- By excluding intangible amortization associated with patents/product rights that have a definite life and substantial cash restructuring/integration charges, Valeant (and Actavis) are inflating the profits they present to investors.
- Their poor free cash flow, need to constantly make acquisitions to make up for their lean R&D, and high debt levels present significant risks to equity investors.
- Valeant’s shares have 40% downside to fair value.
Accounting shenanigans are as old as financial reporting, but have lost favor among corporate managers as the potential penalties in the post-Enron world are more severe. The presence of an active community of short-sellers that seek to sniff out these tricks, and the emergence of databases where queries can easily be run to see if receivables, inventory or PP&E are rising more than they normally would has also helped reduce the incidence of accounting fraud. But changing times lead to new innovations, and CEOs have discovered that the surest way to goose up one's stock is to exclude an ever-increasing amount of expenses and present pro-forma or non-GAAP numbers. Investors have apparently resigned themselves to ignoring such recurring and operational expenses like stock-based compensation, non-cash interest (due to convertible accretion), transaction expenses, restructuring charges and amortization of financing fees. Low interest rates have helped companies make acquisitions and easily present them as accretive by accelerating expenses and treating the charge as non-recurring. This was a technique perfected by Tyco in days gone by, but today's ardent practitioners are doing even better by layering on an additional element - the ignoring of intangible amortization after buying companies with patents and product rights that have a definite life. This practice is particularly rampant in the pharmaceutical space, with Valeant (NYSE:VRX) and Actavis (NYSE:ACT) being the main players employing it.
To simplify things, imagine a company with a patent that generates $20 of revenue per year, has associated costs of $10 and has five more years to expiration. The undiscounted value of these cash flows is $50. Simple logic would tell you that buying this company for $50 does not create any value. The GAAP accounting after such an acquisition would show:
Intangible amortization: $10
If the acquisition was funded with debt, there would be an added interest cost, and the profit would be negative, reflecting the time value of money.
However, with pro-forma accounting ignoring intangible amortization, one can hoodwink investors into imagining that a tremendous amount of value is created.
Add back intangible amortization: $10
Non-GAAP profit: $10
Let's say investors assign a 15x multiple on profits, and now we have created $150 of value by buying $50 worth of assets for $50.
It gets even better. What good would an acquisition be if there were no restructuring charges? Let's hire consultants, fire some people, pay them severance, consolidate facilities (will still have to pay rent for the rest of the lease term, but that amount will be a restructuring charge). Let's assume, we take a $10 restructuring charge that decreases annual expenses over the next five years by $2. Notice there is no value created here, except in the non-GAAP accounts which will now show profits of $12 per year, thus increasing the value of the company by $180 at a 15x multiple. Not bad for a $50 acquisition.
Some intangibles have indefinite lives with an associated expense to maintain them (think trademarks and customer relationships), and so one can justify ignoring the related amortization. However, pharmaceutical patents and product rights very definitely do not fall in this category.
The theory in practice
There are two pharma companies that have perfected the above technique and they are Actavis and Valeant Pharmaceuticals. I will focus on presenting the case for Valeant, with the logic and conclusion being pretty similar for Actavis.
Two years ago, Valeant traded below $50 per share. The company was solidly profitable, with a low double digit operating margin, and generating about $600 million of cash per year. The company was always acquisitive, but decided to amp up the pace, fueled by cheap debt thanks to the Fed's quantitative easing program. The company made more than $10 billion of acquisitions (more than its starting market cap), the biggest being Bausch & Lomb for $8.7 billion. At each stage, investors rejoiced by pushing the stock ever higher, oblivious to how value could be created by buying other companies at a premium, especially some that were considered challenged with looming patent expirations in the not too distant future
Valeant touts its single digit tax rate as a competitive advantage when it makes acquisitions. However, it is questionable how Valeant can substantially lower the tax rate of an American company after an acquisition since the intellectual property was presumably in the US. As per IRS rules, the US subsidiary would have to sell the patents to a foreign subsidiary at fair market value, triggering a capital gains tax on the sale of an asset. This would negate any future tax savings. It is possible that a team of high-priced lawyers and accountants came up with a plausible way around this, but it leaves the company open to an IRS challenge and penalties.
Valeant also significantly reduces the R&D spending of its targets. While most pharma companies spend 15-20% of their revenue on R&D, Valeant spends a mere 3%. There is no doubt that there is a significant amount of wasteful R&D spending, but the flip side of spending so little on R&D is that the company has to constantly make acquisitions to replenish its pipeline. So rather than spending the money on R&D, it spends it on acquiring other companies that have spent money on R&D. While the risk is lower, it involves paying a premium for proven therapies. The only upside of this strategy is that the company can claim in its non-GAAP accounting that this expense is "non-cash" and should be ignored. Investors in the technology space have come around to the realization that this strategy by companies like Cisco (NASDAQ:CSCO) and Hewlett-Packard (NYSE:HPQ) does not create value in the long run, but the message has apparently not yet reached pharma investors.
When VRX reported first quarter 2014 results, it touted that "Cash EPS" for the quarter was $1.76. Never mind that the GAAP EPS was a loss of $0.07. How did it convert the loss to a profit? Among other items, the reconciliation lists amortization and impairment of finite-lived intangible assets, restructuring costs, stock compensation and amortization of financing costs. Most of these seem like regular costs of doing business, including ones that involve cash outlays. That's more than $600 million of expenses for the quarter that the company excluded in its non-GAAP presentation. The numbers are so large that one can have little confidence that most of them have any semblance to one-time, non-recurring expenses.
Since the income statement is of little help, one can look at the cash flow statement to get a sense of the cash generative power of the business. The company generated $484 million from operations, spent $79 million on PP&E and intangible assets for free cash flow of $405 million. Excluding share-based compensation of $25 million gives you adjusted free cash flow per share for the quarter of $1.11. This free cash flow includes the add-back of intangible amortization and so is a short-term indicator of cash generative power, but is not sustainable in the long term as patents and product rights expire.
For 2014, the company has given guidance of Cash EPS of $8.55 to $8.80. The company has not provided a reconciliation to expected GAAP EPS, in apparent contravention of SEC guidelines that call for non-GAAP figures to be reconciled to GAAP ones. Based on the first quarter results, GAAP EPS is likely to be in the $2 range for the full year.
Valuation: Fair value of $75 per share, with 40% downside
What are the company's shares worth? 14x first quarter annualized free cash flow (and remember, some of the cash flow has a limited life) would give you $62, which would amount to approximately 30x GAAP EPS. Not too far off from the $50 the shares were fetching before the large acquisitions that enabled the company to inflate its non-GAAP figures, but have in real terms probably not created much value.
Let's increase the valuation by 20% to be conservative and say the shares are worth $75. That's still 40% off from the $130 they are trading at.
How does the game end? Eventually, the company runs out of meaningful acquisition opportunities to feed the beast, patents and product rights expire, debt comes due, and earnings (even the non-GAAP kind) fall. Or maybe in a tighter investment climate, investors tire of fantastical non-GAAP exclusions. The company has more than $17 billion of debt at an average interest rate of 5%. It is unlikely to be able to refinance it at such a low rate in the future. At the current rate of cash generation, it will take more than 10 years to repay this debt. I would be worried if I were a debt holder, and would run for the hills if I owned the stock.
While VRX has had a free run in the last few years, questions have recently been raised about the company's strategy, accounting and sustainability of the business. Jim Chanos and James Grant have revealed that they are short the stock. The company is holding an investor meeting in New York on May 28 to address some of these concerns. The very fact that the company feels compelled to publicly refute the assertion that their business model is not sustainable is in itself revealing.
The Allergan acquisition saga
On April 22, Valeant revealed a cash and stock takeover offer for Allergan (NYSE:AGN), a company of similar size, which would be its biggest acquisition to date, and provide even larger opportunities to continue with its Cash EPS exclusions. Allergan has so far resisted the takeover attempt. In contrast to prior acquisition announcements, Valeant's stock price has not risen in response. The wrinkle in this tale is that Pershing Square, a hedge fund, built up a 9.7% stake in Allergan prior to this announcement, and after being informed by Valeant about the pending bid. This apparently does not qualify as insider trading because Valeant and Pershing Square have an agreement to be a single group for the purpose of this acquisition. This certainly calls into question whether the senior management team of Valeant has failed its fiduciary duty to shareholders by allowing a hedge fund to profit from confidential information about a pending takeover offer. According to published accounts, Pershing Square approached Valeant and expressed a desire to become a significant shareholder. But rather than buying Valeant stock in the open market, it offered to help the company with its next acquisition. Valeant revealed that its preferred target was Allergan, and Pershing Square proceeded to deploy one-third of its capital on rapidly accumulating Allergan stock. The benefit to Pershing Square is substantial - a profit of billions of dollars with little risk and the advance knowledge that Valeant was going to make a bid. The benefit to Valeant seems to be minimal. After all, the company is a serial acquirer, and having a 10% shareholder of a target on its side doesn't seem to amount to much. Perhaps it is a sign of its desperation that it has chosen to align itself with a fund that has employed questionable tactics in its fight against Herbalife (NYSE:HLF), and hand over billions in free money in the bargain.
Whether Valeant succeeds in its takeover attempt or not, this should not significantly affect its intrinsic value as it is offering a full price of more than 20x forward EPS.
Disclosure: I am short VRX, ACT. 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.