The illusion of debt-fuelled earnings

By Edward Chancellor

Low rates have forced investors into a dangerous search for yield. Just look at the surge in junk-bond and emerging-market corporate debt sales over recent years. Cheap money has also driven record levels of stock buybacks in the United States and fuelled a boom in corporate mergers.

This is evidence of what the Japanese call “zaitech” – the use of cheap capital to boost reported profitability. Like all grand experiments in financial engineering, though, this one too will come unstuck.

Japan’s infatuation with zaitech arose in the late 1980s, at a time when economic growth was slowing and the rising yen threatened corporate profits. Many companies responded to those headwinds by issuing warrant bonds in the eurodollar market, swapping the proceeds back into the domestic currency and investing in Japanese shares, which were held in special trust accounts.

While the Tokyo stock market soared, these companies enjoyed rising earnings and a negative cost of debt funding. However, after interest rates rose and stocks plummeted in the early 1990s, it was game over. Many enthusiastic zaitech players, such as Hanwa, reported large losses.

The mid-1960s witnessed an earlier experiment with financial engineering in America. This was the era of the conglomerate boom. Companies such as ITT, Gulf + Western, Saul Steinberg’s Leasco and Ling-Temco-Vought (LTV) expanded rapidly through acquisitions. Between 1966 and 1968, conglomerates accounted for more than 80 percent of U.S. takeovers. These conglomerates often adopted dubious accounting techniques to boost profits.

Take LTV, cobbled together by the ambitious Oklahoman James Ling. The company expanded from a core electronics business into meat packing, sporting goods, airlines, insurance and eventually steel manufacturing. Ling understood that investors -in particular, the “gunslinger” fund managers of the “go-go” era -were focused on earnings per share.

To deliver EPS growth, Ling issued convertible bonds and bank debt to finance his acquisitions. He also enticed shareholders to exchange stock for convertible securities, which further boosted EPS. Ling would often float shares in acquired companies (like today’s tracking stocks) and use the proceeds to retire debt.

As long as the stock market continued rising, these feats of financial engineering worked wonders for LTV’s shares, which climbed 17-fold between 1964 and 1967. After interest rates rose towards the end of the decade and the stock market turned down, the conglomerate bubble burst. LTV was forced to divest companies to pay down debt, Ling was fired, and his company ended up as a second-tier steel concern, eventually going bankrupt in the mid 1980s.

In a presentation at the Grant’s Conference in New York last month, Chicago-based hedge-fund manager James Litinsky drew an intriguing parallel between the 1960s conglomerates and today’s so-called platform companies, businesses which have grown rapidly through M&A.

Unlike the conglomerates, they are not diversified but focused on a single industry. Like the conglomerates, however, they have thrived in an era of financial repression, when interest rates have been kept below the rate of inflation. Like their predecessors, platform companies have been using debt to generate EPS growth. Similarly, they have been egged on by investors, with activist hedge funds replacing the gunslinger generation.

Litinsky highlighted companies from various sectors, including brewing (Anheuser-Busch InBev) and consumer staples (Kraft Heinz). But pharmaceutical companies dominate. One of them, Valeant, resembles a modern-day LTV. The firm has grown rapidly through acquisitions, such as of Bausch & Lomb, and slashing costs to meet cost-cutting targets.

Valeant platform companies

Valeant promised to take $900 million from Bausch’s $1.2 billion of operating expenses. Valeant’s takeovers have been funded by cheap debt – interest expenses relative to long-term debt have averaged below 6 percent in recent years. Cost-cutting, takeovers and low-cost loans have boosted Valeant’s EPS, which climbed from 29 cents (on a diluted GAAP basis) in the fourth quarter of 2012 to $1.56 in this year’s third quarter.Like LTV, Valeant has adopted complex financial structures. Its ownership stake in specialist pharmacy Philidor, which distributed some of its drugs, was held through what’s called a variable interest entity. Critics claim this structure, which Valeant is now unraveling, kept contingent liabilities off the balance sheet. What’s clear is that Valeant has borrowed a lot -long term debt has grown from around $10 billion in late 2012 to over $30 billion today.

Corporate roll-ups, from LTV to Tyco International, have tended to come unstuck when they stop growing. Valeant’s stock is down more than 70 percent since its peak earlier this year. Its high-yield bonds are now trading below par. Valeant’s days of acquisitive growth would appear to be over.

The Valeant story is not an isolated case of aggressive financial engineering. At a time of ultra-low debt costs, announced global M&A activity this year has reached a record $3.9 trillion, according to Thomson Reuters. Global non-financial investment-grade debt issuance has climbed to $1.3 trillion so far this year. Acquisition-related debt reached a record $365 billion, says Thomson Reuters.

Even more debt has been issued by U.S. corporations for share buybacks. Over the past five years, the top 100 share repurchasers have grown their EPS by 93 percent. Their return on equity has climbed to 19 percent from 13 percent during this period, according to Thomson Reuters Worldscope, and their shares have handily outperformed the broader market.

This may look impressive. But the buyback leaders have also seen their sales growth slip and leverage rise. Their median capital spending (relative to cash flow) is below the S&P 500 average. To deliver EPS growth, these companies have been leveraging up and eating their seed corn.

Valeant’s fall from grace is just another example of how debt-fuelled growth creates only an illusion of value. Real worth comes from companies investing wisely for the future and acquiring shares -whether their own or in other companies – at low valuations. While corporate revenue is declining and debt is cheap, financial engineering is an easy way out -until it all falls apart.

Published on Nov. 18, 2015

Valeant CEO gets called on $100 mln excess

By Robert Cyran

Valeant Pharmaceuticals Chief Executive Mike Pearson has been called on his $100 million excess. That’s how much stock he put in hock to do everything from paying taxes to donating to charity to buying more shares in the company -he even helped finance a community swimming pool.

Now he has been forced to repay the debt. Compensating bosses in equity is supposed to nudge them to serve shareholder interests. In this case it serves as an apt example of the skewed incentives that have rocked Valeant.

The pharma giant required that Pearson buy a substantial amount of stock when he took the job in 2008. It then granted him lucrative restricted equity worth $4 for each $100 of value created on his watch. The board made more such grants in subsequent years so that essentially all of Pearson’s pay came in equity and cash incentives tied to performance.

Pearson owned about 3 percent of Valeant as of its last proxy statement. His serial-acquisition strategy yielded riches for a while as the stock rose about 20-fold since he took over. The fact he has never sold any of his holdings makes the story seem even more appealing to those investing alongside him. One reason he has kept his shares, though, is because the company allowed him to use his stock as collateral to borrow money.

That can distort executive incentives. In Valeant’s case, management’s focus on rapid share appreciation has played a role in its aggressive accounting and M&A strategy. Investors have now grown disenchanted with the results and are questioning whether Valeant has grown too fast. The company’s involvement with a specialty pharmacy that has been accused of seeking improper insurance reimbursement and altering prescriptions has added to investor skittishness. The stock has lost 70 percent of its value from its high.

The drop prompted Goldman Sachs to call Pearson’s loan and sell 1.3 million of shares it held as collateral. That has put investors even more on edge, not helped by the company’s silence about whether the stock sale occurred during a blackout period, when executives can’t sell. It’s a mess that better board oversight could have prevented.

Published on Nov. 6, 2015

Valeant poised to cause much collateral damage

By Robert Cyran

Beware the collateral damage from Valeant. The acquisitive drugmaker’s travails have so far wiped out some two-thirds of its market value, vaporized fortunes of its investors, damaged reputations and dusted the pharmaceuticals industry with political radioactivity. The indirect effects could be even larger, as Valeant will incinerate belief in so-called platform companies, “adjusted” accounting and the genius of hedge fund managers.

valeant market cap


Valeant’s intellectual underpinning was that it was a platform. Its market capitalization, which reached a peak of about $90 billion, derived not only from the assets it controlled, but also from management’s ability to buy companies, add them to the mix and enhance their collective value.

The success inspired several other drug rollups, including Mallinckrodt, Endo International, and Horizon Pharma. The combined value of the four companies swelled from about $20 billion to over $130 billion in just a few years. Copycats have proliferated in other sectors, including cable where Patrick Drahi’s Altice is hoovering up operators around the world. The Brazilian masterminds behind 3G Capital are doing it in beer with Anheuser-Busch InBev and food with Kraft Heinz.

Avago Technologies has joined the platform party in semiconductors while in chemicals, investors Martin Franklin and Pershing Square’s Bill Ackman went so far as to tout the strategy right in the name: Platform Specialty Products.

For these enterprises to succeed, bosses need to consistently identify good targets, pay a cheap price and manage the resulting assets effectively. Valeant failed on all three counts.

In August, it bought a barely effective drug for low sexual desire in women for $1 billion. Initial sales, when such “lifestyle” pills typically fly off the shelves fastest, indicate a glacial start. Valeant won an $11 billion bidding war for Salix Pharmaceuticals, which was embroiled in an accounting scandal. And Valeant Chief Executive Mike Pearson acknowledged recently, in response to a question about possible fraud at a subsidiary, that for a company the size of Valeant it’s “impossible to have full knowledge of everything at any one time.”

Some of the other platform companies are probably built on similarly shaky ground. Few have the patience required to succeed in serial dealmaking. It’s even harder when investors hunger for growth and executive compensation packages encourage an orgy of debt-driven acquisitions. Tightening credit markets, in particular, could expose the dependence on easy financing.


Valeant’s profitability is mediocre. The company also has gilded the figures with non-standard metrics that omit important costs such as compensation, legal fees, and acquisition and integration expenses. Over the past nine reported months, Valeant earned $75 million using generally accepted accounting principles. Using the company’s self-created measures, it has generated a bottom line of $2.7 billion. The company-adjusted pro forma EBITDA estimates performed a similar optical trick with credit metrics when the company acquired rivals.

These puffed-up and pleasingly named “cash” earnings, and the stock’s steady upward progress, appealed to unsophisticated investors. Yet the myriad adjustments -Valeant’s quarterly results contain dozens of footnotes -also paradoxically lured some of the best minds on Wall Street. They convinced themselves that within the complexity was contained opportunity, and that the two sets of figures would converge once Valeant stopped making acquisitions.

Owners big and small are now cottoning onto the reality that at Valeant “one-time” charges have a habit of repeating themselves, amortization is a real cost in a business built on intellectual property and compensation comes out of the pockets of shareholders.

The valuations of many Silicon Valley startups – there are now 145 unicorns worth at least $1 billion apiece, according to CB Insights – and even many more mature technology companies also prefer non-GAAP figures that strip out stock compensation and other “non-cash” charges. They, too, could be in line for reappraisal.


The involvement of ValueAct Capital, one of the best activist funds, on the board acted as a seal of good housekeeping for Valeant. Other star investors piled in, and the great returns they made -Valeant’s share price increased more than 20-fold from 2008 to its height -encouraged still more to join in, turning the stock into a hedge fund hotel. The fall in Valeant’s stock has erased much of those returns, and left many late followers sitting on some ugly paper losses.

There’s nothing wrong with copying a good idea. The belief in Valeant, however, became pernicious group-think accompanied by hubris. Risk management suffered, as big investors took concentrated positions. Valeant’s stock accounted for almost of third of Sequoia Fund this summer, and the manager recently bought more. It wasn’t alone, as Ackman raised his stake to 9.9 percent last month. Ackman even held a conference call about Valeant in late October. About 10,000 people listened to him back the company for four hours. That’s more than twice as many as dialed into the company’s own defense a few days earlier.

Most specialized healthcare funds knew enough to avoid the carnage. They guessed correctly that Valeant’s model of slashing R&D and jacking up prices would result in shrinking prescription counts and pushback by insurers and politicians.

Pershing Square, Sequoia and other funds put their faith in spreadsheets and access to management instead. The numbers they inputted were overly optimistic. There’s little value in asking a CEO, “Is there any fraud happening?” as Ackman did of Pearson. A more cautious approach to the limits of their expertise would have served these investors well. It’s yet another worthwhile reminder for those who would believe in the supposedly smartest investors with a solid track record: past performance won’t always guarantee future returns.

 Published on Dec. 7, 2015

Valeant’s latest fix reinforces its challenges

By Robert Cyran

Valeant Pharmaceuticals’ latest fix reinforces its challenges. The drug company has appointed three executives to take the reins while Chief Executive Mike Pearson is on medical leave and three board members to oversee and guide them. The double triumvirate shows how reliant on one man Valeant has become.

Pearson, who has been hospitalized with a serious case of pneumonia, is the architect of the company’s serial-acquisitions strategy. This business model and Pearson’s leadership have come under intense scrutiny. Critics have attacked the company’s accounting, its stifling $30 billion debt load and its price hikes on acquired drugs. As a result, Valeant’s market capitalization has plummeted by 60 percent since August. This loss of faith by investors has forced the company to switch to integrating businesses, instead of buying new ones, and paying off debt.

The company’s prompt action in addressing Pearson’s illness by disclosing and appointing interim leadership is commendable. And there’s a good chance Pearson could be back shortly. But the structure is convoluted.

General Counsel Robert Chai-Onn, company Group Chairman Ari Kellen and Chief Financial Officer Robert Rosiello will share management responsibilities in a newly created Office of the Chief Executive Officer. The board has also created a committee to “oversee and support” the office of the CEO. This, too, comprises three members – lead independent director Robert Ingram, president of big stakeholder ValueAct Capital Mason Morfit, and former Chief Financial Officer Howard Schiller.

The company says this reflects Valeant’s non-traditional organizational philosophy. It relies on what it says is a deep bench of qualified executives working in areas of expertise rather than a traditional hierarchy with roles such as a chief operating officer. Chai-Onn has been at Valeant for a decade; Rosiello advised the company for eight years before joining the firm as finance boss. Moreover, the additional board oversight could augur better corporate governance if it leads to the company eventually separating the roles of chairman and chief executive.

Investors are more worried that this structure reflects the fact Pearson can’t be replaced easily, and the risk of executive and board infighting. These fears sent the stock down 10 percent on Monday morning. More turmoil is the last thing Valeant needs.

 Published on Dec. 28, 2015

Valeant plays chicken with death spiral

By Robert Cyran

Valeant Pharmaceuticals is playing chicken with a death spiral. The company’s failure to file audited results has started a countdown to default that vaporized over 40 percent of its market value in early trading. Executives are mulling selling assets. But with so many questions about its financials unanswered, Valeant’s outlook is bleak.

It’s never good when the conversation on a company’s earnings conference call focuses on its liquidity and ability to meet debt obligations. The now $12.5 billion company has about $30 billion of debt, thanks to a string of acquisitions; with over $1 billion of cash on hand executives argue it can meet its remaining scheduled debt and interest payments this year.

That becomes irrelevant if it cannot produce audited results within 60 days, as investors can then demand Valeant repay a chunk of its debt. The company says it’s trying to file as fast as it can.

There are more than a few other discordant notes, however. The bullish case for Valeant always centered on its ability to throw off lots of cash. Yet that’s shrinking. Chief Executive Michael Pearson, back in charge after a couple of months of sick leave, now thinks it will produce about $5.7 billion of adjusted EBITDA this year, almost a fifth lower than its previous estimate. Moreover, while the company wants to patch up its balance sheet, it now thinks it will only pay down about $1.7 billion of debt this year, compared to its previous estimate of more than $2 billion, and had already drawn down $1.5 billion on its revolver by the end of December -about double what it had tapped just three months earlier.

Investors were already skeptical about Valeant’s adjustments to the financial figures it trumpeted. They are more so today. Valeant press release stated that adjusted EBITDA for the next four quarters would be around $6.2 billion to $6.6 billion. On the conference call, though, Pearson had to admit the company only expects around $6 billion and had to defend himself against an analyst’s accusation that the company had deliberately puffed up the numbers.

Valeant’s old M&A business model is dead, customers are demanding big price cuts or not reimbursing various medicines and the company can’t file audited financial statements. It’s now impossible for an outsider to know exactly what is happening within the company -or if it can avoid falling to its doom.

Published on March 15, 2016

(Image: REUTERS/Christinne Muschi)

Valeant’s multiple organ failure puts it in ICU

By Robert Cyran

 Valeant Pharmaceuticals is running the risk of an Enron or WorldCom endgame. The beleaguered drugmaker has uncovered accounting impropriety, it said on Monday. It is booting Chief Executive Mike Pearson but Howard Schiller, formerly chief financial officer, has refused to quit as a director. The board, the numbers and the strategy are fractured. Add some $30 billion of debt, and Valeant could easily crumble.

Take the company’s organs in turn, starting with the board. Hedge-fund boss Bill Ackman will now join. His Pershing Square Capital Management, which owns about 9 percent of Valeant’s stock, now has two directors. Another activist fund, ValueAct Capital, also has a nominee on the board. Schiller will still be there, too. The company pointed the finger at him for “improper conduct” in Monday’s release. The ex-CFO, though, said in a statement he had done nothing wrong. The mixture looks toxic.

The financial glands aren’t doing much better. The company’s failure to file audited 2015 financial statements on time may put it in default and potentially force it to repay slugs of debt -something it might struggle to do. Raising new cash would be a challenge even without the other clouds hanging over the company now that its market capitalization has tumbled to a level that’s less than a third of its debt load.

The company’s latest update also criticized “the tone at the top of the organization” as a contributing factor, presumably referring to Pearson. And 2014 numbers are in question, too. It takes a leap of faith to believe that further problems won’t emerge and that the figures can be corrected and cleared by auditor PricewaterhouseCoopers in short order. Even figuring out which Valeant executives should sign off may be difficult.

Then there’s the company’s strategic brain. Its indebtedness stems from the serial acquisition of sometimes mediocre assets at inflated prices, partly in a quest by senior executives to achieve aggressive targets -at any cost, it now seems. If anything, Valeant will have to become a seller of assets to reduce debt. The famous collapses of Enron and WorldCom involved similar multiple organ failures exacerbated by heavy borrowing. To be clear, Valeant so far hasn’t been charged with fraud. Even so, it’s in a fight for survival.

Published on March 21, 2016

Valeant’s new CEO a good choice for a dim future

By Robert Cyran

Valeant Pharmaceuticals’ new chief executive is a good choice for a dim future. Joseph Papa’s skill running a tight ship at Perrigo is sorely lacking at his new company. Valeant needs to keep staff, sell assets and pay down the company’s $30 billion of debt, all while coping with drug pricing pressures that have also hit the rest of the industry.

Papa is parachuting into a mess. He will start in early May, by which point Valeant intends to have filed its delayed audited 2015 financial statements. Few things have gone according to Valeant’s plans over the past year, however. Finding executives willing to sign the statements, for example, may be a challenge. Papa will at least have over a month to file them and cure the default.

That’s just the start. Valeant’s old boss, Mike Pearson, acquired mediocre assets at inflated prices and hiked drug prices. The company then slashed expenses but never fully integrated the grab bag of assets. The result was demoralized employees, crippling debt and a damaged reputation.

Asset sales will be an early step. Valuable brands such as Bausch & Lomb could do without being tarred by the Valeant association and may be worth more outside the company. The resulting smaller firm would be easier to manage and have some extra cash to pay down debt. This isn’t a panacea, however. If Valeant appears desperate, it may not fetch high enough prices on cash-generating assets to cut enough of its liabilities.

Papa also must improve the businesses the company keeps. That’s getting harder as insurers are pushing back on drug price increases. Perrigo on Monday warned these pressures will cause the company to miss analysts’ revenue and profit estimates.

That may initially give Valeant shareholders some pause. Papa had, for example, promised his previous investors a bright future. While the stock jumped fivefold under his decade-long reign, it has lost almost a third of its value since Papa and his assurances helped push away a hostile offer from rival Mylan late last year. Valeant, though, is a highly dysfunctional company where owners are likely to welcome even mediocre results and a modicum of adult supervision.

Published on April 25, 2016

(Image: REUTERS/Christinne Muschi)