Let me start with my credentials, only because it's important in the VRX chaos. I trained as a Chartered Accountant (auditor or CPA in US parlance) at KPMG London, and was in the top quartile of my class, albeit 2 ½ decades ago. After that I became an equities analyst and fund manager.
There're a plethora of articles on Valeant (VRX). This company could be the most controversially listed entity over the last 5 years; there are some highly knowledgeable writers on SA that will give you detail in the pharma industry that I could not dream of. But what has astounded me is the lack of clarity on the underlying accounting and the nature of an audit.
This article will not attempt to unravel the company's complex history, but refer to it only when it's relevant for the present.
My first port of call for a reasoned and grounded analysis on VRX has always been SA Author Early Retiree, who supported the company since its ignominious descent from $200 in October 2015, sold around $60. I single this author not to portray his personal misjudgement, but only to illustrate how the tragedy has led to unmitigated capitulation by the most ardent believers. To be fair, I don't blame them.
Let's start with the announcement by the company on 21 March, after a +50% fall in the previous week. The main points:
- VRX may not file their annual and quarterly results by the deadline 31 March 2016; this will give bondholders the right to trigger a default, if the statements are not filed by 29 April 2016;
- There will be a retraction to previous quarterly and annual statements dating all the way back to the year to Dec. 2014. These quarterlies and audited results may or may not be restated;
- A new CEO is to replace Michael Pearson as soon as a suitable candidate is found;
- The ad hoc committee that was investigating the Philidor disaster has not completed their investigation and more transgressions may be reported;
It's not a surprise that this caused investors to panic en masse. There was ample talk swirling (SA articles linked) of a bankruptcy, that the bondholders could trigger a default, that the auditors would qualify the company's audit and deny them 'a going concern' status; that massive fraud detected within Philidor and others will lead to a material restatement of historic results. There was also a renewed focus on GAAP earnings and how the company had misled investors for years with their version of non-GAAP earnings.
I will address most of these, the first point summarising much of the misunderstanding:
Valeant's audit will not be qualified by the going concern qualification. There will NOT be a material restatement of historic earnings, but there will be an impairment of goodwill and intangible assets.
- the delay is NOT about the audit. Let me assure you from my first-hand experience as an auditor, that has been done weeks ago; debtor-creditor balances, bank reconciliations, revenue checks, stock takes have been done by extensive fieldwork way in advance before and after the year-end. PricewaterhouseCoopers (PWC), the auditors were ready to sign off, as they were well aware of the regulatory deadlines.
- The delay is not about the ad hoc investigation over which PWC has NO obligation - this was an internal control that went awry and is being urgently addressed.
- There may have been further audit work required due to the Philidor disaster, or the doctoring of invoices (probably illegal and need to be reversed) but these are isolated domains that can be audited exhaustively in a few days. The materiality of this restatement is evident in the most recent VRX release, where the full extent of Philidor precipitated a minor timing adjustment in booking revenue between 4Q 2014 and 1Q 2015. If you are looking for a massive restatement on the P&L forget it, it's not happening.
- This is not about the going concern, as there is no way PWC would strike that fatal blow so prematurely. After all, interest cover is about 3x, even on prudent forecasts. All VRX has to do is defend their earnings and cash flow forecast, and the onus is on PWC to prove the forecast wrong. No auditor would take that risk. I can virtually guarantee this is not the reason for the delayed financial statements. Let me assure you, the audit delay is NOT about the ability of VRX to continue as a going concern.
- The more I think about it, this is about Goodwill and the Intangible assets. $20bn worth, as at the end of Dec. 2014. PWC has to make a final assessment that the financial statements give a 'true and fair' view of VRX, including the balance sheet. The PWC partners have to sign off that there has NOT been a permanent impairment to these intangibles. There is almost overwhelming evidence that there has - the earnings capacity (in terms of future price hikes) has been broken; their realisable value has obviously come down; hence their value on VRX's balance sheet has to be adjusted. From VRX's 2014 annual report, this is the accounting treatment of intangible assets (my emphasis):
We evaluate potential impairments of amortizable intangible assets acquired through asset acquisitions or business combinations if events or changes in circumstances indicate that the carrying amounts of these assets may not be recoverable. Our evaluation is based on an assessment of potential indicators of impairment, such as:
• An adverse change in legal factors or in the business climate that could affect the value of an asset. For example, a successful challenge of our patent rights resulting in earlier than expected generic competition;
• An adverse change in the extent or manner in which an asset is used or is expected to be used. For example, a decision not to pursue a product line - extension strategy to enhance an existing product due to changes in market conditions and/or technological advances; or
• Current or forecasted reductions in revenue, operating income, or cash flows associated with the use of an asset. For example, the introduction of a competing product that results in a significant loss of market share.
Impairment exists when the carrying amount of an amortizable intangible asset is not recoverable and its carrying value exceeds its estimated fair value
- So allow me to picture the scene. The partners at PWC will propose writedowns. VRX board will reject them. PWC will insist, fearing another Enron-style litigation (if VRX does implode) that destroyed Arthur Andersen. At the end of the day, final writedowns will be more aligned in favour of PWC (what they are proposing and VRX will obviously resist them, as it would be a concession to terrible acquisitions). But PWC will prevail.
- KEY POINT: THIS IS AN ISSUE OF NEGOTIATION AT A TABLE. THE DELAY WILL ONLY BE AS LONG AS THE PARTIES DISAGREE.
- HENCE VRX WILL HAVE AUDITED RESULTS IN A VERY SHORT TIME, NO DOUBT WITH MASSIVE IMPAIRMENTS TO INTANGIBLES. More on the consequence below.
Valeant debtholders will not trigger a default
This suggestion is the most ludicrous of those doing the rounds. VRX has not been late on a single payment of interest or principal. Why in the world would debtholders want to force a company into liquidation? There is absolutely no reason to the argument. Note for any tranche to trigger a default, it has to be initiated by 25% of the principal amount of each such series of Notes. However, this debt is held in CLOs (Collateralized Loan Obligations) and spread amongst a highly diverse range of underlying debtholders. From the Fortune article linked, "To be exact, that's 753 funds over 103 managers who own Valeant debt, according to research from Wells Fargo. Barclays is the "agent bank," meaning it is the bank that is meant to organize the negotiations of the various lenders of the loan." So grouping 25% of the debtholders to consent and trigger a default would be like herding squirrels. Nah it's not gonna happen.
So what is the impact of Impairments to Intangible Assets and Goodwill
As mentioned above, PWC will be obliged to take a new look at their value, and in light of the new pricing environment, their earnings power has indubitably been impaired. So what does this mean? Well, there will be under GAAP accounting, an extraordinary write-off in the restatement. This will not affect GAAP earnings for 2014 or 2105, but will be an extraordinary charge in either/both years. How big could it be. God knows.
But let's assume that of the $20bn intangible assets (goodwill and intangibles) on VRX's balance sheet as at the end of Dec. 2014, PWC, the auditors demand that $10bn is written off before they sign an unqualified audit.
Does this affect cash flow? No.
Does this affect earnings for 2014 or 2015? No, it's an extraordinary item under GAAP.
Does it affect book value? Definitely. The current book value (using Dec. 2014) balance sheet is intangible assets of $11.2bn, and goodwill of $9.3bn, and this is roughly reflected by equity of $5bn and debt of $15bn. If PWC demands an impairment of $10bn, it would lead to a total elimination of shareholder equity.
However, before you get alarmed, this is of no consequence. The accumulated deficit already sitting on the balance sheet (due to historic goodwill write-offs) is already negative $2.4bn. So this figure would simply rise to -$12.4bn with zero consequence to earning power or debt covenants.
After the possible $10bn impairment that PWC will oblige VRX to swallow, what will the book value be? It will be $16bn. And remember the current market value is down to $11bn. The P/BV was probably absurd at 12X (when VRX traded at $250) but remember the share price has fallen by 90%. So with the $10bn impairment that I forecast, VRX's current P/BV will be 0.8X, compared to the S&P 500 of 5X.
Yes, life has changed materially for the acquisitive roll up, but an impairment to book value along with a slight reduction in earnings power (no immoral price hikes in the future) will be the new order. The current price has more than adequately reflected the new order. Far more than required. Watch Valeant bounce dramatically once the new 10-K is released.
Disclosure: Very long at an average price of $34.
Disclosure: I am/we are long VRX.
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.