Why Philidor is still more important than most realize

For the traders in VRX the stock movement has made this an extremely interesting name to watch and a chart like it has now just begs for jumping in as a bargain. But there is really a much bigger issue about Philidor than some realize when it is merely painted as some kind of rogue pharmacy that can be lopped off.

This post will also point out exactly why it is so important for MP to peg Philidor at 7.2% of revenue or less where that figure is quite a head scratcher considering the demand letter sent to R&O.

Here's what you have to do to follow along. Grab the June 2015 10Q which anyone could get here:
https://research.scottrade.com/qnr/uploadhandler/z03e9100azff9a92f8e81e482c99e98a93b9e0676b.htm

Now 10Q's are ordinarily very dry documents to plow through and this one is way more complex than most. BUT here is a little trick that is going to take you to some particularly juicy parts for the current drama.

Hit control F and in the find box put in "subsidiary" in the box. There are still about 210 hits for the term, but just scroll down and read some paragraphs around the found terms.

If you should actually do this exercise, you will see some detail that shows a better picture of the financial condition than most have based on the pro forma numbers. There are also juicy definitions about immaterial subsidiaries, subsidiary disposition or investment restrictions in the loan covenants, etc., etc. Also some choice nuggets like the salary of new McKinsey fellow Rob Rosiello.

This exercise might make one pause about whether the Philidor strategy was ever possible at all under the covenant restrictions and whether Philidor should have signed on as a guarantor, whether the lenders might have recourse, and whether VRX could in any way shape or form finance Philidor or a local pharmacy net under its control. And again, it's also why it is so important for MP to keep the revenue from Philidor at 7.2. But of course the revenues are also laid out in this filing, conveniently around one of the "subsidiary" hits that shows up...

Reading between the lines as to who the lenders to VRX are versus who the administrators of the loans and you can see why some banks came out so vigorously in defense, while some lessor invested names with insight into the loans swiftly moved their ratings and price targets lower, like say GS.

Extremely dry exercise and possibly only for those with a tendency towards accounting accuracy but sometimes doing this kind of work is what allows one to save their hide as leverage can sometimes be a swift sword.

No matter how you slice it, it seems as if MP is painted into a corner with regard to Philidor and what Philidor chooses to say. Many of their customers were told Philidor was a wholesaler that negotiated specially with Valeant... It really seems like the Valeant management is having a tough time deciding exactly what it was and how separate it was, etc. Fortunately, it seems like there may be some applicable definitions in their 10Q

 

In case people can't find the 10-k, here are a few interesting sections:


Immaterial Subsidiary ” means any Subsidiary of Borrower, designated in writing to Administrative Agent by Borrower as an “Immaterial Subsidiary,” that, individually and collectively with all other Immaterial Subsidiaries as of the relevant date of determination, has (i) total assets as of such date of less than 7.5% of Consolidated Total Assets as of such date and (ii) total revenues for the ended four-fiscalquarter period most recently ended prior to such date of less than 7.5% of the consolidated total revenues of Borrower and its Subsidiaries for such period. It is understood and agreed that Borrower may, from time to time, redesignate any Immaterial Subsidiary as a non-Immaterial Subsidiary to the extent that the requirements set forth in Section 5.10 are satisfied with respect to such Subsidiary at or prior to the date of such redesignation.

“ Excluded Subsidiary ” means (a) any Subsidiary that is not a wholly-owned Subsidiary and (b) any Immaterial Subsidiary.

In the event that any Person becomes a Domestic Subsidiary of Borrower (including with respect to any Subsidiary Redesignation resulting in an Unrestricted Subsidiary becoming a Subsidiary) (other than a Subsidiary that is, or would be, an Excluded Subsidiary), Borrower shall: (I) promptly cause such Domestic Subsidiary to become a Guarantor hereunder and a Grantor under the Second Amended and Restated Pledge and Security Agreement by executing and delivering to Administrative Agent and Collateral Agent a Counterpart Agreement and a Pledge Supplement (as defined in the Second Amended and Restated Pledge and Security Agreement ), and (II) take all such actions and execute and deliver, or cause to be executed and delivered, all such documents, instruments, agreements, and certificates as are similar to those described in Sections 3.1(b), 3.1(f), 3.1(h) and 3.1(i) of the Original Credit Agreement

Breach of Certain Covenants . Failure of any Credit Party to perform or comply with any term or condition contained in Section 2.6, Section 5.1(e), Section 5.2 or Section 6; or


“ Permitted Acquisition ” means any acquisition by Borrower or any of its wholly owned Subsidiaries, whether by purchase, merger, amalgamation or otherwise, of all or substantially all of the assets of, all of the Equity Interests of, or a business line or unit or a division of, or a product or a product candidate of, any Person; provided that: (i) at the time the definitive documentation for such Permitted Acquisition is entered into, no Default or Event of Default shall have occurred and be continuing or would result therefrom; (ii) all transactions in connection therewith shall be consummated, in all material respects, in accordance with all Applicable Law and in conformity with all applicable Governmental Authorizations; (iii) in the case of the acquisition of Equity Interests, (a) all of the Equity Interests (except for any such Securities in the nature of directors’ qualifying shares required pursuant to Applicable Law) acquired or otherwise issued by such Person or any newly formed Subsidiary of Borrower in connection with such acquisition shall be owned 100% by Borrower or a Guarantor Subsidiary, and (b) Borrower shall have taken, or shall promptly cause to be taken and, in any event, shall cause to be taken within 60 days of such acquisition (or such longer period as shall be reasonably acceptable to the Administrative Agent), each of the applicable actions set forth in Section 5.10 (including causing such Subsidiary, other than an Excluded Subsidiary, to become a Guarantor and subject to the Collateral Documents), it being understood that the acquisition of Equity Interests shall constitute a Permitted Acquisition during such period if it satisfies all conditions of the definition of Permitted Acquisition other than those set forth in this clause (iii)(b);


And Rosiello's share package: if he nails his targets, he gets 408,000 shares. (And in order to nail his targets, the price of the stock after 5 years would need to be over $400 at least - so that would be 160 million).


The Company’s Talent and Compensation Committee of the Company’s Board of Directors (the “Committee”) approved, effective as of the Appointment Date, the grant of a target number of 68,000 Performance-based Restricted Share Units (each, a “PSU”). The Committee has also approved the additional grant of a target number of 68,000 PSUs (each, an “Additional PSU”). The PSUs and Additional PSUs shall vest between 0-300%, based on meeting certain Company performance criteria described below, as measured approximately five years from the grant date in respect of the PSUs, and approximately three years from the grant date in respect of the Additional PSUs. The triggers for 1x, 2x and 3x vesting shall be based on attaining a 10%, 20% and 30% 5-year or 3-year compound total shareholder return, respectively, with measurements governed by the award agreements (which shall contain terms consistent with the terms customarily provided to other similarly situated executives of the Company, with such modifications to reflect that the applicable performance measurement period) and measured off of a base price equal to the average of the closing price on the NYSE of the Company’s share price for the 20 trading days ending on (and including) the trading day immediately prior to the date hereof.

 

Are you saying that the scary part of all this is that Valeant might breach its covenants?

I note from the Business Insider article that their take on the math makes it sound like a LOT more than the 7%

Here is what they said:

Reitz's attorney, Gary Kaufman, submitted an extensive declaration in California court that also calls Valeant's 7.2% number into question.

It puts R&O's sales at up to $245 million for 2015. Roddy Boyd, a reporter at the Southern Investigative Reporting Foundation, calculates that this makes R&O (and thus Philidor) far more important Valeant than it claims.

The Kaufman declaration's release of the Philidor/Valeant invoices to R&O imply a prospective quarterly sales run-rate of about $55 million (an average $4.6 million weekly shipment multiplied by 12 weeks.) This would have accounted for 18.5% of Valeant's total organic growth in the second quarter. From there, it's a sure bet that given the prominence of West Wilshire to Philidor's billing unit, its sales volume would easily surpass R&O.

Notionally, organic growth equal to 40% or more of that $299 million could have come from two pharmacies that even the most gimlet-eyed Valeant sleuth didn't suspect existed.

Again, Valeant gave no indication that it would break out these numbers to pacify investors. It also said it would not comment on R&O's allegations as legal proceedings are ongoing.

That's all from this article here:
http://www.businessinsider.com/valeant-still-mum-on-specialty-pharmacies-2015-10

But again, what does this really mean as far as future possibilities?

 

"(Valeant) also said it would not comment on R&O's allegations as legal proceedings are ongoing."

Isolani/Philidor/Valeant dropped their lawsuit without prejudice against R&O in early November, and their request was granted by the court on 17 Nov 2015. It appears (?) Isolani/etc. are walking away from the $25M that they originally claimed they are owed by R&O, rather than force a trial. Would too much come out in discovery/trial if they were under the microscope, worth much more than $25M? (Note: even though Isolani/etc have dropped their end of court proceedings, R&O probably are still plaintiff in a different connected lawsuit.)

Also, are the legal definitions connected with Variable Interest Entities (VIE) such that this is why Valeant cannot permit showing a larger business connection to Philidor beyond the 7.2% to which they are admitting? Is that why Philidor is more important than most people realize? Because then Valeant would be running afoul SEC rules? I need a good financial writer/reporter to explain this information about Philidor in a way that even I, a dull normal, can understand.

 

Does the 7.2% have to do with Variable Interest Entities and SEC reporting?

 

I think it is higher. To get 408k shs, it would need to be a compounded 30%, which given his reference price of somewhere around $240/share, after 3yrs would be $527/share. If it were 5yrs (it is not clear whether the 30% target for the 3x RSU/PSU uplift needs to be met over what period) it would have to be $890/share. That would have been $180-300bn in market cap.

Which is a lot starting from a tangible book value of -$34bn and a derisory level of GAAP earnings (because GAAP earnings are what would allow retained earnings to fill the $34bn hole to get back to a zero tangible book value). Not impossible but a much bigger bezzle.

Shows you what the incentives were in any case...

 

Does it have to do with VIEs? No, not specifically, though the 7.2% was Philidor which was a VIE for accounting purposes.

Does it have to do with SEC reporting? Probably. Valeant did not want to show what it was doing. As long as below "10%" it could say for accounting purposes that it didn't need to be broken out. There would have been a LOT of leeway to reduce the 'revenues' actually thought to be due to Philidor so I think the explanation provided on Oct21 was 'from-the-hip'.

Does it have to do with what would need to be disclosed to the Lenders? Yes.

But there is some trickiness here. Based on the fact that it was an option and not actually purchased, they consolidated but it was not a subsidiary - material or immaterial. And could be claimed as such. If you got over 10%, you'd have to show it in your numbers, BUT as noted above, there would have been an VERY easy way to claim that Philidor revenues were WAY WAY lower than 10% of Valeant, even if 20% of Valeant revenues went through Philidor AND Philidor were a full sub and not held through an option.

The real issue at 10% would have been reporting Philidor as a major customer.

 

Look, the only real thing you have to do to determine that Philidor was in fact material is the fact that Valeant paid MORE THAN 10% of its 2014 net income for the OPTION for Philidor.

That is it, BAM, case closed. Obviously, by any definition, there was a duty to disclose. In fact, at the time of the payment for the option, the 4 quarters previously were not nearly that good as the end of 2014. Trying to frame the materiality question on the revenues is a sleight of hand misdirection. Look the term up on wikipedia. There is no test anywhere that frames it as 10% of gross revenues, that is frankly outrageous and the fact that MP got away with that is astounding.

Of course there are a lot more factors than mentioned above that have to do with whether the Philidor was an indirect subsidiary, etc. but that isn't going to matter. The option payment alone will control. And of course there were the performance bonuses, etc etc etc.

By the way, the performance stuff for RR was just the kicker. He got a 1 million salary per the document, a 6 million signing bonus, other bonuses possible AND then the kicker mentioned by the poster above. If you are wondering where the cash is going in this company, it's obviously to McK pals.

 

I read that before. I am not sure I see the problem.

First, the 'easy out' is that while the revenue and income was consolidated (and revenue far more important because the 'income' which comes from the consolidation is just the net income of running a call center), Valeant didn't "own" Philidor therefore even if it had gone to 25% of revenues, it would not have been a Material Subsidiary. Yes, this is semantics, but that's why people pay lots of money for smart CFOs. If they had wanted to separate it out, they could easily make it 'non-wholly-owned' by issuing stock to 'partners' (Philidor employees) and that would get the ownership outside the 'material subsidiary' line.

Second, I had expected that the effort to build different pharmas was in part to create different "lines" of ownership. Philidor could continue to provide "pharmacy administration services" to all the different lines of pharmacies owned and "operated" within the Valeant/Philidor family.

Third, it would be easy to say from an accounting perspective that the 'sales' of the subsidiary were the 'pharmacy administration services' because it was an agent without price risk or inventory which it owned. An example is that securities brokers report 'net revenue', not 'gross revenue' (they don't claim that they earn 0.05% margins on total revenues of the sum total of all trading volume on the NYSE, their revenues are simply the 0.05%).

As to WHY, assuming that none of the above could be used to defeat the 'Material Subsidiary' clause (though I am certain they have a lot of wiggle room in there), would MP want to keep it below 7.5%, it is probably twofold:

1. Declaring it makes it something others can more easily look into. The banks would likely not have cared. It would not have changed the loan coverage calculation, the Secured Leverage Ratio, or anything else. But Valeant thought of this as a potentially huge channel to increase sales. The co-pay assistance, and zero co-pay coupons and the 'arbitrage' of routing through different pharmacy names are all aspects of this. The co-pay assistance and zero co-pay coupons drives volumes. The routing drives margins. If Valeant achieves lower margins through Philidor than through 'traditional channels', it can always be blamed on 'charitable efforts' - making sure the patients get the medicine which is good for them. As long as volumes grow faster than market, it's all money good.
2. the Guarantor aspect: this is a tricky structuring thing. IF Philidor makes money as a 'pharmacy administration services' business for a network of self-owned pharmacies, it ends up collecting a surplus (the money it makes) and that creates a stash of cash which shows up on the consolidated balance sheet, but not in the audited accounts of Valeant, UNLESS Philidor lends its cash to Valeant's bank account through an inter-company loan at the time of the photo (i.e. end of quarter or specified audit date). Because VRX consolidated Philidor, the loan would simply wash out. But if anyone audited Philidor by itself, it would look a little weird until someone explained it, in which case it would look fine. What this does over time is it could create a war chest (a stash of cash) with which to do stuff which would not necessarily be audited in the same way AND would not be subject to oversight by the Loan Docs. That said, the only cash this applies to is the $X that Valeant pays to Philidor for processing the transaction, not the profit which is SalesPrice less (COGS plus other Valeant SG&A plus distribution fee paid to pharmacies, PBMs, and other rebates). Who knows what that cash could be used for. If it were 'trickled out' over time, it wouldn't be so noticeable - it would just reduce consolidated margins (and Valeant could claim the charity angle) but anyone auditing Philidor would see it, so this strikes me as an unlikely angle unless there was serious, serious fraud going on, but if I were MP and I were bent on fraud, I would certainly do it larger than Philidor.

#2 is not huge money. There is so much more money in expanding usage of Valeant products through a captive channel than in keeping the 'administrative services' profit margin.