Valeant Pharmaceuticals (NYSE:VRX) CEO Mike Pearson has been in the news for all the wrong reasons lately. Here's another to heap onto the ever-growing pile.
For the past few months, Valeant's management has been battling accusations of misleading investors about the company's performance with their ever-popular Deal Model. To newcomers, the Deal Model is a performance measure which prescribes: a) a 20% cash return on investment after tax, and b) a target 5-6 year payback on acquisitions.
In theory, the conditions of the Deal Model are fantastically shareholder-friendly, as they hold management accountable to the difficult task of optimal capital allocation, one of the prerequisite factors for successful management in William Thorndike's The Outsiders. It's no surprise then that Valeant's continuous streak of hitting bat for almost all its acquisitions has drawn some skepticism from various parties, most notably AZValue's blog post titled, Valeant: A Detailed Look Inside a Dangerous Story.
Today, I present to you proof of such window dressing.
In Pershing Square's Allergan (NYSE:AGN)-Valeant presentation, Ackman demonstrates how the Deal Model is reconciled against GAAP earnings. For those not in the know, Valeant makes its own non-cash adjustments to GAAP earnings in its Deal Model to show how the business is actually performing. This is perfectly acceptable given that Valeant actively seeks to reduce taxable income by taking on debt. The problem that everyone seems to have is with how it approaches it.
Ackman's presentation has a slide showing the reconciliation of the Deal Model to GAAP earnings. This reconciliation was reconstructed from Valeant's Q4 2013 earnings call, where Pearson and team spoke about it.
As you can see, a total of $3.425 billion in pre-tax income has been added back to arrive at non-GAAP cash earnings. This turns a net loss of $1.314 billion for FY13 to positive cash earnings of $2.111 billion. The significant adjustments have been laid out in the following page - amortization of intangible assets of $1.902 billion, inventory step-up reversal of $436 million, acquired in-process R&D impairment of $154 million, restructuring & acquisition costs of $551 million, and finally other adjustments of $382 million - totaling $3.425 billion.
My attention was drawn to the Amortization of Intangible Assets of $1.902 billion, since it constituted the majority of the non-cash adjustments. At first glance, such amortization of intangible assets didn't seem out of the ordinary, as Valeant's MO was growth by acquisitions - which results in amortization of goodwill. However, I recalled a number of analysts mentioning that the company's depreciation/amortization was a black box. Given how much this item represented cash earnings, I figured uncovering the details of it would be material to the valuation. So I prodded Valeant's FY13 financial statements for more color.
Flipping to the income statement of Valeant's 2013 Annual Report reveals the line item Amortization and Impairment of finite-lived intangible assets of $1.902 billion - as stated in Ackman's presentation. There's a nice note there that says disclosures are in note 12, so that's where I went next.
Under Note 12, management has neatly provided the $1.902 billion impairment charge next to previous year charges, with the explanations for the charges right below. You'll observe that the very first disclosure item is a $551.6 million impairment charge related to ezogabine/retigabine. That's a particularly large portion of the $1.902 billion, so I sit up. Following the "described above" cue, I scroll up slightly and find a note which tells me to go to Note 7.
At first, it wasn't immediately obvious where the $556.1 million charge was located. It turns out that Note 7 is a huge deca-page disclosure that explains practically all of Valeant's operational activities - this single note could have used its own table of contents. The analysts weren't kidding when they said that Valeant's financial statements were a labyrinth to navigate.
After a bit of digging, I managed to find the disclosure for the ezogabine/retigabine impairment charge (it's on page 52). Here we see the $1.902 billion total, as well as the $556.1 million impairment expense for ezogabine/retigabine (there's a small offset, but it's not material). The only other primary impairment charge relates to amortization of intangible assets of $351.9 million. All other impairment charges seem to be an aggregation of smaller write-offs of $30 million or less.
But wait! In the same disclosures relating to the year 2012, the ezogabine/retigabine impairment charges appear again - this time, it's a much smaller $109.8 million impairment expense in 2012. However, there's also a disclosure that the intangible asset was reclassified from an IPR&D to a finite-lived intangible asset in December 2011.
Going back to the intangible asset schedule, you'll notice that the Acquired IPR&D item does not suffer from any amortization whatsoever. So this ezogabine/retigabine item must relate to a brand asset - which is not subject to amortization unless fair value measurements dictate an impairment has taken place.
Okay, so by now my interest is piqued. During my search for the elusive ezogabine/retigabine disclosures in Note 7, I came across this particular item over and over again. I really want to find out what this thing is.
If you were observant, you'll notice that one of the snapshots above mentioned that the ezogabine/retigabine formulation was "co-developed and marketed under a collaboration agreement with GSK (GlaxoSmithKline)". A Google search of 'ezogabine/retigabine' reveals that the compound was used in an epilepsy prescription drug called Potiga in the US, and Trobalt in the EU. The reason for the impairment charge was because EU regulators had found that Trobalt was overly potent, which caused some patients to experience impaired vision and skin discoloration. This resulted in a ruling by regulators that Trobalt should only be prescribed if all other epilepsy medication had failed to produce results - implying that sales would fall dramatically. The impairment charges certainly reflect that.
Now we know that the amortization charge of $556.1 million is related to the permanent loss of sales of Trobalt in the EU. Which leads us to our next question.
Why is Pearson adding it back to GAAP earnings as a non-cash adjustment??
Since the loss of Trobalt represents the loss of future sales of an extremely tangible product - as opposed to an arbitrary write-off of an intangible asset - adding it back to represent actual 'true' earnings is a definite misrepresentation.
The default argument management might make is that since this is a one-time non-recurring expense, it doesn't reflect recurring loss of economic value down the road - and thus shouldn't factor into a DCF valuation. This is not how Buffett would define owner earnings - as the R&D assets that were previously capitalized are now useless; hence they should be written off as a loss, the same way you'd write off an obsolete piece of plant and machinery.
To add insult to injury, let's reflect back on what Ackman wrote in his presentation. His slide states that "these non-cash charges do not reflect a loss of economic value for Valeant".
If you've ever wondered whether these superstar fund managers possess unattainable 'in-a-class-of-their-own' levels of due diligence… you now have your answer.
In any case, my perception of management's integrity has completely deteriorated after this. It seems more and more likely that AZValue was right in his assessment of the Deal Model. And that would be incredibly bad news, because his numbers are particularly damning. His suggestion is that some of Valeant's numbers relating to FCF from acquisitions have been blown up by almost 100% cumulatively over a number of years.
Will today's release of the 10-K reveal more mysteries and surprises? Only time will tell.
Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.