Valeant’s Q3 Report: Curious & Curiouser

I will be writing a series of articles about everybody’s favorite financial topic – Valeant. These articles will have one central assumption: the statements of Valeant’s management not recorded in SEC filings are not to be trusted. Subsequent articles will discuss the reasons for this assumption in more detail, but it is important to remember. Thus, things such as Valeant’s prior guidance of $7.5 billion EBITDA for 2016 will be regarded as hot air.  Instead, these articles will rely primarily on Valeant’s quarterly/annual reports and outside sources. If you trust Valeant’s management, then you will understandably disagree with these articles. And, in that case, you should definitely raise whatever funds you can to buy more stock – after all, according to Mike Pearson, it was a bargain at 160.  At 75, it must be a fantastic bargain.  And, you will have the market to yourself because Valeant, according to them, will be too busy paying down debt to take advantage of this amazing opportunity.

(NOTE: The original article, I think, contained a significant and unfortunate error regarding the payment of bills, which was exacerbated by some excited rhetoric. I attributed the increase of 281 million in the Q3 accounts payable, accrued and other current liabilities exclusively to the accounts payable portion of the line item. In fact, as the first page of the balance sheet would have indicated, the increase in accounts payable between Q2 and Q3 was only about $60 million, the rest was made up of a difference in accrued and other liabilities. I do not know where that sum came from. The innocent, and probably most likely explanation is that it had something to do with Salix, but Salix did close in Q2. A more interesting, but difficult to understand explanation is that it had something to do with Philidor because here is Valeant’s description of how it accounts for Philidor: 

Gross product sales for products dispensed through Philidor Rx Services, LLC (“Philidor”) pharmacy network (which is consolidated  as a variable  interest  entity within our consolidated  financial  statements)  are  recognized  when a prescription  is dispensed  to a patient.  Net sales recognized through the Philidor pharmacy network represents 7% and 6% of our total consolidated net revenue for the three months and nine months ended September 30, 2015, respectively.  Any inventory on hand in the Philidor pharmacy network is included in inventory in our consolidated balance sheet.    Provision  balances  relating  to  estimated  amounts  payable  to  direct  customers  are  netted  against  accounts  receivable,  and  balances  relating  to  indirect customers are included in accrued liabilities.  

This suggests that there is at least an argument that the increase occurred, at least in part, because Valeant increased its estimation of the returns and rebates it may need to make to its indirect customers (PBMs/Insurance companies). In any case, my apologies for the error in the original post, I have adjusted the language throughout. I think my point on GAAP cash flows remains (relatively) unchanged.) 

Let’s begin with the most recent quarterly report. A close reading reveals two strange and potentially important things.

-If Valeant’s accounts payable and accrued and other liabilities balance had not increased by 281 million, it would take Valeant more than 15 years to pay down its debts if that was the only thing that it did with its GAAP operating cash flows.

-Valeant’s revenues from existing businesses (i.e. businesses not acquired this year) has grown by less than 1% in 2015 if the financial impact of foreign currency rates is included and a majority of Philidor’s revenues are excluded.  If all of Philidor is excluded, Valeant’s revenues from existing businesses has declined so far this year.

Valeant’s accounts payable/accrued and other liabilities has increased by $281 million and thus increased its GAAP cash flow by 38%.  If this had not occurred, and its GAAP operating cash flow stayed flat, then it would take Valeant more than 15 years to pay back its debt even if it used all of its operational cash flow for the task.   

Valeant’s bulls frequently argue that amortization is not a valid expense (the key to the cash EPS figure that is their favorite statistic).  That argument seems questionable according to at least one Oracle.  But regardless, let’s take them at their word and turn to GAAP cash flow from operating activities.  As its name suggests, this, and not cash eps or Ebitda, is a measure of how much cash Valeant is actually generating from its business. And GAAP cash flow is a measurement that even Valeant uses in its own presentations – so it must have some validity.

Last quarter, Valeant had a GAAP cash flow of 737 million from operating activities.  That’s not bad.  Pro-rated, and extended, it would still take them over 10 years to pay off all of their debt if that was all they used their cash for (3 billion a year of cash flow, 31-ish billion of debt).

But there is a significant reason to wonder about that number.  Lurking at the bottom of the statement, Valeant credits its cash flow with 281.6 million for “Accounts payable, accrued, and other liabilities.”  Simply put, these are bills that it hasn’t paid yet.  Unlike amortization, this is a real obligation that Valeant has to satisfy.

And we have external evidence that Valeant has stopped paying its bills.  Approximately a week ago, PDL Biopharma stated that Valeant had missed three months of royalty payments.   Valeant did pay its obligation of $16.9 million in late October, but this evidence suggests Valeant has not been timely paying very real obligations.

281.6 million is a very large number (presumably the missing royalty payments to PDL made up a portion of it).  It accounts for approximately 38% of Valeant’s Q3 GAAP cash flow from operating activities.  If Valeant paid all its bills on time, then its operating cash flow would be 450 million.  Pro-rated (1800 million a year), and extended, it would take them over 17 years to pay off their debts.

I have not found an easy explanation for where this number comes from.  It is presumably not from Salix, because the Salix balance sheet was incorporated into Valeant for Q2.  (In Q2, Valeant’s cash flow from operating activities was only 410 million, with accounts payable standing at 110 million).

I searched Valeant’s Q3 document and found no specific explanation for the accounts payable number.

Valeant explained its increase in GAAP cash flows this way (pg. 50)

“Net cash provided by operating activities increased $118 million , or 19% , to $737 million in the third quarter of 2015 , primarily due to:the inclusion of cash flows in the third quarter of 2015 from all 2014 and 2015 acquisitions, including Salix, Marathon and Dendreon; and incremental cash flows from the continued growth of the existing business, including new product launches.”

They do not provide any direct explanation for why they have an increased credit of 281.6 million in accounts payable and accrued and other liabilities.

Innocent explanations: Salix? Deferred severance packages? Perhaps some friendly supplier doesn’t mind his bills being late? Valeant throwing its weight around?

But that would constitute newfound leniency on the part of Valeant’s suppliers, because the number also dwarfs Valeant’s previous credits for this line item. Valeant’s total line item for all of 2014 was 188 million.  The line item balance was negative in both 2012 and 2013.  In short, deferring its liabilities is a new development for Valeant.

And, to answer the retort of Valeant bulls, Valeant only lodged $75 million in restructuring expenses during this period.  Let’s take Valeant at its word that these are one-time charges and include that back into the cash flows while excluding the $281 million.  Now we’re at $531 million. Pro-rated and extended ($2100 million a year), Valeant, using all of its cash from operating activities, could then repay its debt in only 15 years.  I’m sure the bond holders will be thrilled.

Without Philidor, revenues from Valeant’s existing businesses appears to have grown about 1% over the last 9 months    

Buried rather deep in the Q3 report, is the following series of statements. (page 43)

For developed markets, Valeant states that it experienced:

“(1) a “negative foreign currency exchange impact on the existing business of $66 million and $198 million in the third quarter and first nine months of 2015 respectively.” (2) a negative impact from divestitures and discontinuations of $5 million and $116 million in the third quarter and first nine months of 2015

Excluding the items described above, we realized incremental product sales revenue from the remainder of the existing business of $236 million and $820 million in the third quarter and first nine months of 2015 , respectively. The growth … incorporates sales directly to wholesalers and retailers as well as use of specialty pharmacies (primarily Philidor).”

But, what if we don’t exclude the impact of foreign currency exchange (Valeant’s debt is dollar denominated) and include the impact of Philidor’s demise?

For 2015 so far, Valeant’s existing product lines in developed markets has grown by 820 million.

First, let’s include the impact of foreign currency ($198 million). Now we’re down to 622 million.

Valeant says that Philidor accounted for “approximately 6% of the Company’s total consolidated net revenue.” Philidor only operated in the U.S., and Developed Markets are 82% of Valeant’s total revenue, so let’s bump up Philidor’s effect on Developed Markets to 8%.  8% of Valeant’s developed markets revenue so far in 2015 is 498.6 million. (total developed markets revenue is 6,322.77).

Now, what portion of Philidor’s revenue (which per Valeant was immaterial in 2014) should we take out?  Let’s be pessimistic but not doom & gloom and say Valeant will lose 75% of this revenue. That gets us to 373.92 million.

We take that out from the $622 million and now we’re down to a $249 million increase in incremental revenue in developed markets.

So, for developed markets, Valeant grew revenue 249 million over the last 9 months.  Valeant’s developed markets revenue for the comparable period in 2014 was 4,409.4 million.  That’s an increase of about 5% total.

But wait, there’s those pesky emerging markets where Valeant has been acquiring businesses left and right.

Over the first 9 months of the year, Valeant realized an incremental product revenue increase of approximately 71 million in the emerging markets.

Unfortunately the emerging markets had a negative foreign currency exchange impact of 275 million.

So Valeant’s actual revenues (in those pesky debt denominated dollars) from the existing emerging market businesses actually decreased by 204 million. Total emerging markets revenue for the comparable period in 2014 was 1,574.1.  So Valeant’s revenue from existing products in emerging markets fell by over 10%.

Put it all together – total product revenue for existing product lines (excluding discontinued lines) grew by a whopping $45 million.

Based on a 2014 revenue base of 5,983.5 million, Valeant managed to increase revenue from its existing products by less than 1%. Not great Mike!

If all of Philidor’s revenue is written off, then Valeant’s revenue from existing products actually fell between 2014 and 2015.

Valeant bulls, presumably, will say that it’s not fair to include the impact of foreign currency exchange.  But, if Valeant wants to truly live in the financial world where the dollar is weak rather than strong, then there are steps that it can take. It can pay cash for currency hedges, like many businesses do. It can attempt to borrow money in those pesky zlotys and rubles that are causing it so much trouble, and then repay the debt in the same currency.  But, Valeant is a business, not a George Soros currency trader.  I see no reason why Valeant should be granted the right to decide what is the normatively correct currency level and assume that things will inexorably revert to this state.  (There is also a more sinister assumption – Valeant is making up foreign currency adjustments to disguise the fact that it’s business is shrinking. After all, this is a completely opaque measurement. But, again, even if we accept Valeant at its word, these foreign currency adjustments result in less U.S. dollars.)

For reference, this is the only explanation that I could find in the 2015 annual report of how Valeant performs its foreign currency translation. I do not see any discussion of the base that Valeant uses for the translation and, because Valeant operates in so many different markets with no discussion of revenues from each country, I see no easy way to double check their work:

The assets and liabilities of the Company’s foreign operations having a functional currency other than the U.S. dollar are translated into U.S. dollars at the exchange rate prevailing at the balance sheet date, and at the average exchange rate for the reporting period for revenue and expense accounts. The cumulative foreign currency translation adjustment is recorded as a component of accumulated other comprehensive income in shareholders’ equity. Foreign currency exchange gains and losses on transactions occurring in a currency other than an operation’s functional currency are recognized in net income.

(Relatedly, and a much smaller point, Valeant’s ability to even show some measly GAAP income is entirely dependent on its ability to exclude foreign currency adjustments from that calculation. For example, for all of 2015 so far, Valeant has had a net income of 74.6 million.  But it also has had a foreign currency translation adjustment of negative 548.3 million.  If that is included, then Valeant has had a comprehensive loss so far in 2015 of 477.3 million.  Makes one wonder why Valeant continues to expand into emerging markets so aggressively.)

Conclusions

So, let’s put it together.

According to the GAAP operating cash flow, Valeant right now would be generating around $500 million a quarter in cash if its accrued liabilities had stayed flat.

Valeant’s revenue from existing product lines is basically flat if most of Philidor is excluded.

If Valeant cannot grow its revenues significantly, and it is not doing so for its existing products right now, then it will take it at least 15 years to pay down its debt even if it devoted all of its operating cash flow to the task.  In this scenario, Valeant would not have much money to invest in R&D and little clear-cut remedy for when many of its important products (including even precious Xifaxan) began to lose patent exclusivity.  Valeant would have little margin for error if either interest rates rose, or it had to refinance its debt at a significantly higher rate. It seems likely that little, if anything would be left for the equity holders of the company.

But, I think, this is probably a generous assessment. If there are serious questions about Valeant’s ability to actually repay its bond holders, then the equity will simply become a call option on whether there will be anything left after the bond holders are satisfied – especially once the bond holders begin to increase pressure to ensure repayment. The equity will be a leveraged call option on Valeant’s ability to survive. I don’t think this leveraged call option is worth $75 a share. In fact, I’d be surprised if it ends up in the money at all.

Disclosure: I am short Valeant through put options.

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Valeant’s Q3 Report: Curious & Curiouser

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