Valeant's (NYSE:VRX) New Potential Accounting Concerns
Before getting into the potential accounting issues, it is suspiciously curious why three of Valeant's most important accounting professionals left between November 2014 and June 2015. Here they are in chronological order:
1. Candice Cobb - Director of Accounting at Valeant left November 2014
2. Marc Padre - US Controller at Valeant left May 2015
3. Howard Schiller - CFO of Valeant left June 2015, but recently returned as CEO
Is it just a coincidence that all 3 originally left within 8 months of each other?
Now, moving on to the potential accounting concerns. Here are two big accounting issues that potentially involve incorrect expensing of charges possibly overstating reported Net Income. Are there legitimate reasons? Or is Valeant possibly engaging in some serious financial shenanigans?
1. Prepaid Expenses grew substantially faster than Revenues indicating possible red flags for incorrectly expensing and possibly overstating Net Income by a substantial amount.
Generally, Prepaid Expenses should grow in line with the revenues of a business. There can be seasonal or timing variations but anything way out of line could indicate that management is under expensing items, improperly making company profits higher. Rather than correctly accruing the expenses on the income statement, the company may misclassify them as Prepaid Expenses on the balance sheet. This would effectively keep the expenses off the income statement, and boost reported Net Income. In 2002, WorldCom was found to have improperly capitalized expenses as "Prepaid Line Costs" rather than running the expenses through the income statement, inflating WorldCom's Net Income.
Valeant's reported Revenues in the 3Q of 2015 were up 36% while Prepaid Expenses were up 105% year over year. The differential is enormous.
The longer the time frame the worse it gets. For the period from the 4Q 2013 to the 3Q 2015, Valeant's reported Revenues were up 35%, while Prepaid Expenses were up 178%.
|4Q 13||Q3 15||Change|
On the cash flow statement, Prepaid Expenses used up $397m from cash flow from operations in the 12 months ending 9/30/2015. This may have provided a boost to Net Income as a result of possible under expensing.
Competitors Bristol-Myers Squibb and Eli Lilly have balance sheet items "Prepaid expenses and other" that were ~13% and 15% of quarterly revenues respectively, while Valeant's was ~34% as of 9/30/15. For the 3Q 2015, Bristol-Myers Squibb's Revenues grew 4% year over year while Prepaid Expenses and Other were up 10% YOY. For the 3Q 2015, Eli Lilly's Revenues grew 2% year over year, while Prepaid Expenses and Other were down -7% YOY. Valeant's Prepaid Expenses seem to be far higher than competitors and have grown significantly faster than revenues.
In the 10-Q for the 3Q 2015, I did not see any explanation for why Prepaid Expenses were so out of line.
This is a quote from Howard Schilit, Forensic Accounting expert and author of the Financial Shenanigans book (and not to be confused with Howard Shiller), on Prepaid Expenses (from an April 2002 Bloomberg Business article):
"Watch out for vague categories that allow companies to fudge the numbers, Schilit advises. Some of his favorites include "prepaid expenses and other current assets," "noncash revenue," or "unbilled receivables." Meanwhile, large write-offs can be legitimate reflections of a plant closure -- or an excuse to lower the value of assets so future performance looks even better. Hidden reserves can also provide a nice secret fund to tap when times turn bad, giving a misleading boost to the bottom line."
Bottom Line: I believe Valeant is likely to have possibly substantially increased its reported Net Income the last 1-2 years by improperly putting operating expenses into their Prepaid Expenses balance sheet line item rather than an income statement expense.
Note: Valeant's exact description of the balance sheet and cash flow line item is: "Prepaid Expenses and other current assets" but I have used Prepaid Expenses for simplicity. Valeant also appears to have reclassified $138m of Accounts Receivable to Prepaid Expenses in the 1Q of 2014 on the 12/31/2013 balance sheet. The higher amount of $343m includes the reclassification and was used in the analysis.
2. Valeant's post acquisition accounting for Salix's Allowance for Product Returns and Rebates. Valeant seems to have changed the amount of Salix's Allowance for Product Returns and Rebates after the acquisition was completed, resulting in possible overstatement of pretax income of $123m for the 3Q 2015.
This is fairly complex acquisition accounting so I will do my best to simplify and summarize it.
When a company normally creates an allowance for product returns and rebates, there is an expense that is contra revenue and deducted from gross revenue which results in net revenue on the income statement and a corresponding accrued liability is set up. Basically, when the allowance for product returns and rebates is typically set up there is an expense to the income statement that is deducted from revenue.
When an acquirer buys a large company (the target), they generally report the balance sheet of the target as of the acquisition date. When in later filings, the balance sheet of the target on the same acquisition date changes, it can raise a number of red flags. These changes are usually reported as measurement period adjustments and may be legitimate. If an acquiring company is using aggressive post acquisition accounting rather than expensing they could increase goodwill and a corresponding accrual liability on the balance sheet of the target entity, as of the acquisition date, and the expense would never hit the income statement of the acquirer in that period. The expense would be buried in the goodwill increase on the target balance sheet as of an acquisition date.
Embedded within Salix's current liabilities was an "Allowance for Product Returns and Rebates" of $251m as of 4/1/2015, the date Valeant's closed on the Salix acquisition. This is disclosed on page 9 of the 2Q 2015 Valeant 10-Q, see e, last sentence, in small font.
A careful reader of Valeant's 3Q 2015 10-Q will note that the "Allowance for Product Returns and Rebates" as of 4/1/2015, has suddenly increased to $374m, a $123m increase versus what was originally reported. This is disclosed in small font on page 10, see g, last sentence. There is no explanation that I could find in the 3Q 2015 10-Q for this $123m increase.
On page 9, I believe this allowance increase is included in "Measurement Period Adjustments" within the current liability increase.
Also of note, FASB has recently closed this loophole because as of 12/15/2015, public companies have to record the expenses on the income statement in the period when any prior period adjustments are made. My understanding is Valeant would have had to expense an additional $123m if the measurement period adjustment had occurred after 12/15/2015.
FASB Change to Measurement Period Adjustments
Valeant's post acquisition increase of Salix's Allowance for Product Returns and Rebates was very large especially when Salix appeared to be more than adequately reserved at 4/1/2015. Salix had revenues in the 4Q 2014 of $13m and most likely a very small amount of revenue in the 1Q of 2015, as accounts receivable were very small as Salix was deloading the trade channels.
Bottom Line: I believe Valeant may have increased its 3Q 2015 pretax income by $123 million by increasing Salix's "Allowance for Product Returns and Rebates" from 4/1/2015, after the acquisition was completed.
1) Valeant's Free Cash Flow is far less than Cash Net Income
Valeant's Free Cash Flow LTM (as of 9/30/15, excluding proceeds from the Pershing investment) is around $1.7 billion while reported Cash Net Income was around $3.5 billion. Free Cash Flow is roughly half of Cash Net Income. This is very unusual for a company that should require little capital for organic growth. In my experience, if a company is missing a substantial amount of Free Cash Flow vs. what should be there given the company's organic growth and investment needs, it can be a tipoff that the company is using its balance sheet to boost its Net Income.
2) Valeant is likely worth less than $50 per share
Valeant should have around $4.00 in Free Cash Flow per share excluding Philidor. Valeant is a highly levered business with a business model that probably makes little long term fundamental sense. There will likely be extra pressure on Valeant's drugs from PBM's and insurance companies so I think Valeant is worth less than $50 per share.
These are critical issues for Valeant's investors, Board of Directors, outside auditors, and internal auditors to require robust and documented support for. With so many potential red flags, one also must wonder if there are any other possible financial shenanigans not yet uncovered.
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.
Additional disclosure: My research, writing and analysis, is my own opinion based on generally available information and other sources. There may be mistakes and errors in it. Do your own research and thinking.