After writing yesterday's long article on Allergan (NYSE:AGN) and Valeant (NYSE:VRX) ("Why Allergan Should Reject Valeant"), I thought it would be a while before I wrote another one. But then I realized it is important to illustrate a timeless accounting trick with simple examples. I was inspired by the lucid example in the Valeant article by Ranjit Thomas.
This accounting trick is very important for Allergan shareholders to understand. They can then understand why Valeant stock should be worth half its current price, as I said in yesterday's article.
First, let us look at some definitions, and then look at an example towards the end. Readers who know some accounting can skip to the example if they want.
Expense is something that is deducted from revenue to report profit. By GAAP convention, R&D is an expense. This does not have any bearing on economic value. But to be conservative, R&D is expensed. This appears on the income statement.
Capitalizing, depreciation/amortization, impairment
Capitalizing refers to treating something not as an expense, but instead as an asset. For example, if a company constructs a building, the cost of construction is not deducted all at once from its revenue. Instead, the company then evenly distributes the cost of the building as an expense over the life of the building. For example, if the cost of the building is $500 and the cost is to be distributed over 20 years, the company subtracts $25 from profit every year. This even distribution is called "depreciation".
When this even distribution is done on an intangible asset, like a trademark or customer database, it is called amortization.
When a company is acquired, the acquisition is treated like the construction of a building. The purchase price is distributed over the acquired company's identifiable assets - whether they are tangible or intangible. Any excess unallocated purchase price is recorded as another intangible asset called goodwill.
As earnings are squeezed from these assets in later years, these purchased assets are depreciated or amortized, depending on whether they are tangible or intangible.
If a company finds out that an acquired drug gets rejected by the FDA, it would record an impairment expense; just like it would for a building whose roof fell in. An impairment expense will also be incurred if a competitor invents a better drug.
Since acquisitions are supposed to be rare one-time events, by colloquial practice, amortization and impairment expenses are added back to GAAP earnings to yield non-GAAP earnings, or cash earnings, or adjusted earnings, or whatever you want to call it.
This is the key - accounting conventions assume that major acquisitions are supposed to be rare one-time events, not an occurrence every year.
Example to illustrate R&D versus acquisitions
Warren Buffett used a famous example of two companies A (Agony) and E (Ecstasy). In that vein, let us consider two companies "A" and "V". We use A and V as examples to illustrate expensing versus capitalizing. Suppose both A and V start with zero in the bank.
A believes in R&D, and makes a drug that produces revenue of $2 per year. Its R&D expense is $1 per year. It reports profit of $2 - $1 = $1 per year. Assume this drug can be sold for only 5 years.
V says it can produce R&D output without input through acquisitions. Since V needs to pay an acquisition premium, V can acquire a similar drug for $20 (i.e. P/E = 20, with profit of $1 per year) from a company that did the R&D. Suppose this drug can also be sold for only 5 years.
Since this drug can be sold for only 5 years, V records amortization expense of $4 per year ($20 / 5 = $4). Since neither V nor A started with money in the bank, V borrows $20 for the acquisition.
What do we have at the end of 5 years?
A has squirrelled away $1 of profit per year, and has a cash balance of $5 in the bank.
V has total revenue of $10 over the 5 years at the rate of $2 per year. V has no R&D expense, but has $4 of amortization expense per year. This means V's GAAP loss per year is $2 - $4 = -$2. That is, according to GAAP, V loses twice as much money every year as A makes in profit every year.
But V says, "Ignore this loss, just look at my cash earnings. The amortization expense by convention is added back to GAAP earnings. So, if I add back $4 to my GAAP loss of $2, I get cash earnings of $2 (i.e. $4 - $2 = $2). And please don't look at the debt."
But here is the catch: what about the $20 debt? V says, "Ignore the debt, just look at my price-to-"cash earnings" ratio."
A has $5 cash.
V has $10 debt (the accumulated cash earnings over 5 years is $10, which is deducted from the original $20 debt).
To make this even more lucid, I have produced these tables below.
Company A Table - A ends with $5 cash
|Time||GAAP Profit||Amortization||Cash Earnings||Bank Balance|
V's table is below - V ends with $10 debt, i.e. negative bank balance of -$10.
|Time||GAAP Profit||Amortization||Cash Earnings||Bank Balance|
What V tells investors
V says, "Hey look at my higher cash earnings. Pharma R&D is a waste of money. Look at A's lower cash earnings."
What about the debt? V never mentions it.
Let us make this interesting by using a P/E of 10 for both A and V? What do we see?
If we multiply A's cash earnings by 10, we see a stock price of $10.
If we multiply V's cash earnings by 10, we see a stock price of $20
But is this right? What's the catch? It's the debt and amortization. The terminal net worth of A is $5, whereas the terminal net worth of V is a negative -$10.
If we value A and V using P/E, where the E is cash earnings, we get their valuations horribly wrong.
Werewolf and the full moon
If we ignore V's debt, we overstate V's value and understate A's value by a huge amount. At full moon, V turns into a werewolf with a negative net worth of -$10. But if we use price-to-cash earnings, V appears valued at $20!
Now that we acquired the insight of capitalizing versus expensing, let us compare Valeant and Allergan.
Valeant's income, operating cash flow, cash earnings and debt history show big divergence
Valeant's GAAP income history: 2013 $866M loss, 2012 $116M loss, 2011 $159M profit, 2010 $208M loss.
Valeant's debt: 2013 $17.1B, 2012 $10.5B, 2011 $6.5B, 2010 $3.5B.
Valeant's Operating cash flow: 2013 $1B, 2012 $656M, 2011 $640M, 2010 $676M.
Valeant's Adjusted Operating cash flow: 2013 $1.8B, 2012 $1.2B, 2011 $925M, 2010 couldn't find data.
Cash flow is cash flow. Operating cash flow already adds back all amortization and impairment and other non-cash charges. But Valeant further reports an "adjusted operating cash flow". This is what it projects as cash earnings. Valeant's "adjusted operating cash flow" was $1.8B for 2013 - almost twice its operating cash flow! Valeant projects this "adjusted operating cash flow" to be $2.6B for 2014.
If you look at Valeant's cash flow statements, you will see a big gap in what it calls "cash earnings"/adjusted operating cash flow and its actual operating cash flow (see page F-9 of the linked 2013 10-K).
The above numbers show that there is huge divergence between GAAP income and operating cash flow. There is yet another big divergence between operating cash flow and adjusted operating cash flow.
Allergan's GAAP and non-GAAP income
Allergan has no debt. Instead, it has had net cash.
Allergan's GAAP and non-GAAP EPS show very little divergence. Since Allergan's share count has had no change over the last many years, we can use EPS to look at divergence. Allergan's share count was 305M in 2006, and is 298M now. It has stayed remarkably steady throughout 2006-2014.
Allergan's GAAP EPS: 2013 $4.2, 2012 $3.57, 2011 $3.05, 2010 $0
Allergan's Non-GAAP EPS: 2013 $4.78, 2012 $4.04 2011 $3.65, 2010 $3.16
Allergan projects $5.73 per share non-GAAP EPS for 2014, and $14.9 in non-GAAP EPS for 2019.
Most importantly, Allergan has had 11 FDA approvals in the last 4 years, with two more expected this month alone. This has led to accelerating growth, as I wrote in my previous articles.
Allergan and Valeant's debt ratios
As a reminder, Valeant's Debt/Equity = 3.2, Debt/EBITDA = 4.6.
Allergan is debt-free, with net cash of $1.6B.
Valeant avoids any mention of its debt or enterprise value like the plague
Did you see any mention of Valeant's huge, eye-popping debt in Valeant's 176-slide presentation last week?
Did you see any mention of Valeant's huge, eye-popping debt in Valeant's latest presentation yesterday?
Answer to both questions is a resounding NO.
The standard metric in mergers and acquisitions is EV/EBITDA (EV = Market Cap + Debt). Valeant fears any mention of that numerator. That is why Valeant keeps talking about P/E, and has never mentioned EV/EBITDA. This is even though nobody knows what Valeant's E in the P/E really is, especially accounting-challenged bulls.
Allergan needs to hire even more forensic accountants than last time in order to ferret out Valeant's true profits. But then, Valeant won't allow any time for forensics.
Valeant in an incredible hurry
Valeant made one offer last Wednesday, one more on Friday, and filed for a proxy fight on Monday. All this without giving a chance for Allergan to respond! This is unprecedented.
Why is Valeant in such obscene haste? It is because at the anniversary of the B&L acquisition in Q3, Valeant turns into a werewolf. It is trying everything possible to close this deal before that time.
This is Valeant's business model - keep pushing out the day of reckoning by using its overvalued stock to make acquisitions every year around the anniversary of the previous year's acquisition.
Levadex and Ozurdex decisions in June
Allergan has two major drug approval decisions coming in June. Is Valeant afraid of this?
Undoubtedly, Allergan will raise profit guidance if the FDA approves these drugs. It is highly likely for these to be approved, as I covered in previous articles.
Readers can take a look at Charlie Munger's great talk titled "Psychology of Human Misjudgment". In that talk, Munger says that humans cannot sense absolute values, they can only sense contrasts. Munger says this is why magicians can perform their tricks.
This is why Valeant looks like a magician. As the magician removes people's wrist watches, people don't notice. When Valeant pulls coins from behind people's ears, or rabbits out of a hat, the audience lets out ooohs and aaahs.
Charlie Munger has a saying - "Common sense is uncommon".
This sleight-of-hand trick of capitalizing versus expensing is very old, and appears many times in different forms. I think this is the first time it is manifesting itself in the pharma industry.
I searched on the Internet for examples, and found WorldCom. At one point, WorldCom was the second-largest telco in the country (second only to AT&T). WorldCom was built mainly through acquisitions too. Two links about the WorldCom catastrophe are here and here. If people don't learn from history, they are condemned to repeat it. Those two articles are nice vaccinations against misery.
This is why Buffett's year 2000 letter said that when a bubble bursts, "a new wave of investors learn some very old lessons".
Yesterday's article is really long, and contains a lot of stuff that I can't repeat. Readers are highly encouraged to read it.
If people understand the difference between capitalizing and expensing as shown by the above example, they can better understand Valeant's business model and financial statements. Valeant is hugely overvalued (look at my table in yesterday's article).
This is why Valeant is in a terrible hurry to acquire someone.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.