The Case of Valeant; Not Over By a Long Shot

I had the good fortune to visit New York and my MarketWatch colleagues week before last and like all good intentions, the spirit was there but reality interceded.   Between my stop in at the Grant’s Interest Rate Observer annual conference on Tuesday afternoon to say hi to Michelle Leder of, who had spoken in the morning and the FinTech conference on Wednesday afternoon to hear about the CAT, Valeant happened.

Well, technically Valiant happened on that Monday, when the company responded on its earnings call to an investigative report issued by SIRF.  Then for the first time the company admitted to a distribution channel that contributes 7% of its sales that no one heretofore had ever known about.  Because the company had never before disclosed anything about the primary vehicle for that channel, Philidor , or the fact that the company consolidated Philidor as a VIE.

By Wednesday morning all hell broke loose–and I do not exaggerate since I was in New York and witnessed it in the MarketWatch and Wall Street Journal newsrooms with my own eyes–when short seller Andrew Left of Citron research published another report accusing Valeant of using this previously unknown distribution channel to “channel stuff.”

Great stuff if you’re a journalist or an expert who gets called to comment on such things.

Valeant put out a hastily prepared rebuttal to the short sellers report, explaining that since it consolidated Philidor and another downstream pharmacy called R&O, there could be no channel stuffing.  That’s because in this case, no revenue is supposed to be booked and no inventory to be relieved until the product goes out the door to the final patient.

There’s only one problem with this explanation.  It’s only as true as far as you can throw it.

I wrote a short piece that Friday, October 23rd, republished on Monday the 26th in anticipation of another conference call by Valeant, that explained why.

Valeant responded to Citron with a statement that said all sales to Philidor and its network pharmacies are “accounted for as intercompany sales and are eliminated in consolidation.” That would imply financial ownership of Philidor and an organizational connection with a distribution channel that had not been, until Monday, ever mentioned in Valeant’s financial statements or filings with the Canadian or U.S. securities regulators.

Valeant had already responded to SIRF’s findings on its earnings call on Monday by saying that it has a “contractual relationship” with Philidor to fill prescriptions on its behalf, that it recently bought an option to buy the pharmacy, and that it also consolidates Philidor’s results with its own based on a variable interest entity (VIE) relationship.

According to the guide to VIEs produced by Valeant’s auditors, PricewaterhouseCoopers, a reporting entity must consolidate any other entity in which it has a controlling financial interest. That means Valeant already has voting control, most likely more than 50% of Philidor’s voting interest. That’s because under the VIE model, if Valeant is consolidating Philidor’s results, it must have the power to direct Philidor’s most significant economic activities and the ability to share in its profits.

Valeant’s call on Monday morning was more of the same and rather unsatisfying to investors. One thing new it did disclose is that the option to buy Philidor was purchased for $100 but the actual purchase price was $0. Odd, to say the least.

I commented on that in another story late Monday that questioned that a[roach and also whether the “channel stuffing” concerns were now moot.

On the call, CEO J. Michael Pearson admitted the structure of the deal to potentially buy Philidor was “probably” unusual but said, “I think it is legal.”

Valeant’s Controller Tanya Carro explained that Philidor was not considered material to Valeant at the time it purchased its option to buy the firm because it generated only $111 million in revenue. Carro cited the Generally Accepted Accounting Principle for what’s material as 10% of revenue.

The rule, ASC 280, refers to the threshold for determining which customers to disclose, not when to disclose an M&A transaction in the footnotes.

When determining whether to disclose an M&A transaction, such as the purchase of an option to buy a company for $0, the line is not so bright. The current definition of materiality for financial statement footnote disclosures, found in the standards issued by the Financial Accounting Standards Board, the keepers of the GAAP, says that information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.

Philidor is no longer considered a customer for accounting purposes, because ever since Valeant purchased the option to buy it, its results have been consolidated into Valeant’s. So disclosure of its activity from that perspective is not likely.

Pharmacies in the Philidor network, including R&O, are also consolidated by Valeant and their net revenue is only booked when the product is sold to a patient. On the call it was also revealed that Philidor has an option to acquire another pharmacy Isolani, LLC that is not yet exercised. Isolani holds a 10% equity stake and the right to acquire the remaining 90% of equity of R&O which has not yet been exercised. Valeant says that R&O’s results are also consolidated into its own.

That should make Valeant’s accounting, as well as Philidor’s, resistant to Citron Research’s accusations of “channel stuffing,” according to the company. However, that conclusion is premised on the assumption Valeant is accounting for the sales and inventory as they have described. An internal audit of Philidor’s accounting and operations by what it says will be a Big Four accounting company has been postponed while an ad-hoc committee of the board investigates additional accusations made by The Wall Street Journal over the weekend. That report published evidence that Valeant executives used fictitious email address when working to support Philidor’s operations.

By Friday morning this week, Valeant had announced it was cutting all ties with Philidor, Philidor was shutting down completely, and it had hired a former partner from law firm Kirkland & Ellis to help it investigate all the allegations and prepare for the government investigations that were in progress with surely more coming.

One of Philidor’s largest investors, the usually short Bill Ackman, also held a call for his investors Friday morning to explain why he was long Valeant.  The call lasted almost four hours.  During that time my tweets were unforgiving of Ackman’s tone deaf defense of his investment.

Most of all, I was disappointed in Ackman’s lame “Valeant is not the worst of the worst” defense of potential criminality as nothing more than the cost of doing business in the pharma industry.

I wrote another piece on Friday afternoon that I think sums it up.

Hedge fund Pershing Square Capital Manager and its founder Bill Ackman, one of the biggest shareholders of embattled pharmaceutical company Valeant Pharmaceuticals International Inc. VRX, said Friday that Valeant is no worse than any other global pharmaceutical company.

Ackman told investors on a call that major drug companies have all weathered severe regulatory scrutiny, paid huge fines and accepted significant sanctions for illegal behavior—and survived.

So will Valeant, said Ackman.

“These penalties are very big but not designed to destroy a company,” he said.

No one wants another Arthur Andersen, Ackman reminded listeners on the call, which stretched to over three and a half hours.

If you have been following this blog for a while you know I thought Ackman was right about Herbalife, also audited now by PwC.

But in this case Ackman is wrong.  And the potential for a channel stuffing situation is still present.  Why?

How do you suddenly cut off a channel that has been providing 7% of your revenue?  What happens to the inventory, reportedly up to 5% of your total inventory, sitting there?  Are either of these numbers accurate?  PwC, Valeant’s auditor, has most likely never been out there.  The consolidation of Philidor’s results only started this year.  There is still a potential for revenue recognition issues through 2014 and potentially for 2015 if the processes needed to accurately book sales and inventory relief have yet to be put in place.

Now that Valeant has cut off the gangrenous Philidor arm, we may never know.

Be prepared for big inventory writeoffs, or maybe even a restatement.

What should Ackman do?  He should, as he did in the Herbalife case, ask external auditor PwC to be accountable.  Did they or did they not know about Philidor and R&O?  Did they let Valeant get away with continuing the bad accounting of its other acquisitions–Biovail, Medicis, and Salix.  All have been in serious trouble with the SEC and shareholders for revenue and inventory issues. Valeant and Ackman say that the company inherited the specialized pharmacy relationship with Philidor from Medicis.

Isn’t that special?

Ackman said on his call that the best thing about investing in companies that have weathered frauds and scandals is that they are cheap.  In this case, unfortunately for Ackman’s investors, cheap is coming at a very high price.










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