Valeant Pharmaceuticals International was one of America’s best-performing stocks in the five years to August 2015, with a cumulative gain of almost 1,800%. Rising from relative obscurity, the company became a market darling and aspired to be America’s largest pharma business.
In the fourth quarter of 2015, however, the SEC announced an investigation into the company’s accounting practices and the wheels began to fall off. Valeant’s stock price suffered a catastrophic 90% decline from which it has never recovered.
The SEC formally charged Valeant (subsequently renamed Bausch Health Companies) in July 2020 for improper accounting practices. The company has not recorded a profit since 2018.
This article examines the rise and fall of Valeant. It also unpacks the risk signals identified in the company's financial statements over the years by Transparently's AI-powered screening tool.
Table of contents
Valeant is frequently called the “Enron of Pharma.” Although the scale of fraud was not comparable, there were similarities: Both companies were Wall Street darlings, both run by former McKinsey consultants, both reported explosive growth, both used arm's-length entities to misstate revenue, and both collapsed after being investigated for accounting fraud.
Many analysts and investors were shocked by Valeant’s demise but, in the decade prior to the SEC investigation, the Transparently system consistently ranked Valeant in the bottom 5% to 15% of all companies globally for its accounting quality standards. Companies with such a poor ranking are invariably unable to sustain high valuations.
This article will reveal what our system uncovered. The results are all the more impressive considering financial analysis of pharma companies’ accounts is exceptionally difficult. This is because of:
- The heavy reliance on R&D;
- The highly subjective valuation of drugs in development and drugs coming off-patent;
- Differences in the pricing of the same drug in different jurisdictions;
- Complex pricing and subsidy schemes for different drugs and different kinds of patients;
- The complexity and diversity of distribution channels for drugs versus other products.
The ability of Transparently’s AI system to detect manipulation in Valeant in the presence of these complications is testimony to the robustness and broad applicability of the platform.
Valeant under Milan Panić (1959-2002)
The early history of Valeant makes fascinating reading and helps explain the DNA of the company. As we saw with Wirecard, Marvell and many other companies, it is crucial to understand the early history of any company.
Poor corporate governance in a company’s formative years often sets the tone for later developments. The history of Valeant provides a further demonstration of this pattern. For the sake of brevity, we focus on regulatory breaches rather than matters involving corporate governance, of which there were many.
Valeant’s origin dates back to 1959, when Milan Panić, a famous Serbian World War II resistance leader and Olympic athlete turned communist defector, founded the ICN Pharmaceuticals Corporation (ICN) in his California garage.
A colourful and energetic leader, Panić ruled ICN with a heavy hand for 42 years except for a remarkable leave of absence from July 1992 to March 1993, when he served as the Prime Minister of Yugoslavia.
Panić inspired great loyalty in some and loathing in others. He cultivated powerful political connections and survived numerous scandals, lawsuits, battles with disgruntled shareholders, and scuffles with regulators until his final downfall.
In its early years, ICN engaged in drug research and grew via shrewd acquisitions of cheap pharmaceutical companies in niche areas. By the early 1970s, ICN sales exceeded $100 million.
In June of 1970, ICN received its first Food & Drug Administration approval for a compound known as L-dopa. This was hailed as a miracle drug for Parkinson's disease. ICN‘s stock surged on the news but fell sharply when the severe side-effects of L-dopa became widely known.
Antiviral drugs were rare and seen to have great promise. By the early 1970s, ICN had accumulated a catalogue of these compounds.
ICN’s stock quickly recovered, however, due to optimism surrounding its research into antiviral agents known as nucleoside analogs. Antiviral drugs were rare and seen to have great promise. By the early 1970s, ICN had accumulated a catalogue of these compounds. In 1970, ICN synthesised a key compound, ribavirin, a nucleoside analog that the company claimed would kill certain viruses by jamming their reproductive systems. ICN claimed the drug would be effective against a broad spectrum of viruses such as influenza and possibly hepatitis C.
Before ICN could progress with ribavirin, the drug required FDA approval. Differences between viruses and bacteria meant that antiviral drugs were difficult to bring to market. Antibacterials focus on killing bacteria living outside the cell. Antivirals, however, must eliminate a virus without killing the host cell or harming the host organism. In the early years of developing antivirals, the approval process was torturous, meaning ICN faced a legal and financial struggle to get its compounds to market.
Pharma is a highly probabilistic business. Generally, the patent for a drug will be valid for 20 years. This patent life, however, begins from the time of drug creation. For a complex drug, a pharma company might spend 10 to 12 years of that patent life in developing the drug and gaining FDA approval. The productive life of a patent drug, in which a company can earn monopoly profit from the drug, is only between 8-to-10 years. Delays or unexpected breakthroughs in the development and approval process will have a material effect on the value of a pharma company.
They should be reflected in the accounts and be accurately communicated to investors.
SEC complaint
ICN had its first run-in with the SEC in 1977 when the Commission filed a complaint against both ICN and Milan Panić, alleging violations of sections 10(b) and 13(a) of the Securities Exchange Act of 1934. These sections pertain to securities manipulation (including insider trading) and inadequate or false financial reporting. Essentially, the Commission alleged that Panić used exaggerated drug claims to manipulate the share price.
Panić and ICN agreed to refrain from future violations of securities laws while admitting no wrongdoing. These were the days when the SEC had fewer teeth than today and when insider trading was seen as a slap on the wrist offence.
In 1985, more than fifteen years after its initial discovery, ribavirin, marketed under the name Virazole, finally gained FDA approval but only for the treatment of respiratory syncytial virus (RSV).
In a press release, ICN claimed that Virazole was "so free of side effects that it could be used in premature infants". The FDA ordered ICN to recall the press release because it contained "false or misleading claims" of the drug's effectiveness against a range of viral illnesses and minimised potentially lethal side effects. ICN already sold Virazole, or a licensed equivalent, in countries with less stringent drug regulations by the mid-1980s.
This incident marked just the beginning of controversy with ribavirin:
- In January 1986, ICN announced that clinical tests indicated that Virazole “may delay AIDS onset in people infected with HIV”. Thereafter Panić aggressively sought FDA approval to sell Ribavirin as a treatment for the AIDS virus.
- In July 1986, PaineWebber (PW) underwrote a $137 million stock and bond offering for ICN. In a subsequent report, PW extolled Virazole's potential against flu and as an AIDS treatment drug, triggering a 67% rally in the stock to $34 in the subsequent three days. However, the price sank back to US$20 after the claims met with scepticism from the medical community.
- In 1987, the FDA said that it could find no evidence of ribavirin's effectiveness in combating AIDS.
- In November 1986, an investor who purchased ICN on PW‘s recommendation filed a lawsuit, accusing PW and ICN of inflating ICN's stock through a false and fraudulent research report.
- In February 1987, the SEC announced it was investigating insider trading of ICN stock. Following the news, a class-action lawsuit was filed in Los Angeles against ICN, accusing it of fraudulently inflating the ICN stock price and misrepresenting the potential of Virazole.
At about this time, federal regulators sued Panić for defaulting on a $8.4 million real estate loan and the IRS accused Panić and his wife of failing to pay taxes.
After three years of wrangling, ICN abandoned efforts to win approval for ribavirin as an AIDS treatment. The company took a $71 million write-off on its ribavirin operations and reported a $82 million loss in 1989 on sales of $185 million. Notwithstanding this loss, ICN gave its senior officers monumental pay increases, the highest being 91%. Panić gave himself a 39.6% pay rise and the company paid his considerable personal legal, accounting, and indemnity insurance fees.
In 1991, ICN paid $600,000 in costs and penalties to settle FDA charges that it had misrepresented the medicinal properties of ribavirin and settled the SEC lawsuit by consent decree, without admitting or denying wrongdoing. The class action suit would not be settled until 1996 when ICN agreed to pay $14.5 million in damages to an estimated 7,500 shareholders.
Politics in Yugoslavia
Motivated by ICN’s dismal performance, Panić returned to Yugoslavia determined to transform ICN into an international drug manufacturer. He acquired a 75% interest in Galenika Pharmaceutical, a major drug manufacturer and distributor in Yugoslavia.
The acquisition gave ICN new product lines and substantially expanded the company's sales volume, making ICN one of the first Western pharmaceutical companies to establish a direct investment in Eastern Europe after the fall of communism. ICN expanded into several other former communist nations and established a global distribution footprint.
Panić’s political career overshadowed this early 1990s growth phase for ICN. In July 1992, Panić accepted an invitation from Yugoslav President Dobrica Ćosić and Serbian President Slobodan Milošević to serve as prime minister of Yugoslavia.
Several months later he announced that he would challenge Slobodan Milošević in Serbia’s upcoming presidential election. The December 1992 election was rigged, Panić lost and was soon ousted as prime minister. In retribution, the Yugoslav government reneged on payment for pharmaceuticals purchased from ICN, leading to sizable losses.
In 1992, ICN's stock plummeted. Panić, meanwhile, received $619,000 in salary and an estimated bonus of $5.3 million while serving as the Prime Minister of Yugoslavia - not bad for an absentee CEO.
After his Yugoslav adventure, Panić refocussed on ribavirin when clinical trials showed promising results in the treatment of hepatitis C. Once again, investors grew excited about the prospects for ribavirin as the company hyped expectations of imminent FDA approval.
In a letter dated November 28, 1994, the FDA rejected ICN's application to market ribavirin as a sole treatment for Hepatitis-C. The rejection was material to the ICN share price but the company waited three months to disclose the news. When the company finally announced the rejection in a February 17, 1995, press release, ICN stock fell 41% in the subsequent six days.
Insider trading
Panić sold 55,000 shares of ICN stock worth $1.24 million in the day following the FDA rejection letter. When this news surfaced, the SEC initiated yet another probe and stockholders began another class-action suit. A grand jury was formed to investigate whether Panić engaged in insider trading. Further complicating matters, Panić was subject to an expanding number of sexual harassment allegations.
As a palliative to angry investors, ICN announced an internal review which exonerated Panić of insider trading based on “evidence” that he informed others of his decision to sell before the FDA announcement.
Amid mounting legal problems, ICN pressed forward with niche acquisitions that enabled it to leverage its global sales footprint. By the end of 1996, annual sales exceeded $500 million with distribution in more than 60 countries. Although ribavirin was only approved for the treatment of RSV in the US, it was approved for use in more than 40 countries for a variety of viral infections, including RSV, herpes simplex, influenza, chicken pox, hepatitis, and HIV.
In 1995, ribavirin was one of fewer than 10 antiviral agents marketed worldwide, accounting for 10% of ICN's sales and a much higher share of earnings due to royalties. The company was in reasonable financial shape but legal problems were costing millions and inciting animosity among shareholders. Proxy shareholder battles had become an annual event.
In 1997, the company paid $15 million to settle the class-action lawsuit over Panić’s share sale following the FDA rejection in 1994. In 1998, district officials within the SEC urged the commission to ban Panić as an officer of the company and to seek penalties in connection with the event.
However, in September of the same year, the SEC dropped its 3-year investigation of the alleged insider trading. At that time insider-trading allegations would not stand up unless regulators could prove that an insider sold stock strictly on the basis of undisclosed information. Without a whistleblower, the SEC was forced to drop the case.
After dropping its investigation, the SEC filed a civil lawsuit in the District Court in Los Angeles, claiming ICN failed to make a timely, accurate disclosure of the FDA rejection to investors.
In 2000, while the SEC was still seeking to bar Panić via a criminal conviction, ICN announced a restructure that would split the company into three public companies, all controlled by Panić. The restructure was delayed by yet another shareholder revolt and ongoing proxy battle.
In 2001, ICN pleaded guilty to a single count of criminal securities fraud in connection with certain of the events alleged in the SEC civil complaint and paid $5.6 million in criminal fines. In 2002, the SEC announced that it had settled its civil injunctive action against ICN and company officers. ICN had to pay another $1m fine and Panić had to pay $500,000 in civil penalties.
The legal losses of 2001 and 2002 made Panić’s demise inevitable. The R&D unit was hurriedly spun off, raising nearly $300 million, and netting Panić a $33 million bonus. This was the final straw, and on June 12, 2002, dissident shareholders prevailed, celebrating Panić's removal as the ICN chairman and chief executive officer.
The company changed its name to Valeant in an effort to distance itself from the Panić era.
Accounting quality under Panić
We do not have sufficient data to undertake a risk assessment of the early years of ICN. We do, however, have data for the later years of Panić’s tenure.
Between 1999 and 2003, the Transparently system placed ICN in the bottom 5% of US health sector companies for accounting quality and transparency.
The data for 1999 illustrate how the company looked in the boom years before Fed tightening in 2000 and subsequent recession. As is usual, account quality worsened in the recession.
In 1999, ICN had an accounting manipulation risk score of 77%, very poor for a company with a market capitalization approaching $6 billion and for a company under SEC investigation. More typically, companies under investigation make some attempt to clean up their act.
Viewed against Valeant’s history of regulatory and criminal charges for false reporting and stock manipulation combined with acute corporate governance concerns, this risk score was perhaps unsurprising.
Looking at the detailed risk report for 1999, the system detected red flags in 10 of the 14 risk clusters it examines. According to the system, ICN warranted extreme care in the risk clusters for growth signals, working capital, credit and asset quality. It warranted high caution for corporate governance, cash quality and smoothing activity. The system found further patterns indicating risk in business manipulation, income quality and valuation signals.
Figure 1: An overview of ICN’s risk signals in 1999
Source: Transparently.AI
Figure 2 summarises the major red flags that the system identified in each of these risk clusters. This figure only shows the top three signals in each category. If there were many factors evident with none particularly standing out, the system may highlight only one or two examples.
The system is particularly alert to companies that demonstrate exceptional growth in sales and assets. Such companies are rare and, if genuine, should demonstrate financial strength because companies with unbridled demand typically have the option of raising prices to improve margins, profitability and cash flow. Further, companies with runaway sales should not show patterns associated with accounting measures used to inflate sales or earnings growth. Companies with truly strong growth should have no need for aggressive accounting.
In the 1999 accounts, the Transparently system found patterns consistent with efforts to inflate sales and earnings and signs of financial.
In the 1999 accounts, the Transparently system found patterns consistent with efforts to inflate sales and earnings and signs of financial. These should not be present in a company reporting runaway growth.
The system does not consider these patterns in isolation or as an additive checklist, but rather considers the combined picture of all of these anomalous patterns to derive its assessment. The assessment in this case was damning.
Figure 2: An overview of the major red flags associated with ICN in 1999
Source: Transparently.AI
We won’t explore the detailed meaning of these results but we can summarise some of the main findings:
- Accounts payables were very extended, indicating possible difficulty in paying its accounts. This and other factors revealed working capital strain, anomalous when evident in conjunction with exceptionally sales growth;
- Asset growth greatly out-stripped sales growth. This is typical in companies that grow by acquisition or companies that disguise operating expenses as investment. Highly acquisitive companies have wide discrepancy in accounting and lack transparency in their accounts;
- Asset quality was suspect due to large intangibles (reflecting growth by acquisition) and because other long-term assets were growing rapidly in relation to fixed assets. The latter can be a sign of aggressive capitalization of operating expenses;
- Poor asset quality should be seen in conjunction with the system’s identification of unusual patterns in sales of fixed assets in the risk cluster for business manipulation;
- Receivables were extremely volatile, more volatile than in any company we have ever seen. Volatile receivables are a classic red flag that a company might be manipulating sales;
- The system raised credit concerns in three areas:
- First, sales growth was abnormally weak in relation to asset growth. This signal pairs with the strong growth of “other” long-term assets versus fixed assets and can signal a lack of sustainability in the business model.
- Secondly, gearing was exceedingly low in relation to market capitalization. In a rapid growth company with a high valuation and poor cash generation, this can mean that lenders are reluctant to extend credit and this can signal credit risk.
- Finally, interest expense relative to reported borrowings were remarkably volatile. This can be a sign that a company is manipulating interest expense to improve its financial performance;
- Evidence of credit risk pares with that of highly dilutive equity raising in the risk cluster for corporate governance. The system also highlights ICN’s heavy use of (expensive) non-vanilla derivative funding. Given the low reported debt level of the company, expensive and dilutive issuance either reflects exceptionally poor financial management or of some kind of financial manipulation.
This list is by no means exhaustive. We have only highlighted the main issues but the system identified many more.
The Transparently system identified risk signals that pointed to strenuous efforts to make growth and profitability appear higher than they were.
The Transparently system identified risk signals that pointed to strenuous efforts to make growth and profitability appear higher than they were. The red flag for capitalization growth suggests that investors bought the story.
We took pains to explain the history of ICN and vicissitudes caused by its reliance on ribavirin because it offers a great example of why pharma companies are difficult to assess from just looking at the accounts.
They do things that would appear exceptional for a company in another industry, but are perfectly acceptable in pharma and biotech industries. There will typically be unusual changes in the value of intangible assets, volatility in non-operating assets, accruals and investing activity.
The overwhelming issue with ICN’s numbers for 1999 is that its high manipulation risk score was not dominated by factors typically associated with pharma companies. These include unusual changes in the value of intangible assets, volatility in non-operating assets, aggressive use of accruals and investing activity. Some of these issues were present but in the main, ICN’s dreadful score was due to measures most commonly associated with improper revenue recognition.
For all its promise, the phenomenal challenge of developing and profiting from ribavirin meant that ICN’s business was far less impressive and much less sustainable, than Panić projected. After Panić, the company sought a different strategic direction.
Valeant under Michael Pearson (2008-2016)
The ICN board appointed a damage control team in the wake of Panić’s departure. The first move in early 2003 was to change the company name from ICN to Valeant Pharmaceuticals International. The name change signified a new strategic focus and was an attempt to erase the taint of past legal problems.
The new management team cut costs and made a series of acquisitions, mostly in dermatology and cosmetics. However, a high percentage of the company’s sales were in Eastern Europe, and these suffered in the absence of Panić’s personal connections. The spin-off of the R&D business, meanwhile, left the re-branded company without a meaningful drug pipeline.
Valeant’s share price languished until 2008 when the company appointed Michael Pearson, a McKinsey & Co veteran and pharmaceutical acquisitions expert, as the new CEO. Pearson believed that the development of patent drugs was a mug’s game and that acquisition was the only sure path to deliver shareholder value. After the torturous experience with ribavirin, and with the absence of genuine R&D capacity, the board and Valeant employees were in full agreement.
It was all ahead, full steam. Almost immediately, the company’s new direction was clear as Pearson acquired Coria Laboratories for $95 million and Australia’s DermaTech for $12.6 million. This was the start of a multi-billion dollar buying spree in which Valeant would purchase around 30 pharma and biotech companies, strip them of all unnecessary costs, including the bulk of their R&D capability, and run the existing drug catalogues as cash cows until they were supplanted by generics.
Valeant cut R&D spending to just 6% of sales versus an industry average of 18%. It became an M&A juggernaut with an insatiable appetite for debt-fuelled deals and complex financial engineering.
The Fed’s zero rate policy in the wake of the 2008 financial crisis was ideal for companies that wished to extract rather than create value. It was the perfect environment for Valeant’s new business strategy.
M&A business model
Valeant was the perfect test of the traditional pharma business model, which says the industry survives and thrives on R&D.
Since most patent drugs have a useful life of only 8-to-10 years, the drug catalogue of a newly acquired company might have an average life span of 4-or-5 years. As such, Pearson’s strategy lacked sustainability because few acquisitions ever pay back the original investment in less than five years.
Certainly, none of Valeant’s acquisitions came at anything near a price-to-earnings ratio of less than 5x. The strategy required exponential growth in debt to sustain earnings growth unless Valeant could find a way to offset the price decay in the drugs that were coming off-patent or unless it simply lied about its earnings.
Valeant’s business strategy was doomed to fail. Luckily, most financial analysis of pharma and biotech companies is undertaken by former R&D chemists – people who know a lot about chemical compounds but are arguably less well grounded in the world of finance. Hedge funds adored Valeant’s business strategy and backed it to the hilt. Whereas Enron duped Mom and Pop investors, Valeant duped hedge fund managers.
For a good while, the acquire-and-cut strategy looked like a winner. At the end of 2008, when Pearson took over as CEO, Valeant traded at $9.65 per share. In July 2015, the share price peaked at $236.10 – a return of more than 2,200%! Valeant under Pearson was a 20-bagger.
At the time of writing, Valeant is trading at US$9.26, less than when Pearson took command but with vastly higher debt ratios.
Biovail reverse merger
After the appointment of Pearson, the next major milestone occurred in September 2010 when Canada’s largest publicly owned pharmaceutical company, Biovail, acquired Valeant via a type of reverse merger that would later become known as a corporate inversion.
Under the inversion, Pearson remained CEO of the combined company, with an annual revenue of US$1.75 billion. The new entity took Valeant’s name and business strategy but was now incorporated in Canada. In reality, Valeant took over Biovail while achieving Canadian corporate residency.
Biovail itself had a murky past. In December 2007, for example, Biovail paid $138 million to settle a shareholder lawsuit accusing it of making false statements to inflate its stock price. This dwarfed settlements by ICN in the Panić era and was a very serious breach. In March 2008, the SEC charged the company, its former CEO and three senior executives with fraudulent accounting and with making a series of misstatements to analysts and investors. In 2011, Valeant settled a civil lawsuit brought by the SEC accusing Biovail of accounting fraud.
When the CEO and Board of Valeant chose to partner with Biovail, regardless of the considerable upside in the inversion deal, it meant that it also adopted the governance ethics of Biovail - an enormous red flag.
When the CEO and board of Valeant chose to partner with Biovail, regardless of the considerable upside in the inversion deal, it meant that it also adopted the governance ethics of Biovail - an enormous red flag.
The inversion deal demonstrated exceptional accounting sophistication. It benefitted the shareholders of both companies in the short term. Biovail shareholders received a 15% premium on their shares and Valeant shareholders received a cash dividend of just under US$17 per share.
The long-term winner, however, was Valeant which had tax credits that were about to expire. The inversion lowered its effective tax rate from 35% in California to under 15% in Ontario. Moreover, Biovail had very little debt. The deal was entirely debt funded by Goldman Sachs and boosted the combined entity’s long-term debt by $3.2 billion to $3.5 billion. Pearson and Goldman correctly assumed that this was insignificant in comparison to the debt carrying ability of the combined entity. Pearson would spend a further $32 billion adding acquisitions between 2011 and the end of 2015.
Most of these deals were oriented towards Valeant’s core portfolio in dermatology but diversified over time. Pearson knew that his debt-fuelled acquisition strategy would only work if there was room to boost prices. His overriding strategy was to find companies with underpriced drugs. He sought essential drugs used to treat chronic conditions with patents that were yet to expire and thus not subject to competition from generics. In other words, his strategy preyed upon those with chronic illness.
In January 2014, Valeant cracked the list of the world’s top 15 drugmakers by market capitalization. Pearson told analysts that Valeant would be in the top five by the end of 2016.
But acquisitions with mispriced drugs became progressively harder to find, drugs in the portfolio were now going off-patent and Valeant’s cost of debt rose as its leverage increased.
Short sellers
Desperate for new acquisitions, in April 2014 Valeant teamed up with activist investor Bill Ackman’s Pershing Square Capital Management in an effort to buy the Botox-maker Allergan. Ackman purchased shares in Allergan knowing that he would collaborate with Valeant on a takeover bid, causing a class action suit by Allergan shareholders who sold their shares during this period. The claimants ultimately settled for $290 million in damages rather than continue fighting in court.
In May 2014, short-sellers began to smell blood in the water. Bronte Capital’s John Hempton called Valeant’s accounts “difficult to comprehend.” Jim Chanos accused Valeant of “aggressive accounting games.” Others criticised Pearson’s compensation package, pointing out that he held more than $1.4 billion in stock options.
But there was still juice in the lemon.
As the strategy began to fail, price increases became more extreme.
As the strategy began to fail, price increases became more extreme. In 2014, the company increased prices on 62 drugs by an average of 50%. The following year saw further hikes on 56 meds by an average of 65.6%. Some drugs saw price increases of more than 500%.
In discussing Valeant’s second quarter results in May 2015, the CFO Howard Shiller admitted that price increases represented about 80% of revenue growth.
These predatory pricing practices drew the attention and ire of many. In August 2015, Rep. Elijah Cummings (D-MD) and presidential hopeful Bernie Sanders (D-VT) wrote to Pearson requesting documents and details on the pricing moves.
On September 28, all 18 Democratic members of the House Committee on Oversight and Government Reform sent a letter requesting that the Committee Chairman issue Valeant a subpoena over “massive” price increases for two of its heart drugs. They also called for Pearson to testify before the committee.
On October 15, Valeant said it had been subpoenaed by prosecutors seeking details on its patient assistance programs, drug pricing and distribution practices. Four days later, the New York Times detailed how Valeant used its ties with specialty pharmacy Philidor to sell conventional medications, averting health insurer barriers to reimbursement. Two days later, short-seller Citron Research accused the company of using specialty pharmacies, including Philidor, to inflate its revenue.
In a conference call following the Citron claims, Valeant disclosed for the first time that it had used Philidor’s services, had an option to buy the pharmacy and had indeed already incorporated its financials in its own results.
Philidor was a mail order pharmacy which Valeant helped establish, fund and subsidise. It was later revealed that Valeant paid $100 million for the option to purchase Philidor for a dollar. This made Philidor a VIE (variable interest entity) under the control of Valeant.
Between August 2015 and February 2016, Valeant shares lost more than 60% of their value.
The wheels of retribution were turning. Between August 2015 and February 2016, Valeant shares lost more than 60% of their value as further bad news came to light over its trade practices in other markets, such as contact lenses.
From January 2016 onwards, Valeant gradually capitulated to regulatory and political pressure. In February, it disclosed that it was under investigation by the SEC. In March, Valeant announced the departure of Pearson and said Ackman would join the board in an attempt to save the business. The company admitted accounting issues and “improper conduct” by top finance executives.
Philidor investigation
In May 2016, Valeant hired Joseph Papa to replace Pearson as CEO. Once again, the company name was changed, this time to Bausch Health Inc. Papa's top priority was to pay down the $30 billion in debt amassed to finance Pearson’s acquisitions. Much of this debt still remains.
While the criminal issues associated with the Philidor were quickly settled quickly, it would be several years before the full detail of Valeant’s accounting issues and improper conduct would come to light.
The criminal investigation of Philidor commenced on August 10, 2016. The investigation turned on whether insurance companies realised Philidor was pretending to be neutral, while being affiliated with Valeant. By doing so, Philidor could get Valeant’s medicine covered by insurance plans as a seemingly independent entity.
Philidor was found to be altering prescriptions with intent to fill more prescriptions with Valeant-branded medicines. In doing so, Valeant could get insurance companies to pay for its expensive drugs. The prosecution was swift and two officers, the CEO from Philidor and a Valeant executive, both of whom had been rewarded with a kickback scheme that defrauded Valeant, were sent to jail.
On July 31, 2020, the SEC announced that Bausch Health would pay a $45 million penalty to settle charges of improper revenue recognition and misleading disclosures.
On July 31, 2020 the SEC announced that Bausch Health would pay a $45 million penalty to settle charges of improper revenue recognition and misleading disclosures in SEC filings and earnings presentations. The former CEO, CFO, and controller also agreed to pay penalties to settle charges against them.
According to the SEC’s orders, Valeant misstated revenue transactions and included erroneous revenue allocations. In the most egregious example, the order found that Valeant reported double-digit same store growth for five consecutive quarters with sales derived from Philidor.
Same-store sales growth is not a GAAP item, and so is not strictly an accounting violation, but is a closely monitored item by investors. The orders found that Valeant improperly recognized revenue relating to Philidor sales and did not disclose its unique relationship with or risks related to Philidor in SEC filings and earnings and investor presentations. Bausch Health restated its 2014 financial statements in April 2016, reducing the revenue that was improperly recognized.
In addition, the SEC orders found that Valeant failed to disclose the material impact of certain revenue it received from drug wholesalers following a 500% increase of the price of a single drug that Valeant acquired in April 2015. Valeant erroneously attributed the resulting revenue to more than 100 unrelated products and did not record any as attributable to that drug in its SEC filings and on its GAAP and non-GAAP financial measures.
In summary, the SEC nailed Valeant comprehensively for improper revenue recognition and for multiple examples of misstatement in its accounts.
Accounting quality under Pearson
The account manipulation risk score for Valeant improved in 2009, the first full year following the Pearson appointment. This frequently happens as an incoming CEO seeks to recognize every loss possible associated with the previous regime in order to set a low bar for improvement in future years. Even so, the Transparently system’s accounting risk score still placed Valeant in the bottom 20% of companies globally in 2009.
The Transparently system’s accounting risk score still placed Valeant in the bottom 20% of companies globally in 2009.
From 2010 onwards, however, the risk scores returned to almost exactly where they were under Panić. There was some slight improvement of 2-to-3 percentage points in 2014 and 2015 possibly due to the restatements forced upon the company. Regardless, Valeant was in the bottom 5% of companies in the system globally for accounting quality and transparency. This made the company a bad risk.
We shall take a close look at the detailed risk report the Transparently system produced for Valeant’s 2013 financial statements, which is representative of the results under Pearson’s tenure. The system detected red flags in 10 of the 14 accounting risk clusters it examined, the same result seen in 1999 but the distribution of risk among the clusters had changed.
In 2013, the system identified four new clusters warranting extreme caution: for gearing, income quality, margin signals, and corporate governance. Growth and asset quality still warranted extreme care but the risk level associated with working capital and credit had improved slightly. Three clusters warranted high caution. Those being for cash quality, business manipulation and credit.
The move to a business model based on acquisition versus drug development shifted the accounting risks towards concerns about leverage and sustainability
Looking at the risk report from this high level, it is clear that the move to a business model based on acquisition versus drug development shifted the accounting risks towards concerns about leverage and sustainability and away from evidence of financial strain related to cash generation and credit concerns. This makes sense because when a company is raising tens of billions in debt, immediate cash problems tend to go away.
Figure 3: An overview of Valeant’s risk signals in 2013
Source: Transparently.AI
That said, the elevation of income quality and margin signals suggests that income recognition might have been a more significant risk in 2013 than in 1999.
We gain a more complete picture by examining some of the key risks highlighted by the system in the risk clusters causing concern.
Figure 4: An overview of the major red flags associated with Valeant in 2013
Source: Transparently.AI
Although the risk signals for growth concerns and asset quality remain, growth of long-term assets has disappeared from both risk clusters to be replaced by depreciation in the asset quality cluster and capitalization growth in the cluster for growth signals. The implication here, from a manipulation perspective, is the risk of improper expense capitalization appears to have reduced while the risk of measures to inflate perceived balance sheet strength have increased.
In other words, the company appears more concerned with painting a picture of solvency rather than profitability.
New risk signals
Among the new risk signals, the principal messages are these:
- Risk stemming from much higher gearing. In 1999, Valeant had very little debt but in 2013, the company’s debt-to-equity ratio was eighteen times higher than the median global healthcare company. In others words, Valeant’s leverage was off the charts and thus creating the need to give an impression of balance sheet strength;
- Evidence of more aggressive income smoothing, which likely reflects the pressure of much higher valuation stock market valuation. In other words, the company’s high valuation in these years appears to have added to pressure to meet quarterly revenue targets;
- Unusually high level of options issuance to employees relative to earnings generation.
Interestingly, there was a big switch in smoothing activity between 2012 and 2013. Prior to 2013, it appears that accruals were used aggressively to inflate earnings. In 2013, it appears that this behaviour ceased. One possible explanation is that the company found new sources of earnings. This was the year in which the company began aggressively boosting prices and experimenting with specialty pharmacies to increase sales covered by insurance plans.
Figure 5: An overview of Valeant’s earnings smoothing in 2013
Earnings smoothing refers to the extent to which accruals are employed to offset swings in cash income and reduce overall earnings volatility. Smoothing is measured over 5 years. Smoothing is the correlation between accruals and cash income. A more negative value indicates higher smoothing. (%)
Source: Transparently.AI
Apart from gearing, the biggest change in 2013 versus 1999 was the elevation of risk associated with income and margins. The main concerns detected by the Transparently system in relation to income and margins were as follows:
- A significant proportion of Valeant’s income derived from non-operating activities. High non-operating income can indicate that a company's core operations are not generating enough income to sustain the business. Hence we see concerns about sustainability. In addition, Valeant consistently reported large extraordinary charges. In 2013, these exceeded 5% of total assets. Thus, although operating margins and profit might look good, overall profitability will be poor;
- Abnormally strong EBITDA margin, operating return on productive assets and operating margin relative to industry peers. On the face of it, this is a good thing. At the time, many thought it was due to Valeant’s R&D-light business model. However, when a company demonstrates abnormal profitability in an established industry it can be a sign that a company is artificially boosting income or running a model that pulls forward short term earnings at the expense of future earnings. Either way, it raises doubts about the sustainability of a business. In the case of Valeant, we know that its price increases were not sustainable and revenue derived from related parties (undisclosed) was illegal.
The bottom line is that the Transparently system was ringing alarm bells about Valent throughout Pearson’s tenure. The system warned about the sustainability of the business model and the risk that reported income was inflated. For a company with an accounting risk score as poor as Valeant, it is typically just a matter of time before the SEC brings the hammer down.
Disclaimer: Views presented in this blog are the author’s own opinion and do not constitute financial research or advice. Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.
About the author: Mark Jolley has been an investment strategist for almost 40 years and has advised some of the world’s biggest investment funds, public companies and notable investors. In the mid-1990s, as a global investment strategist with Deutsche Bank, Mark produced a daily note read by more than 16,000 investment professionals including voting members of the Federal Reserve and the European Central Bank. In the 2000s, Mark worked as Deutsche Bank’s Asian strategist and then as strategist for China Construction Bank. He is now an independent analyst.
