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Valeant Pharmaceuticals International: Perspective on financial statement issues

April 11, 2016

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Ken Teegardin Numbers And Finance
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Your Interest in Financial Statement Information

Valeant Pharmaceuticals International (ticker symbol: VRX:US) has struggled this past month and year. From a high just exceeding $260.00 per share in early August 2015, its stock price dropped to $25.27 before recovering to its current (approximate) $33.00 per share. In March 2016 alone, Valeant dropped from $65.80 on Feb. 29 to $26.30 on March 31, partly because the company confirmed plans to file its financial statements late due to an accounting error. Let’s explore financial statement analysis questions that you might ask about Valeant given its misfortunes. As we do, I will point out how one journalist might have further utilized Valeant’s financial statement disclosures in her article.

Synopsis of Valeant’s Financial Issues

First, what has been happening at Valeant? In broad strokes, over the last several years Valeant has purchased a portfolio of pharmaceutical companies with established products. Bausch & Lomb, a well-known maker of contact lenses, is one such company. At the time of purchase, some analysts and investors asserted that Valeant overpaid and issued too much debt doing so. They asserted that Valeant would struggle to pay its interest and debt obligations, because these acquired companies would not generate enough earnings and cash flows. Obviously, the capital market participants that bought Valeant’s debt believed the risks were worth taking; otherwise they would not have purchased Valeant’s debt at prices Valeant thought reasonable.

In the last eight months, Valeant has had to revise down its sales revenue and earnings forecasts. Its reported results were below analysts’ expectations. Several of the same analysts and investors who initially questioned the price Valeant paid to purchase other companies now question whether Valeant can meet its debt repayment obligations. Valeant’s management treated these questions seriously by specifically addressing them in their March 15, 2016 Fourth Quarter Preliminary Unaudited Financial Results Conference Call (see pages 17-20). The stock price drop from approximately $260 to $33 speaks volumes.

Additionally, Valeant management discovered an accounting error where they recorded about $58 million of sales revenue in 2014 (instead of 2015.) Correcting the error meant Valeant could not issue its 2015 annual report by March 31, 2016, which violated debt covenants. When a company violates its debt contract covenants, the debt holders can declare the company in default, perhaps leading to bankruptcy. Often, that does not happen because bankruptcy is expensive for debt holders. Instead, the debtor and debt holders negotiate a solution better for all. Valeant successfully achieved a negotiated solution.

Article Topics and Questions You Might Pursue

Let’s start with the accounting error. First, it is for $58 million. Second, the error was a misclassification of sales revenue in 2014 that Valeant should have recorded in 2015. A recent press release indicates that Valeant’s Board of Directors has investigated the accounting error and does not think the amount exceeds $58 million. Knowing this, several article topics emerge you could pursue.

At first glance, the $58 million misclassification error, at less than 1% of Valeant’s 2014 annual sales revenue of $8,263 million, appears relatively small because it is actual sales revenue, just recorded in the wrong year. One interesting article topic would be whether the error signals a big, systemic problem. If the error was isolated, an honest mistake, due to a few employees and perhaps due to new or unusual circumstances, then the problem likely is small and nonrecurring. However, if the error allowed Valeant to reach analysts’ projections, Valeant managers’ projections or bonus objectives, or stemmed from a systemic weakness in internal controls for financial statement entries (i.e. it could happen again elsewhere in the company), then the issue may be a problem much larger than the $58 million the dollar amount. Either way, the situation looks like an interesting topic for reporters.

Focusing on Valeant’s revised sales and earnings forecasts, which are downward revisions of forecasts Valeant made in December, 2015, one journalist asked what Valeant’s businesses were worth, noting that in mid-March Valeant’s stock market value was $11.4 billion while its debt was $31 billion. This journalist then quoted an analyst who opined that perhaps Valeant’s assets were worth less than its debt. The journalist could have clarified her article by framing it with the accounting equation. Recall that Assets = Liabilities + Shareholders’ Equity, or A = L + SE. If debt (most of Valeant’s liabilities) is $31 billion and the stock market value of Valeant’s common stock is $11.4 billion, then stock market investors value assets at $42.4 billion ($42.4 = $31.0 + $11.4) following the accounting equation. A question worth investigating is why the analyst believes that Valeant’s assets are worth less than $31 billion, which is a substantial 37 percent discount to the market’s opinion. Reporters might consider learning how many other analysts or investors agree with the quoted analyst. His opinion appears extreme at first glance.

Also, the journalist compared Valeant’s debt of $31 billion to its stock market value of equity of $11.4 billion. That comparison feels a bit misguided given that the journalist asked what Valeant’s businesses are worth. The discussion above answers that question: about $42.4 billion. Here, the journalist is likely asking whether Valeant’s debt to equity ratio is excessive (another interesting article topic).

Using the journalist’s numbers, Valeant has debt to equity of a little less than 3 to 1 (i.e. $31 billion ÷ $11.4 billion). In other words, for every $1 of equity, Valeant has about $3 worth of debt. For perspective, investment banks often have ratios in excess of 10 to 1, and historically 25 to 1 wasn’t uncommon. When it went bankrupt, Lehman Brothers was about 30 to 1. Many manufacturing firms also maintain high levels of debt to equity, although not as high as investment banks, while other manufacturing firms maintain almost no debt. A very interesting article or segment would address whether a 3 to 1 debt to equity ratio is sustainable for Valeant. One quick way to answer that question is to check the credit markets. The Moody’s Credit Rating report for Valeant downgraded Valeant’s debt to B2 from B1 on March 31, 2016. Note that Moody’s revised rating occurred after Valeant announced lower sales and earnings forecasts and after the accounting error was publicly acknowledged. Moody’s describes B2 as its view “that Valeant’s cash flow is solid and that it is unlikely to face any near-term payment defaults absent a debt acceleration scenario arising from its late 10-K filing. Other positive factors providing support to the B2 rating include Valeant’s viable business despite a lower earnings base, wide use of its products, good name recognition (particularly at Bausch and Lomb), and a low-cost structure resulting in good margins and profitability.” Moody’s opinion appears to stand in contrast to some analysts’ and investors’ opinions.

Valeant’s March 15, 2016 Fourth Quarter Preliminary Unaudited Financial Results Conference Call (page 20) includes an analysis indicating that management expects to pay down in excess of $1.7 billion of its debt in 2016. Again, an interesting article could focus on the Moody’s debt rating and Valeant’s cash flow and debt repayment analysis, asking whether a 3 to 1 debt to equity ratio is sustainable.

Pulling each of these ideas together, a thoughtful article might simply ask: is it time to purchase Valeant’s stock? Perhaps all the bad news is now largely known, implying little risk of further stock price declines, while substantial price increases may be attainable. I, for one, am interested in an article thoughtfully addressing this question.


  • Steven Orpurt

    Dr. Orpurt earned his MBA and Ph.D. at The University of Chicago Booth School of Business (in accounting). His dissertation entitled “Local Analyst Earnings Forecast Advantages in Europe” was named the American Accounting Association International Se...

    View all posts

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