Valeant Pharmaceuticals International had a bumpy six months between October 2015 and March 2016.

After the firm reached a stock price high of $257 in the summer of 2015, it plummeted to $75 after short-seller Citron published a scathing report in October about its accounting practices, primarily its use of Philidor, a specialty pharmacy, to jack up its revenues. Valeant recovered a bit, hitting $118 in December. However, in March 2016 the stock price nosedived to $33 after the firm admitted it could not publish its 10-K on a timely basis and might violate some of its debt covenants. Creditors have granted some concessions, and as of this writing the price was rebounding a tad, but the jury is still out about the future for this business enterprise.

The financial collapse was predictable. One did not have to know about any possible accounting shenanigans. What was needed was an objective analysis of the firm’s strategy and the financial consequences of that strategy.

David Maris, currently an analyst with Wells Fargo & Co., contacted me in April of 2014 and asked me to analyze the financial reports of Valeant in light of the takeover attempt of Allergan. I wrote my report on May 2. Maris contacted me again in August, asking for an update of my analysis. I wrote that analysis on Sept. 5, 2014.

In this essay I briefly outline some of my findings from two years ago. I did not have the prescience to discern any accounting shenanigans involving Citron. I did take a hard look at the flawed financial strategy of the firm and anticipated troubles. Even in 2014 there was evidence of a toxic growth in liabilities and anemic free cash flows, and these were only going to get worse. One also had to realize that management’s yarn about cash EPS was poppycock and nonsense. Some sort of distress was bound to occur.

THE FLAWED BUSINESS MODEL

Valeant’s strategy in the spring of 2014 was to keep research & development to a bare-bones minimum; by reducing these and associated costs, the enterprise hoped to maximize profits. But any increase in profits could last only a few years because of patent risk and obsolescence risk. As patent protection vanished, the firm would meet greater competition and lose market share. Worse, as products aged, they would encounter greater competition from new products entering the marketplace. Valeant appeared to recognize these risks and countered them with a strategy of acquisitions. It was going to purchase firms and utilize their products; it would exploit their R&D to develop new products and to enhance patent protection on existing products. The process would repeat itself as Valeant’s management cut the R&D of acquired firms, with an eye toward maximizing short-term profits.

The business model of Valeant was deficient in two respects. It could achieve a maximization of short-term profits only if it could cut costs effectively without tearing the corporate fabric. The remaining portfolio of resources still would have to deliver products at high revenues and low costs, but the abridged entity might not be able to deliver at the same level as it did when it was whole. The results as of spring 2014 bore this out: Valeant’s net income remained negative.

Even if Valeant were successful in the cost-cutting efforts and generated excellent short-term profits, it would still face the difficulty of replicating the results. Valeant’s strategy requires a set of corporations that it could acquire at reasonable prices and supplying a product line that it could utilize. This aspect of its business model appeared problematic. Dramatic increases in goodwill demonstrated Valeant’s anteing up huge amounts of resources to play this game. With finite resources, there were limits to this strategy. (See “Valeant by the numbers.”)

The concern in 2014 was whether goodwill was impaired; even if not then, one wondered whether it soon would be impaired. Goodwill is traditionally viewed as an asset because it represents superior earnings because of the business acquisition. Goodwill is the present value of these future earnings, which yield returns greater than the normal returns of the firm. But superior earnings did not surface and have never surfaced.

Even if superior earnings materialized, the business model adopted by Valeant limited the life of goodwill. When it bought a target company, it had to pay a price that covered the value of the target’s product lines, both present and future. If Valeant then slashed R&D, it reduced the value of some of those future products because they would not come to the marketplace. Valeant’s strategy therefore limited the period over which goodwill can persist. Perhaps each acquisition would have goodwill for, say, 10 years and then disappear. The very business model utilized by Valeant created future impairment losses because of the inability of the subsidiary to generate new products because its R&D process was enervated by the parent company.

A final point concerns metrics. The measures by which one should evaluate the performance of managers should be consistent with the firm’s business model. Later I adjust free cash flows to incorporate Valeant’s strategy of using business combinations to purchase plant and equipment and various identifiable intangible assets to increase its product line. This metric in 2014 suggested near financial problems because of Valeant’s business model.

A LOAD OF DEBT

Valeant’s liabilities grew mightily because of the business combinations. Financial leverage, that is, debt as a proportion of the capital structure, swelled from 34.24 percent in 2009 to 81.29 percent in 2013 (see table). Credit risk is captured by the times interest earned, or TIE ratio, which plummeted (see table).

Earnings before interest and taxes was negative in 2010 and 2013, so earnings obviously does not cover interest expense in those years. In 2011 and 2012, EBIT was smaller than interest expense, so there is concern in those years as well. Only in 2009 was interest expense adequately covered by EBIT.

Analysts and investors had to wonder about the capital structure of Valeant at least by 2014. After all, how much more debt could the firm absorb and not increase its risk of default?

Further, from the 2014 second quarterly statement, one could see the amount of debt soon coming due. (These amounts, as reported then, are included in the table.)

Could Valeant generate enough cash to service these debts? To address this question, we turn to an analysis of free cash flow.

FREE CASH FLOW

Traditional free cash flow equals cash flow from operating activities found on the cash flow statement minus capital expenditures. In the accompanying chart, I list Valeant’s net income and its cash flow from operations, and compute its free cash flow (in millions of dollars).

The two cash flow numbers appear respectable; however, they do not accurately reflect Valeant’s business model. Recall its strategy: Acquire business enterprises, utilize their products and harvest products near completion from the R&D process, and then slash R&D activities to a bare-bones minimum. In other words, instead of spending money on R&D and the ancillary assets to support R&D activity, Valeant spent funds on targets who engaged in R&D processes. This implies that the acquisition of property, plant and equipment and intangibles other than goodwill, including IPR&D, in business combinations are in fact capital expenditures to Valeant. For example, when Valeant acquired Bausch & Lomb in 2013, it purchased property, plant and equipment for $766 million, intangible assets except for goodwill and IPR&D for $4,342 million and IPR&D for $418 million. Via this business combination, Valeant purchased these capital assets; they should be included within capital expenditures when computing free cash flows.

I adjust the free cash flow measurements to include how much it spent for property plant and equipment, intangibles other than goodwill and IPR&D, and IPR&D in business combinations. The results are in the accompanying table (in millions of dollars).

Valeant had a positive adjusted free cash flow in 2009 but not in any of the other years. These results suggest that Valeant’s strategy was not working and cast doubts about the strategy’s viability. With these adjusted free cash flows, the firm would not be able to service its debts.

NON-GAAP NONSENSE: CASH EPS

Management paints a rosy picture of the performance at Valeant by focusing on what it calls cash EPS, instead of earnings or EPS. This cash EPS metric is disclosed in its press release on Feb. 27, 2014. Unfortunately, the cash EPS measurement suffers from significant problems.

The most obvious point about pro forma earnings such as cash EPS is that it is created by (and only employed by) the company. This metric seems arbitrary and perhaps even capricious. If one desires to utilize non-GAAP pro forma metrics, it would be better to apply those well known to the investment community, such as EBITDA or free cash flow.

Besides, if managers want investors to ponder cash flows instead of earnings, why not just focus on cash flows either disclosed on the cash flow statement or calculable from that statement and similar disclosures? Free cash flow is a well-known metric and quite helpful in assessing a firm’s ability to generate cash.

A number of adjustments that management applies in its press release are the same as those found in the cash flow statement, such as an adjustment for IPR&D impairments. Other adjustments do not follow GAAP, such as the adjustment for restructuring, integration, acquisition-related and other costs. These adjustments are not consistent with the firm’s business model. Since the firm’s strategy embraces business combinations, acquisition-related costs are critical in assessing managers’ success in that strategy and should not be eliminated in this metric. And some adjustments seen on a cash flow statement are not made, such as adjustments for working capital items. This is curious, as adjustments for working capital do convert GAAP income to cash flow. Perhaps these adjustments are not included because they would reduce cash EPS — there are large increases to accounts receivable every year — and managers are just massaging this measure.

I would not analyze Valeant with its cash EPS: It is a fatuous and self-serving metric. For all its warts and acne, I prefer to use GAAP numbers. Until Valeant achieves respectable GAAP earnings, any success story is based more on faith than performance.

CONCLUSION

The play for Allergan by Valeant came down to this. A debt-laden company with weak cash flows was trying to buy a firm with much less debt (about 38 percent of capital) and with great cash flows. Who can blame them?

In defending their offer to Allergan shareholders, Valeant’s managers asked them to forget GAAP and see the wonder of its cash EPS. If we learned anything from the dotcom bust, it is not to be swayed by metrics that a firm invents.

The near collapse of Valeant is due to various factors, but at the center is a flawed strategy. Buying companies and then stripping them of their R&D activities led to greater debts to finance these transactions and worsening cash flows. Without the cash to carry on business and pay the debts as they come due, adversity was inevitable.

J. Edward Ketz is an associate professor of accounting at Penn State. His opinions are not necessarily those of the Pennsylvania State University or Accounting Today.