(Bloomberg) "In Valeant, a financialized age has produced a financialized pharma company," Jim Grant, legendary contrarian investor, wrote in March of last year. More than a year later and the wider markets are only just beginning to unpick the complicated underpinnings behind Valeant's stunning run.
As the assumptions underpinning Valeant's growth story quickly unravel, attention has quickly turned to the company's accounting and its deviation from standardized accounting measures known as generally accepted accounting principles, or GAAP. Writing for the
The flattery of Valeant's bottom line arguably helped it do two things essential to its growth; borrow billions of dollars from bond markets at a lower cost and continue the acquisition spree that lay at the heart of its business model.
Nowhere was this dynamic more pronounced than in the pharmaceutical giant's use of earnings adjustments known as "add-backs." And while Morgenson rightly focuses on certain expenses Valeant had been subtracting from earnings, it's well worth focusing on the items it has been adding back.
Such add-backs allow companies to include expected savings or extra revenue in their adjusted, or pro forma earnings numbers. They are often deployed ahead of transformational M&A deals, and Valeant has, to put it mildly, had a few of those. As others have pointed out, accounting conventions assume that big deals are a rare occurrence; in Valeant's case they were the norm.
When Valeant agreed to buy Bausch & Lomb for $8.7 billion in 2013, for instance, it estimated that add-backs and synergies would increase its adjusted earnings before interest taxes and amortization, or EBITDA, from $2.035 billion to $2.468 billion. The $433 million boost to earnings had the effect of dampening Valeant's leverage, or indebtedness, to 4.6 times earnings, according to Standard & Poor's LCD unit.
That was crucial since Valeant's lenders had placed a limit on its debt load of 5.25 times earnings. "Valeant has some room to issue additional debt now; the current incurrence tests allow for up to 2.5 times senior secured debt and 5.25 time total, but that’s not sufficient for the large fundraising contemplated here without being able to lump in Bausch’s cash flow," LCD reported at the time.
Other examples include Valeant's acquisition of Salix Pharmaceuticals and Medicis.
While there's an argument to be made that Valeant's repeated use of add-backs simply went hand-in-hand with the acquisition spree, it's difficult to deny that the promise of future, larger cash flows made investors and lenders willing to accommodate the company's plans. Repeated use of add-backs helped boost the Canadian company's adjusted earnings, flatter its leverage profile and ensure continued access to relatively cheap bonds and loans to help fuel further expansion.
"When Valeant acquires a company, it must adjust the target’s balance sheet for fair value post the completing the acquisition," Evan Lorenz, an analyst at Grant's Interest Rate Observer, said by email. "Management must use its best judgment for a lot of these adjustments and there is a good degree of leeway in how this is done."
Valeant is far from the only company to have made generous use of add-backs in recent years.
Bloomberg News has previously highlighted similar behavior by companies including Travelclick, which secured $560 million worth of loans while claiming leverage of 6.6 times EBITDA. Stripping out add-backs resulted in a debt load closer to 10 times EBITDA, according to rating agency Moody's. Another example is SFX Entertainment, which would have recorded negative cash flow without add-backs.
The concern here is that yield-hungry investors for returns are willing to overlook such flattery in their desperation to eke out any sort of meaningful return. Ironically, balance sheets enhanced through use of add-backs likely encourage investors to accept lower yields than they otherwise might.
"Ultimately, obtaining this lower yield is the motivation for an issuer to apply add-backs," Scott McAdam, portfolio specialist at DDJ Capital Management, said in a report published a year ago.
The antidote to aggressive use of add-backs and other accounting chicanery is simple discipline and vigilance; investors, lenders and analysts must be on the lookout. Unfortunately, beyond a handful of investors such as Jim Grant, it seems such vigilance has been far too lacking when it comes to Valeant.
