Why Chanos And Grant Are Wrong On Valeant

Mar. 7.14 | About: Valeant Pharmaceuticals (VRX)

Summary

Due to Valeant's business model the comparison to the industry average R&D/sales ratio is not relevant.

Some of Valeant's acquisition costs effectively are R&D expenditures, hence the "serial acquirer" argument is less relevant.

Grant's thesis on Valeant's revenue recognition policies is wrong.

I'm not surprised at all that some of the planet's most famous short sellers are announcing their bets against Valeant (NYSE:VRX). As I laid out when Druckenmiller announced his (until now not very successful) short on IBM, what really counts in these cases are not facts but perception. For people not very familiar with Valeant's strategy, the company effectively seems to be a highly probable short candidate:

- The stock has increased tenfold over the past five years.

- Over the past few months price action has been driven mostly by momentum investors (that don't do a lot of fundamental analysis and are likely to jump off as soon as momentum stops).

- GAAP-EPS is still negative and accounting is somewhat intricate.

- Debt is high and interest rates might rise soon.

- The words serial acquirer sound risky.

- Some ratios like R&D/sales are far below or very different from industry standards.

So, if you are a so-called legendary short seller, why not try your chances? You don't have to say much, you just have to announce your bet and certainly most of the momentum investors will jump off.

But, as this article points out, Grant's questions are not really new.

First of all, the R&D/sales ratio argument is totally off target, as it has always been Valeant's strategy to avoid paying for uncertain results. Valeant buys products that are already marketed, have received all the necessary approvals and returns on investment are almost certain. Hence, it would be realistic to say that part of Valeant's acquisition costs effectively are R&D expenditures. (By the way, this fact somewhat sweetens the sound of the words "serial acquirer", doesn't it?) Or, the other way round, you could call Pfizer (NYSE:PFE) a R&D spendaholic, as it spends far more than Valeant on R&D. The point here is that looking at a ratio alone doesn't say much about a company. What ultimately counts is yield on investment, whether you do research in company-owned laboratories or acquire already authorized products. As yields on R&D investments for most pharmaceutical businesses have been low historically, Valeant prefers to buy certainties rather than hope. That's a legitimate strategy, but it does not mean Valeant underspends on R&D, it just means that it spends differently.

One very specific question Grant raises relates to revenue recognition: Before Valeant acquired Medicis in 2012, says Grant in his newsletter, the company used to recognize revenue when products were actually sold to the doctors - not when they were shipped to the distributor. Following Valeant's acquisition, however, Medicis started recognizing revenue as soon as the products went out to the distributor.

So I looked up Johnson & Johnson's (NYSE:JNJ) revenue recognition rules:

The company recognizes revenue from product sales when the goods are shipped or delivered and title and risk of loss pass to the customer. Provisions for certain rebates, sales incentives, trade promotions, coupons, product returns and discounts to customers are accounted for as reductions in sales in the same period the related sales are recorded.

[…]

Sales returns are generally estimated and recorded based on historical sales and returns information. Products that exhibit unusual sales or return patterns due to dating, competition or other marketing matters are specifically investigated and analyzed as part of the accounting for sales returns accruals.

Sales returns allowances represent a reserve for products that may be returned due to expiration, destruction in the field, or in specific areas, product recall. The returns reserve is based on historical return trends by product and by market as a percent to gross sales. […] The sales returns reserve for the total company has been approximately 1.0% of annual sales to customers during the fiscal reporting years 2013 , 2012 and 2011. (Source)

Now let's see how this compares to Valeant in 2012 and we'll see that there is not much difference:

We recognize product sales revenue when title has transferred to the customer and the customer has assumed the risks and rewards of ownership. Revenue from product sales is recognized net of provisions for estimated cash discounts, allowances, returns, rebates, and chargebacks, as well as distribution fees paid to certain of our wholesale customers. We establish these provisions concurrently with the recognition of product sales revenue.

Medicis customers consist principally of financially viable wholesalers and depending on the customer, revenue is recognized based upon shipment (FOB shipping point) or receipt (FOB destination) net of estimated provisions. We recognize revenue for Dysport®, Perlane®, and Restylane® upon the shipment from McKesson, our exclusive U.S. distributor of our aesthetics products, to physicians.

Under certain product manufacturing and supply agreements, we rely on estimates for future returns, rebates and chargebacks made by our commercialization counterparties. We make adjustments as needed to state these estimates on a basis consistent with our revenue recognition policy and our methodology for estimating returns, rebates, and chargebacks related to our own direct product sales. (Source)

So we can see that in 2012 there was full disclosure of revenue recognition principles related to Medicis and that even after Valeant's acquisition of Medicis revenues from Dysport, Perlane and Restylane were recognized only upon shipment to doctors. In 2013, Valeant effectively changed its revenue recognition policy related to these Medicis legacy products, but only because of structural changes in its distribution agreements (as disclosed in its most recent form 10-K). Basically, Grant is simplifying a bit, trying to convey the picture of Valeant pushing its sales figures.

But there was even more to discover. In 2012, Valeant also included the following table showing that the allocated provisions for returns and rebates have always been sufficient to cover effective payments:

Click to enlarge

This is very valuable information and far more transparent compared to JNJ.

All in all, I have to say that in very short time I have discovered more flaws in Grant's short thesis than in Valeant's accounts, business strategies and accounting policies.

Disclosure: I am long VRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.