Pharma companies are notorious users of accounting tricks to portray themselves in the best light. Two years ago, I published an article on Seeking Alpha detailing how Valeant Pharmaceuticals (NYSE:VRX) was deceiving investors by making acquisitions and pretending they were free by presenting pro forma financials that backed out the associated amortization of intangibles. In this article, I will show how Biogen (NASDAQ:BIIB), one of the largest biotech firms in the world, is inflating its results by aggressively accounting for the earn-out payments it is making for its best-selling drug.
Last month, Biogen came out with a good set of results, and also announced that its CEO, George Scangos, will step down once a successor is identified. He has been with the company for six years, and the announcement was something of a surprise. This week came reports suggesting that it may be an acquisition candidate as a result of its lame-duck leadership, causing the stock to spike up by 10%. With a $70 billion market cap and $11 billion in revenues, it would certainly be a big bite to swallow for another pharma company. At 16x EPS, it also does not look expensive. However, this EPS multiple is deceptive. The company pays approximately 30% of its profits ($600 million in the first half of this year) as an earn-out payment for an acquired drug and does not expense this amount. This is cash that is now not available to invest in the business, pay down debt or buy back stock. The amount is paid to former shareholders of Fumapharm AG or holders of their rights. The company increased its goodwill by $515 million in the first half of 2016, representing the $600 million paid net of $85 million in tax benefits.
In 2006, Biogen acquired Fumapharm AG, and acquired the products Fumaderm and Tecfidera. It entered into a complex earn-out agreement, essentially agreeing to pay 30% of revenues if annual revenue from the products exceeds $3 billion until the cumulative sales reach $20 billion. To date, the products have done $9 billion in revenue, with the products (primarily Tecfidera) generating $4 billion a year currently. So, at the current rate, Biogen is on the hook for these payments amounting to $1.2 billion a year for the next three years, totaling $17 per share. Curiously, the terms of the agreement seem to imply that if the company were to scale back its marketing or price to bring the revenue from the acquired products below $3 billion a year, it would not owe any contingent payments and would actually be better off!
Tecfidera, which treats multiple sclerosis, is now Biogen's best-selling drug, amounting to 40% of its revenues. In the latest quarter, the company sold $987 million of the drug, up 11.7% from the previous year, primarily a result of price increases in the US.
Why is the Company's Accounting in the Grey Area?
Tecfidera is a patent protected drug with a definite life (through the year 2028 in the US). It is puzzling as to how the company can get away with not expensing the earn-out payments for this drug, but rather adding it to goodwill with indefinite life. Absent expensing the payments as accrued, the company could add the amount to its intangible assets and then amortize it over the life of the drug. In this case, it may choose to exclude the amount in its pro forma results, but it would depress GAAP earnings. The technical way Biogen is getting away with it is probably by presenting the payments as for the corporate entity it acquired, but that entity really had no assets other than the drugs. This goodwill is going to disappear when the drug's patent life ends. At that time, the company will probably write off the amount, terming it a "non-cash" charge (never mind that it actually paid billions in cash for it!).
This article is not making an investment case for or against Biogen. It is presenting some facts that are not mentioned by any analysts, who value the company on its stated earnings. If you decide to buy the stock, be aware that its real earnings (and free cash flow) are 30% less than its stated figures, at least for the next few years. On the other hand, the company has an Alzheimer's drug in development, which could be a blockbuster if it successfully clears trials.
Disclosure: I am/we are long BIIB.
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.
Additional disclosure: Short calls and puts in addition to being long the stock.