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Valeant - Risks Of Goodwill Impairment Is "New" News"

|Includes: Bausch Health Companies Inc. (BHC)

Dear all,

This is my first article on Seeking Alpha. I think it is interesting to share some other thoughts regarding Valeant's impairment risks. We are all very well aware of the current issues at Valeant and the major obvious ones are:

- 1. Significant amounts of debts lying in the balance sheet (approximately 31 billion at end of second quarter 2016).

- 2. Falling sales in the dermatology segment (especially in second quarter 2016).

- 3. Wallgreen Boots' issues regarding the negative selling prices.

- 4. Significant amounts of goodwill US$ 18.5 billion lying in the balance sheet at the end of second quarter 2016.

The first three points had been well discussed by various writers. What is of interest is the amount of goodwill lying in the balance sheet. For a market capitalization of USD 9.13 billion (based on closing price of 26.28 at 28 September 2016), the goodwill is twice that of the market capitalization. That is astounding.

Obviously, this goodwill arose from a variety of reasons. We all understand that this is primarily due to the premium that Valeant paid for its acquisitions.

Goodwill has to be tested for impairment from time to time. The apparent reason (in accounting) is that the value of assets should be fairly stated (or, for that matter, misstated). How does one gain confidence that goodwill is fairly stated?

There are various ways to answer this. One is the present value of its future earnings arising from the acquisitions. Would the acquisitions have higher potential upside in the future? This is a question relating to business. Common sense should dictate that it then falls back to whether the business has some plans (for its newly acquired entities) to achieve growth.

Where the future growth can be sustained, the risk of impairment will then diminish.

Personally, I have ever worked for companies where we face tremendous risks of asset write downs. Auditors frequently pose the question of whether the investments and intangibles are fair valued in the (then) carrying amounts. One such example was an associate which my former company had invested in and auditors questioned if the associate will be profitable in future and that forecasts be provided to show that the carrying value of the investment is fair and not unrealistically overstated. The same applies to Valeant and whether it is able to prove the business case for its acquisitions.

Back to Valeant's risk of having to write down its intangible assets (especially the investment in Addyi), this risk is not an unknown in the first place. Let me provide the following extract:

USD in million

2011

2012

2013

2014

2015

Goodwill

3,599

5,141

9,752

9,346

18,553

Total assets

13,142

17,950

27,971

26,353

48,965

           

Goodwill as a percentage of total assets

27%

29%

35%

35%

38%

Goodwill as a percentage of total assets had steadily risen over time from 2011 to 2015. For the period 2011 to 2015, goodwill itself had compounded annual growth rate of 50.6% per year, while total assets grew by 38.9%. Maris may have rightly pointed out that Addyi impairment is a risk. Then again, do we all not know that this was a problem from the beginning? These were all in the balance sheet for a very long time.

As a comparison, the following shows goodwill as a percentage of total assets for other "well known" companies (for the respective financial years ending in 2015):

USD in million

Pfizer

Allergan

Endo Intl

Perrigo

Average

Goodwill

7,606

46,552

7,813

10,369

18,085

Total assets

29,137

135,841

19,350

19,721

51,012

           

Goodwill as a percentage of total assets

26%

34%

40%

53%

35%

Pfizer has the lowest goodwill to total assets, while Perrigo (surprisingly) has the highest of 53%. Valeant is 38% in 2015, while still slightly less than Endo International. The average of the four companies is about 35%. Valeant's 38% is hovering just over this 35% average. This gives a rough benchmark. Valeant's goodwill in the books is not an unreasonable amount and it faces impairment risks like any other pharmaceutical businesses.

To reiterate my earlier point, this (the goodwill impairment risk) is not an unknown in the first place. Honestly, have a look at the financials. It is not a new discovery. Consider that Joseph Papa and Paul Herendeen went into join Valeant after knowing these issues. They would be crazy to join a company knowing that the impairment risks will sink the ship.

Obviously, the impairment risks will not sink the ship completely. However, it may pose significant risks to earnings over the next few years. I will not be sleepless over Valeant writing off Addyi. After all, if they do, it will surely benefit future results which will not be exposed to this risk of goodwill impairment (more specifically, the impairment on the investment in Addyi).

David Maris (Wells Fargo) brought up a valid point, but it is not "new news" today. What I hope Valeant will do is to apply whatever impairment necessary to help it start on a clean slate for 2017. There is as such, no necessity to fear about poor earnings for a quarter or two more, considering the longer term turn around plans from Jo Papa.

Just sharing my piece.

Disclosure: I am/we are long VRX.