationship with Philidor on 30 October 2015. Most people remember the presentation because it went for four hours.

I just remember this slide:

It says that Pershing Square's perspective is - and I quote:

  • Volume is primary growth driver for ~90% of Valeant’s business

It also states that there will be "no more “price increase” deals and that price increase deals were only four out of approximately 150 historical acquisitions.

Mike Pearson (the CEO of Valeant - now on medical leave at an undisclosed location) has repeatedly supported roughly this view. After all look at the first quarter conference call from last year (transcript here). Mike Pearson is asked specifically about price versus volume. To quote:

Gary Nachman - Goldman Sachs - Analyst 
...And then if you could quantify a little bit how much was price versus volume that contributed to growth in 1Q? And what do you factor in your full-year guidance price versus volume?

The response:

J. Michael Pearson - Valeant Pharmaceuticals International Inc - Chairman & CEO 
In terms of price volume, actually volume was greater than price in terms of our growth. Outside the United States it's all volume. In fact, we had negative price outside the US with FX. And in the US it's shifting more to volume than price, and we expect that to continue with our launch brands. 
A lot of our prices for most of our products are negotiated with managed care. And there's only a limited amount of price that we can take. And then if you look at our consumer business, very little. Walmart doesn't like price increases. If you look at our contact lens business, we're not discounting contact lenses. We are keeping the prices the same. I think there is some noise in the market that there's discounting going on. We're not discounting, but that's all volume growth. And similarly in the cataract surgery market, again, we're just holding our prices. So it's primarily volume, and we expect that to continue.
You see everything that Bill Ackman said was consistent with what Mike Pearson was saying.

Alas it is not true!

Today we got an insight into Valeant's price and volume strategy and it categorically demonstrates that Pershing Square's perspective (as quoted above) is false. The source is a summary of Valeant's documents given in response to Congressional subpoenas.

One tartly pertinent quote:
On May 21, 2015, then-Chief Financial Officer Howard Schiller sent an email to Mr. Pearson with the subject “price volume.” He wrote: “Last night, one of the investors asked about price vs volume for Q1. Excluding marathon, price represented about 60% of our growth. If you include marathon, price represents about 80%.”
You see Mike Pearson apparently knew that growth was driven by price. If you include Marathon (the Nitropress and Isuprel acquisition) price represented 80 percent of volume. And that was an email from Howard Schiller (current acting CEO) to Mike Pearson (now CEO).

Mike Pearson lied in the conference call. This seems beyond dispute. Just compare the quotes.

Moreover the Congressional documents show that multiple acquisitions have been driven by a pricing strategy. Bill Ackman said that "price increase deals" were a minor part of Valeant's strategy. He has been proven wrong.

I do not think Mr Ackman was deliberately wrong. Mike Pearson misled the world in the first quarter conference call (and in other conference calls). Mr Ackman was wrong because Mike Pearson misled him.

And that is understandable. Mike Pearson convinced many people.

So Bill, you told the world untruths, but they were not deliberate. Mike fooled you.

Love as always,


Post script: 

Some may ask why I picked on Pershing Square as the victim of Mike Pearson's apparent deceptions. After all Ruane, Cuniff & Goldfarb, T. Rowe Price, ValueAct Capital Management, Viking Global, Paulson & Co. and an ambush of Tiger Cubs are major Valeant holders.

I picked on Pershing Square because of this - a slide in an old Pershing Square presentation:

Pershing Square signed a confidentiality agreement (9 February 2014) and this allowed them to conduct "substantial due diligence" on Valeant. This included:

  • extensive management interviews
  • a review of parent and regional business plans
  • a review of historical and projected organic growth by business unit and region.

We now know that many acquisitions were price driven and growth was driven by pricing but Mr Ackman told us otherwise...


(a) Mr Ackman knew that price not volume was the driver but told us otherwise


(b) Mr Ackman thought he was telling the truth when he said that volume, not price was the driver. But he thought that because the company systematically misled him. The deception came not only from Mr Pearson but was repeated throughout "extensive management interviews".

I believe Mr Ackman thought he was telling the truth. (I could be persuaded otherwise but at this time Mr Pearson's credibility is more questionable.)

And if Mr Ackman thought he was telling the truth and he was systematically misled it is pretty obvious what he must do. He must sell his stock. He owns lots of Valeant stock.

If he keeps his stock now he is stating loudly and clearly that it is acceptable for him to invest 30 percent of his clients' money in a company which systematically misled him not just at CEO level but during "extensive management interviews".

Pershing Square surely cares more about the investment process than that.


General disclaimer

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.