Danger Zone: Valeant Pharmaceuticals

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

With news that Valeant Pharmaceuticals (VRX: $84/share) is likely to restate its 2014 financial results investors must ask themselves “is it safe to own VRX now?” If listening to Valeant management, one might think “yes”, but we say “no”.

History Of Questionable Accounting

In June 2014, we pointed out Valeant was presenting itself in a misleading way in an attempt to bolster its takeover bid of Allergan. The main issues at the time were:

Valeant’s dubious claim of “undervaluation.” Valeant argued that it was undervalued based on P/E ratios, which we know to be a poor measure of value. Valeant failed to mention that it compared its adjusted P/E, which removed numerous “one-time costs” related to acquisitions, to the unadjusted P/E ratios of its industry, sector, and S&P 500. By comparing its non-GAAP metrics to others’ GAAP results, VRX was comparing apples and oranges. More rigorous metrics, like price-to-economic book value (PEBV), showed that VRX was significantly overvalued versus its peers.

Valeant’s false claims that previous acquisitions were value creating. In order to entice Allergan to consider the buyout, Valeant wanted to tout its acquisitions as value creating. However, Valeant’s return on invested capital (ROIC), which provides a true measure of if/how much the company creates value, had fallen from 15% in 2009 to 4% in 2013. The prior acquisitions had increased its invested capital 13 times over while net operating profit after-tax (NOPAT), or cash flows, only tripled. Figure 1 shows Valeant’s long-term declining ROIC.

Figure 1: Long-Term Decline of ROIC

Sources: New Constructs, LLC and company filings

Beware Companies That Point You to Non-GAAP Earnings

In July 2014, Valeant made our list of companies with the most misleading non-GAAP earnings. According to GAAP, Valeant lost $866 million in 2013, but by their non-GAAP metrics the company earned $2 billion. This disconnect stems primarily from excluding the costs related to its acquisitions. Does it make sense to exclude the costs related to how you grow your business from how you measure profits? We find that fishy. Figure 2 shows this large discrepancy.