Valeant’s Lessons about Non-GAAP Reporting Pitfalls

Valeant Pharmaceuticals and non-GAAP reporting: two topics that the press can’t seem to get enough of. They’re the peanut butter and chocolate of the financial world for journalists.

It would be almost negligent to not examine the lessons that Valeant might offer about the over-reliance on mongrel metrics. At the risk of beating a horse further into the hereafter, and with perfect 20/20 vision, let’s start with the following graph as a backdrop. It shows Valeant’s net income, plotted alongside the non-GAAP net income from the company’s fourth quarter earnings release 8-Ks for the years 2008 to 2015:

valeantpharm

The foggy portion on the left can be attributed to “Biovail” which merged with Valeant in September, 2010. That was the first year there was a marked divergence between straight-up net income and non-GAAP net income, and the pattern remained thereafter.  Notice that in the eight years presented, GAAP reporting showed losses in half of them: 2010, 2012, 2013 and 2015. Yet the non-GAAP net income continuously expanded. The greatest adjustments were most often due to amortization and impairments of intangibles with finite lives, and restructuring/integration charges. One could argue that impairments and restructuring charges hamper year-to-year comparability of results, but they’re still using up shareholder resources.

Discarding all of the unpleasantries contained in GAAP net income ignores those facts, and it doesn’t necessarily show the cash generated by the operations – at least, not like the after-tax cash from operations shown in the cash flow statement. For the same time frame, here’s what non-GAAP net income looks like compared to cash generated from operation:

Valeant 2

Valeant’s non-GAAP net income far outpaced its cash generated from operations – especially after the 2010 merger. Notable in the trend: in the years 2011 to 2013, the non-GAAP net income was very wide of the cash generated by operations. This was supposed to be a company that would gush cash because of its slashing of R&D and raising of drug prices. Didn’t anybody bother to check the key premise: the company would generate plenty of real cash after those actions? The all-in, after-tax cash from operations doesn’t begin to support the premise until management put the brakes on acquisitions in 2014.

In 2015, it reverted to prior form: non-GAAP net income up, cash from operations down.

Valeant 3

Another comparison by charts: Market capitalization plotted alongside non-GAAP net income and cash from operations. Over the time frame, the market capitalization tracked the growth pattern of the non-GAAP net income; the relationship of the market capitalization to the cash from operations is not quite as smooth, particularly in the last couple of years.

The obvious message is that paying attention to net income might have kept an investor out of trouble. In its non-GAAP reporting, Valeant regularly added back amortization and impairments of intangible assets, and investors gave them a pass. Maybe they did so on the flimsy grounds that this is a non-cash expense: the resources were already expended and amortization expense separated earnings from cash flow. (Even if other things separate earnings from cash flow.)

Yet Valeant was enjoying the benefits of those intangibles in its revenues; adding back the amortization of those intangible assets ignores the fact that resources were expended to control those intangibles. The non-GAAP result shows the benefit from controlling intangibles, without any of their related cost. Note that the only intangibles that get amortized are the ones with definite lives: their utility is going to expire in a certain period of time, so charging that expiration against earnings makes more sense that recognizing it all on the last day of value. These are not “forever” assets.

Net income, with amortization included, tells more of a story about how those profits were made, with an angle on capital utilization: the amortization carries the implication that to continue the revenue stream, reinvestment in intangibles is necessary. Deducting their expiration against earnings means less profit remains for investors, because reinvestment in the business will consume some of their profits. That’s not something investors want to hear, but it is a fact of life.

Net income still doesn’t say enough about capital investment and returns on capital investment. It’s not hard to figure out, however – and in an acquisition-driven company like Valeant, an investor should care that all those acquisitions have a sufficient payoff. If they don’t look at returns on investment and factor that into their valuation thinking, then management will have free rein to make pell-mell acquisitions – and that’s pretty much what went on at Valeant. It doesn’t even take much work to look at returns on capital. Below, a suggested format for evaluating the cash return on the total dollars invested in assets by Valeant’s management.

($ in millions)

2008

2009 2010 2011 2012 2013 2014

2015

Total assets

$1,623.6

$2,059.3 $10,795.1 $13,108.1 $17,950.4 $27,970.8 $26,304.7

$48,964.5

Accumulated depreciation

118.4

118.1 122.7 125.8 173.5 838.8 977.9

1,184.0

Accumulated amortization

356.2

470.1 704.3 1,110.0 1,997.6 3,827.4 5,140.6

7,411.6

Total dollars invested

$2,098.2

$2,647.5 $11,622.1 $14,343.9 $20,121.5 $32,637.0 $32,423.2

$57,560.1

Average total dollars invested

$2,168.0

$2,372.9 $7,134.8 $12,983.0 $17,232.7 $26,379.3 $32,530.1

$44,991.7

Source of balance sheet data in all tables and graphs: Calcbench. Market cap data from S&P Research Insight. Non-GAAP net income figures from company 4Q 8-Ks.

Adding back the accumulated depreciation and amortization accounts for the dollars spent on assets still being used but eliminated from the investment basis through periodic amortization and depreciation charges. It gets to the total amount of investment that’s still in service to the firm. Impairment charges, on the other hand, are not added back even though they represent capital used. That’s because if the asset has been written off, it isn’t producing a return for investors. The objective is to see the cash return on the funds spent on assets in place.  That’s giving management the benefit of the doubt: it’s not holding them accountable for spending on “assets that didn’t work out.” It seems like a low hurdle to clear. It isn’t. The table below shows Valeant’s net after-tax cash from operations divided by the average total investment for each year.

($ in millions)

2008

2009 2010 2011 2012 2013 2014

2015

Cash from operating activities

$204.3

$360.9 $263.2 $640.5 $656.6 $1,042.0 $2,294.7

$2,200.4

÷ Average total dollars invested

$2,168.0

$2,372.9 $7,134.8 $12,983.0 $17,232.7 $26,379.3 $32,530.1

$44,991.7

After-tax cash return on assets

9.4%

15.2% 3.7% 4.9% 3.8% 3.9% 7.1%

4.9%

Notice that the best years were 2008 and 2009 – when the company was really Biovail. 2010 is something of an outlier, in that the merger occurred late in the year: only about three months (25%) of cash flows were accounted for, but 100% of the investment was included, resulting in a return that was a fraction of what it once produced. It never came close after that: the company followed with ever more investment that did not throw off as much cash as the investment appeared to justify. Even in 2014, its best year, the return was still less than half of what it was in 2009 -  also a year in which the company laid off the acquisitions. 2015’s return was in the same league of mediocrity since the acquisition binge began.

The two graphs below provide a sobering contrast. The graph on the left shows flawed capital allocation: average total dollars invested in assets keeps rising, while the cash from operations – the holy grail of investment decisions – improves only slightly, and return on the invested capital meanders around in sub-territory not tested before the acquisitions went hyper. The graph on the right is damning of investors: while the actual returns from Valeant’s strategy were plain to see (left graph), the market got more enthusiastic as the acquisition machine hummed. The company’s market capitalization grew as the total assets grew.

Valeant 5

The graph below breaks it down some more: it shows the annual incremental change in average investment, and the annual incremental change in cash from operations.

The incremental change in cash from operations – after taxes, after financing cash flow from operations – simply does not keep up with the incremental investment in assets. Maybe there’s supposed to be a delayed effect on cash flow from operations, but it sure seems a long time coming.

Valeant 7

Finally, the graph at left shows the three different returns together: the two that track absolute dollar performance returns, net income and non-GAAP net income, and the cash return on asset investment. The latter is the one that should be of most interest to those who believe that cash matters more than anything else – and there are lots of those investors. It’s a useful relative measure because it relates the returns to the investment that produced them – and thus it’s a report card on management’s allocation of capital. Yet many cash-sycophantic investors will often ignore any all-in measures of cash flow and look at some kind of “cash earnings” figure or EBITDA.

Regardless, it’s interesting to note that the cash return on asset investment and the net income track each other quite closely – and the non-GAAP net income is nowhere near the two.

 So – what are the lessons? 

  • If investors are using non-GAAP earnings as their only measurement of performance, think about using other measures of performance to see if you can find a contradiction.
  • If a company is guiding you to use non-GAAP earnings as a performance measure, be suspicious if they 1) don’t give a solid reason why the non-GAAP earnings measure is superior and 2) they present the measure as “cash earnings.” If they call their “cash earnings”, it’s neither cash flow or earnings. It’s like a “furkey:” part fish, part turkey – and not real.
  • Eliminating line items from GAAP net income also forces one to ignore information that might show that management is wasting capital. Think about capital allocation, not just increases in a prized “operating” metric.
  • If you think you like cash operating metrics, you might as well go for the most stringent measure: cash generated from operations, straight from the cash flow statement.
  • In evaluating performance, it makes sense to relate inputs to outputs. Assets generate cash returns: pay attention to the rate of return on those investments.

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