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Summary

  • Valeant complained to the SEC about Allergan's "misstatements" on B&L organic growth. The SEC should take this opportunity to examine Valeant's earnings releases and ask the following from Valeant.
  • Clearly report the negative organic growth from acquisitions older than a year. Valeant trumpets B&L organic growth even though the B&L acquisition closed in August 2013.
  • Report organic growth on a consistent same-store sales basis. Valeant until recently reported "pro-forma" organic growth. Report same-store-sales organic growth figures in earnings releases that contain only pro-forma data.
  • Valeant repeatedly tells investors it gets an IRR of at least 20%. How does Valeant reconcile this with Valeant low return on capital of 13%?
  • Valeant claims it has low R&D. But it "pre-pays" for R&D in a one-time payment called an acquisition. The SEC should ask Valeant to include "pre-payment" along with "low R&D".

This quote is from Warren Buffett's 2002 letter to Berkshire Hathaway (BRK.A (NYSE:BRK.B) shareholders. It is important because Valeant Pharmaceutical's (NYSE:VRX) "cash EPS" is nothing but "earnings before depreciation, amortization, restructuring, integration, ..."

I believe this quote has a great analogy for how to think of Valeant's low R&D expense. The R&D expense is pre-paid with acquisitions. I gave an example in a previous article, but this analogy is succinct and memorable.

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

- Warren Buffett, 2003.

Valeant complained today to regulators that Allergan (NYSE:AGN) made "misleading statements" regarding Bausch and Lomb. The complaint mentions just Bausch and Lomb. Does this mean everything else Allergan said about Valeant is correct? For instance, the last slide that Allergan posted last week was about the dramatic market share loss in Dysport and the fillers. These products were suddenly sold by Valeant to Nestle last month. Was Allergan's data correct? Was the Wall Street Journal correct on fillers? I covered these discrepancies on fillers in this article.

The SEC can ask Valeant to demystify its statements and earnings releases to investors. The following are things that bother me as an investor.

Valeant's IRR of 20%

Valeant claims an IRR of 20% in whatever it invests in (this claim repeatedly appears in its investor presentations). How does this add up to a much lower return on capital of around 13%? I have shown the calculation in a previous article. SA Commenter porthos and contributor David Trainer have calculated Valeant's ROIC as 4%.

Valeant's organic growth reporting

I can't think of another company that doesn't clearly state its organic growth from businesses that it has owned for 12 months or more. In Valeant's case this would be the organic growth in its non-B&L businesses since B&L closed less than a year ago. In Q1 this growth rate was -6%. Will we see a similar number in its Q2 earnings release; after all Valeant's B&L growth rate in Q2 was the same as Q1, i.e. 11%.

The SEC should also ask Valeant to mention same-store sales organic growth along with Valeant's preferred pro-forma in any old earnings releases that contain just pro-forma.

For example, by selling Dysport and the fillers to Nestle, Valeant improves its "pro-forma" organic growth. But since this closed in July, the "same-store-sales" numbers for Q2 will capture any under-performance in these products.

Valeant's debt maturity

Valeant's debt maturity of 5 years and 3 months, debt of $17 billion, adjusted forward OCF of $2.6 billion means that it relies on being able to refinance its debt. This is unlike any other major pharma company I can think of. This risk is not explained enough in my opinion.

The maturity is unusually short for a Debt/EBITDA ratio of 4.6, and a boilerplate explanation or disclaimer doesn't suffice.

If Valeant cannot refinance, Valeant cannot repay its debt. As simple as that. Just divide $17 billion by $2.6 billion, you get 6.5.

Valeant's EV/EBITDA

I can't think of another case where a company making an acquisition just never mentions its EV/EBITDA ratio. At long last, Valeant managed to mention Allergan's EV/EBITDA ratio in its latest investor presentation. What was conspicuous by its absence was Valeant's own EV/EBITDA.

By touting its P/E and never mentioning EV/EBITDA, Valeant hides its huge debt of $50 per Valeant share.

Valeant's claim of low R&D expense

Valeant says that every other pharma makes the same adjustments to its GAAP earnings. But obviously every other pharma does not make bigger and bigger acquisitions every year.

Worldcom investors got into trouble because Worldcom capitalized what it should have expensed.

Valeant capitalizes R&D output by making acquisitions. It then ignores the resulting amortization when it trumpets its "cash EPS" to investors. It also claims it has R&D output without input like other pharmas.

The SEC should figure out a way to help investors understand acquisitive companies. Warren Buffett's quote at the start of this article is a great explanation. The SEC could use that as a guiding light to make reporting rules. For example, some of the amortization of acquired assets should be compulsorily added back to R&D expense.

Otherwise GAAP and non-GAAP will diverge so much that both GAAP and non-GAAP measures become useless to investors.

Allergan's Q2 earnings released today

Allergan is cutting 13% of its workforce and thus sharply raising its 2015 EPS guidance to $8.2 to $8.4. At its mid-point of $8.3, Valeant is offering just 21 times 2015 Allergan earnings - assuming Valeant's stock is not overvalued. Valeant's offer is highly inadequate.

I can't understand why Allergan hasn't acquired anyone yet. As an investor, I don't care if Allergan generates profits by inventing new drugs or by digging oil out of the ground. Allergan could have saved itself so much trouble by acquiring someone instead of piling up cash.

Hedge fund manager John Paulson last week gave the example of Actavis (NYSE:ACT). Paulson said that Valeant tried to buy Actavis, Actavis in response bought Warner Chilcott and escaped Valeant. This was in response to a question on Allergan's options.

Egging on the arbs

Valeant and Ackman have been encouraging arbs and other event-driven funds by repeatedly saying the takeover of Allergan is inevitable. The SEC should investigate whether this is true - otherwise in my opinion it qualifies as market manipulation. This is because without arbs there won't be any takeover, and without the likelihood of a takeover arbs will avoid this situation. It's a chicken and egg problem for Valeant/Ackman.

Source: What The SEC Should Ask Valeant; Allergan Investors Should Watch Out