It may be the work of a strategist rather than a maverick entrepreneur, but Valeant is still following the plot line of industry consolidators that grow rapidly on debt—stories that often don’t end well. Even Pearson’s supporters are a bit unnerved. “We believe in the strategy and believe in Mike and have for a long period of time,” says Taymour Tamaddon of T. Rowe Price, one of Valeant’s largest shareholders. “It obviously gets harder as you get bigger and that’s not lost on anyone.”
One knock against acquisition machines is that with so many moving parts, it’s difficult to determine their true profitability, as Moody’s Investors Service cautioned about Valeant last September. “It’s very hard to see the earnings power of the underlying business,” says Dimitry Khmelnitsky, an analyst with Veritas. Adds Tamaddon: “It’s definitely the hardest company that I follow to model.”
To guide investors, Valeant has fashioned three customized measurements: organic growth, adjusted cash flow from operations and cash earnings per share. As with any non-GAAP measure, however, Valeant’s metrics are subjective—even problematic, says Khmelnitsky. For example, the company has changed the way it reports organic growth—that is, growth from its existing business rather than acquisitions—three times in the past two years, after investors asked how sales were faring both for products it had been selling for more than a year and its newly acquired products. But Khmelnitsky did his own calculations to determine organic growth. He excluded all acquisitions unless they had been part of the Valeant portfolio for at least a year. The result only tallied to 6% for the fourth quarter of fiscal 2011, not the 10% management reported (and just 4% in the first quarter of 2012, not 11%). “Valeant’s organic revenue growth disclosures thus far have been piecemeal, inconsistent and confusing,” Khmelnitsky wrote in a research note last July. (He says the company’s disclosure has since improved.)
Tamaddon sees things slightly differently: While he wasn’t happy with the original organic growth calculations, “to [Pearson’s] credit, now we get both definitions, every quarter. Most companies I know of would have told me to go pound sand” rather than broaden disclosure, he says.
The problem with Valeant’s adjusted cash flow and earnings numbers, says Khmelnitsky, is that they selectively include items that improve those measures “but don’t count items that reduce [them].” For example, the company has counted one-time investment and acquisition gains in its calculations while excluding acquisition-related costs or losses on divestitures. It includes the tax benefits when employees exercise stock options, but excludes related dilution costs and withholding taxes paid. The way Valeant accounts for licensing agreements has had the effect of increasing revenues without recording related costs, Khmelnitsky says. In the first quarter of 2012, the company reported cash earnings per share of $1.14, which was 17 cents ahead of analyst estimates. But when Khmelnitsky adjusted the numbers for one-time foreign exchange and divestiture gains and royalty payments to a foreign company, he came up with cash EPS that was 16 cents below analyst estimates
There are other issues. After stating in a 2011 annual report that results “historically...have not been materially impacted” by seasonality, Pearson told an investor conference last June “we are a seasonal company and if you just take our guidance and divide it by four…it does not reflect what our underlying business works at.” In fact, Khmelnistsky notes that Valeant made 60% of its cash earnings in the second half of the year—and that there was a more than 30% drop from the fourth quarter of 2011 to the first quarter of 2012.
There is also confusion about Valeant’s dermatology drug Zovirax. Prescription data collected by research firm IMS suggests its sales declined in the third quarter of 2012 on a year-to-year basis; the company reported they increased sharply. Pearson’s explanation: The data doesn’t cover all channels, such as Walmart. Meanwhile, Bank of America/Merrill Lynch analyst Gregg Gilbert warned in a recent note that Valeant’s dermatological organic sales growth resulted from sharp price increases, which “we don’t see...as sustainable.” In addition, 20% of revenues are from drugs that could face generic rivals within the next decade, Gilbert estimated.
Pearson and his team haven’t bristled at the questions but instead have invited an open discussion about their numbers, unlike other companies that have threatened lawsuits in response to Veritas’s criticisms. Valeant has even changed some accounting practices to assuage critics. “We know that we’re a complicated story,” CFO Schiller acknowledged to investors last June.