Filing Season Finds: Valeant Pharmaceuticals (VRX)

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Valeant Pharmaceuticals (VRX: $12/share) was one of the 700 10-K’s we processed last week. Analyst Cody Fincher made a total of 44 adjustments to Valeant’s financial statements with a total value of $50 billion. The adjustments were applied as follows:

  • 21 income statement adjustments with a total value of $4 billion
  • 16 balance sheet adjustments with a total value of $11 billion
  • 7 valuation adjustments with a total value of $35 billion

We first raised red flags about Valeant in 2014 when the stock was trading at ~$120/share. Today, with the stock at 1/10th of that price, we still see many reasons for investors to steer clear. Here are our four largest takeaways from Valeant’s 10-K.

Unusual Goodwill Impairment

One of the largest single adjustments we made was reversing a $1.1 billion write-down Valeant took for the underperformance of some of its acquisitions. We eliminated this non-operating expense from net operating profit after tax (NOPAT) while adding back the after-tax value to invested capital to hold the company accountable for its capital allocation decisions.

This goodwill impairment was plainly disclosed on the income statement, but we did find an interesting detail on page 55 in the footnotes. Valeant assessed the value of its goodwill over the course of Q3 and Q4. During Q4, the company decided they had taken too large an impairment in the previous quarter and essentially took a “write-up” of $39 million for the fourth quarter. This practice is allowed under accounting standards, but it is certainly unorthodox and helped Valeant report better than expected earnings in 4Q16.

Pricing Issues Take Their Toll

It’s no secret that pricing pressure hurt Valeant’s bottom line in 2016. Thanks to a footnote on page 48 of their 10-K, we now know just how big that impact was: $652 million. Lower prices had a bigger impact than volume issues, which lowered contribution profit by $531.

Falling prices compressed Valeant’s NOPAT margin from 18% to 11% and caused its return on invested capital (ROIC) to fall from 5% to 2%. Currently, Valeant is not generating enough NOPAT to cover the interest payments on its debt, which means we can expect to see further asset sales in the future.

Rising Customer Concentration

Analysis of Valeant’s pricing problems has focused on political pressures. However, an item we found on page 180 suggests there could be some structural problems facing the company in particular. The percentage of Valeant’s revenue from its top three customers rose from 36% in 2014 to 49% last year. As Valeant becomes more reliant on a few large customers, it may be losing pricing power.

Falling Stock Could Hurt Employee Retention

Valeant disclosed its employee stock option activity on page 154. The company revealed that it has 4.1 million outstanding stock options with a weighted average exercise price of $49.57/share. Essentially, VRX could quadruple and many employees would still be sitting on worthless options. Even the options Valeant granted just last year have a weighted average exercise price of $25.60/share, more than double the current stock price.

Valeant doesn’t rely on stock compensation as much as some other companies, but you have to wonder if the low stock price will hurt its ability to retain key employees. Vesting stock options are usually a good incentive for employees to stick around, but if those options are worthless, employees might be more likely to jump ship.

This article originally published here on March 9, 2017.

Disclosure: David Trainer, Cody Fincher, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

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