Glossary of Hostile Takeover Terms with Discussion

[Shoham]

Please explain. What does goodwill and intangible assets mean?

It's in accountant speak. Intangible means any identifiable asset that does not have a physical manifestation, for example a patent. Goodwill is a particular type of intangible, that is the catchall for all non-physical assets, not individually identifiable, acquired when a business is purchased. You can think of it as the "good will" of the various constituencies (such as customers and employees) that support the business.

Imagine that I have a tutoring business. I have 100 tutors and 1000 clients. Clients order tutoring sessions on my web site, and I send tutors over to their home to provide the services. My tangible (physical) assets, in this simplified example, may be some laptops the tutors use in their work. My intangible assets may include my client relationships and my website and logo.

Suppose, for example, my business owns 100 laptops (used by the tutors) that are worth $1000 each (for a total of $100K); also, suppose my 1000 clients are worth $100 each (another $100K); and, finally, let's say my website and logo were created at a cost of yet another $100K.
So, on the books, at least, my company is worth $300K ($100K in tangible assets, $200K intangible).

Now, suppose Valeant buys my business for $1M (figuring they can raise prices, fire tutors, and end up making more money ). How are they going to account, on their financial statements, that they just paid $1M for a company with only $300K worth of identifiable assets? The answer is that they create a new phantom asset called "goodwill" that is declared to be worth $700K. Now, the books are balanced. They paid $1M, and got $1M worth of assets ($100K in laptops, $100K in customer relationships, $100K in website and logo, and $700K in goodwill). Ostensibly, the "goodwill" asset represent the assertion that a functioning business is worth more than the sum of it's parts. It's not just 100 laptops and 1000 clients and a website; but, a living, breathing, business that is capable of generating ongoing profits.

Now, what if, after Valeant bought my business, fired half the tutors, made the rest work longer hours for less pay, and raised prices for customers; they ended up losing most of their clients? Well, the "goodwill" is not so "good" anymore, is it? No way the business is still worth $1M. The accountants will have to go and make an objective evaluation of what is the tutoring business worth now above the value of the identifiable assets (if anything). Maybe the whole business is now only worth $500K (including the $300K in identifiable assets, so the remaining goodwill is just $200K). If that's the case, then Valeant just destroyed $500K worth of business (or, perhaps the $1M was overpaying to begin with). In either case, they have to admit they just lost $500K. In accountant speak, this is called "impairment." By accounting rules, every goodwill asset has to be re-evaluated ("tested," in accountant speak) at least once a year, or when something significant and relevant happens.


Valeant's books are famous for having huge goodwill assets; and critics of the company complain that "goodwill" has just become a place to hide losses. If my speculation, that PWC is giving Valeant a Going Concern Disclosure on the basis of their debt exceeds their ability to pay, pans out; the most likely mechanics via which they would manifest this opinion would be through goodwill impairment. Meaning, they will start pointing out that all those businesses they bought are now worth less than what they paid for them, and therefore Valeant needs to declare an immediate loss for all the destroyed value and/or overpayments. Once those assets are revalued at more realistic levels, if it turns out they are worth less than the debt incurred to buy them, then the company is in Going Concern territory.

Dan.

 

[P551]

It's in accountant speak. Intangible means any identifiable asset that does not have a physical manifestation, for example a patent. Goodwill is a particular type of intangible, that is the catchall for all non-physical assets, not individually identifiable, acquired when a business is purchased. You can think of it as the "good will" of the various constituencies (such as customers and employees) that support the business.

Imagine that I have a tutoring business. I have 100 tutors and 1000 clients. Clients order tutoring sessions on my web site, and I send tutors over to their home to provide the services. My tangible (physical) assets, in this simplified example, may be some laptops the tutors use in their work. My intangible assets may include my client relationships and my website and logo.

Suppose, for example, my business owns 100 laptops (used by the tutors) that are worth $1000 each (for a total of $100K); also, suppose my 1000 clients are worth $100 each (another $100K); and, finally, let's say my website and logo were created at a cost of yet another $100K.
So, on the books, at least, my company is worth $300K ($100K in tangible assets, $200K intangible).

Now, suppose Valeant buys my business for $1M (figuring they can raise prices, fire tutors, and end up making more money ). How are they going to account, on their financial statements, that they just paid $1M for a company with only $300K worth of identifiable assets? The answer is that they create a new phantom asset called "goodwill" that is declared to be worth $700K. Now, the books are balanced. They paid $1M, and got $1M worth of assets ($100K in laptops, $100K in customer relationships, $100K in website and logo, and $700K in goodwill). Ostensibly, the "goodwill" asset represent the assertion that a functioning business is worth more than the sum of it's parts. It's not just 100 laptops and 1000 clients and a website; but, a living, breathing, business that is capable of generating ongoing profits.

Now, what if, after Valeant bought my business, fired half the tutors, made the rest work longer hours for less pay, and raised prices for customers; they ended up losing most of their clients? Well, the "goodwill" is not so "good" anymore, is it? No way the business is still worth $1M. The accountants will have to go and make an objective evaluation of what is the tutoring business worth now above the value of the identifiable assets (if anything). Maybe the whole business is now only worth $500K (including the $300K in identifiable assets, so the remaining goodwill is just $200K). If that's the case, then Valeant just destroyed $500K worth of business (or, perhaps the $1M was overpaying to begin with). In either case, they have to admit they just lost $500K. In accountant speak, this is called "impairment." By accounting rules, every goodwill asset has to be re-evaluated ("tested," in accountant speak) at least once a year, or when something significant and relevant happens.


Valeant's books are famous for having huge goodwill assets; and critics of the company complain that "goodwill" has just become a place to hide losses. If my speculation, that PWC is giving Valeant a Going Concern Disclosure on the basis of their debt exceeds their ability to pay, pans out; the most likely mechanics via which they would manifest this opinion would be through goodwill impairment. Meaning, they will start pointing out that all those businesses they bought are now worth less than what they paid for them, and therefore Valeant needs to declare an immediate loss for all the destroyed value and/or overpayments. Once those assets are revalued at more realistic levels, if it turns out they are worth less than the debt incurred to buy them, then the company is in Going Concern territory.

Dan.

Great explanation Dan. You did a better job at it than I would have done

Prior to recent stock price movement the VRX mumbo jumbo could work, and clearly did work relative to goodwill. Now however, with over $9B in goodwill as of 2014 (and it's certainly higher after 2015) but a market cap around $8B it will be harder to justify.

Although not strictly related I think intangible assets are ripe for the picking. Given the pressure on pricing going forward VRX might have a hard time justifying its IP is worth what they say it is. By all accounts they should be faced with a requirement to expense some intangible assets too.

To clarify for readers, goodwill impairment and intangible asset write off are both non cash transactions. They would not impact the ability to pay off debt. Where these hurt VRX is that the reduction of the balance sheet "assets" shows up as a loss on the P&L, meaning VRX will have lower earnings. Most importantly as Dan states, they raise the ugly going concern specter. Non-GAAP reporting allows these accounting ugly duckling entries to be ignored. Once they make their way onto a P&L they can't be ignored.

Some potential collateral damage for us AGNers could result in the short term, as we also have some non-GAAP shenanigans too. Once Teva clears though, and as the debt level shrinks, the potential issue goes away significantly. Until then we might get caught up in the storm. I suspect this is part of the reason our share price has fallen over the last few days. Acquisition oriented companies are all being lumped together.

P551

 

[P551]

Great explanation Dan. You did a better job at it than I would have done

Prior to recent stock price movement the VRX mumbo jumbo could work, and clearly did work relative to goodwill. Now however, with over $9B in goodwill as of 2014 (and it's certainly higher after 2015) but a market cap around $8B it will be harder to justify.

Although not strictly related I think intangible assets are ripe for the picking. Given the pressure on pricing going forward VRX might have a hard time justifying its IP is worth what they say it is. By all accounts they should be faced with a requirement to expense some intangible assets too.

To clarify for readers, goodwill impairment and intangible asset write off are both non cash transactions. They would not impact the ability to pay off debt. Where these hurt VRX is that the reduction of the balance sheet "assets" shows up as a loss on the P&L, meaning VRX will have lower earnings. Most importantly as Dan states, they raise the ugly going concern specter. Non-GAAP reporting allows these accounting ugly duckling entries to be ignored. Once they make their way onto a P&L they can't be ignored.

Some potential collateral damage for us AGNers could result in the short term, as we also have some non-GAAP shenanigans too. Once Teva clears though, and as the debt level shrinks, the potential issue goes away significantly. Until then we might get caught up in the storm. I suspect this is part of the reason our share price has fallen over the last few days. Acquisition oriented companies are all being lumped together.

P551

To finish my previous thread, specifically on the AGN side of the conversation about goodwill and intangible assets, here's where we stand:

2014
goodwill = $21B
intangibles = $16B
LT debt = $$16B

2015 (the year the AGN acquisition was booked)
goodwill = $47B
intangibles = $68B (AGN patents and brand)
LT debt = $41B

So as I said, the Teva deal closing is huge because if we stay as a standalone company the proceeds allow AGN to have either cash on hand, or reduce LT debt. My guess is they will keep it as cash based on the LT debt structure being affordable. However the goodwill and intangibles are alarmingly high and point to the need to grow (big time) revenue on a continual basis in order to justify and slowly work off the large balance sheet entries we have. If we can't/don't grow at a high enough level then we can fall into the same VRX trap in terms of asset valuation (by no means are we close to the "other" VRX nastiness so I'm not implying that).

It is for these realities that I commented several posts ago that part of the reason I feel AGN is pushing for the PFE deal is to get away from the weight of this situation. While not strictly "going away" these entries now become part of the PFE plc behemoth and can be hand waved away with a company with the B/S and P&L they will have and a market cap of $270-$300+ billion. PFE gets to unlock their trapped cash, and gets to reverse accrued tax liabilities which can be an offset (the tax liability that is) to the high goodwill and intangibles. Note PFE has very similar levels of goodwill, intangibles and LT debt as AGN currently has - but in a business with much higher revenue and profit it can be more easily supported. Without the PFE deal, AGN has to work very hard...maybe impossibly hard.

As Dan rightly points out, the "value" I am describing here is dubious and is by no means value creating. It is not a justification to a shareholder to go through with a deal. Investors see through this and this is why the deal appears to have gone over poorly so far. But I think it is very much part of the equation if you are Brent Saunders. If the deal falls through then he needs to go out and acquire another company that hopefully has very little by the way of goodwill and LT debt and very high revenue potential at least. All pharma Co's have high intangibles - rightly so due to the obvious value of IP. By itself I think AGN will struggle to not drift into the danger zone, albeit not anywhere near the VRX redline!

P551

 

[anonymous]

To finish my previous thread, specifically on the AGN side of the conversation about goodwill and intangible assets, here's where we stand:

2014
goodwill = $21B
intangibles = $16B
LT debt = $$16B

2015 (the year the AGN acquisition was booked)
goodwill = $47B
intangibles = $68B (AGN patents and brand)
LT debt = $41B

So as I said, the Teva deal closing is huge because if we stay as a standalone company the proceeds allow AGN to have either cash on hand, or reduce LT debt. My guess is they will keep it as cash based on the LT debt structure being affordable. However the goodwill and intangibles are alarmingly high and point to the need to grow (big time) revenue on a continual basis in order to justify and slowly work off the large balance sheet entries we have. If we can't/don't grow at a high enough level then we can fall into the same VRX trap in terms of asset valuation (by no means are we close to the "other" VRX nastiness so I'm not implying that).

It is for these realities that I commented several posts ago that part of the reason I feel AGN is pushing for the PFE deal is to get away from the weight of this situation. While not strictly "going away" these entries now become part of the PFE plc behemoth and can be hand waved away with a company with the B/S and P&L they will have and a market cap of $270-$300+ billion. PFE gets to unlock their trapped cash, and gets to reverse accrued tax liabilities which can be an offset (the tax liability that is) to the high goodwill and intangibles. Note PFE has very similar levels of goodwill, intangibles and LT debt as AGN currently has - but in a business with much higher revenue and profit it can be more easily supported. Without the PFE deal, AGN has to work very hard...maybe impossibly hard.

As Dan rightly points out, the "value" I am describing here is dubious and is by no means value creating. It is not a justification to a shareholder to go through with a deal. Investors see through this and this is why the deal appears to have gone over poorly so far. But I think it is very much part of the equation if you are Brent Saunders. If the deal falls through then he needs to go out and acquire another company that hopefully has very little by the way of goodwill and LT debt and very high revenue potential at least. All pharma Co's have high intangibles - rightly so due to the obvious value of IP. By itself I think AGN will struggle to not drift into the danger zone, albeit not anywhere near the VRX redline!

P551

Insightful and scary. This explains the enormous pressure we (AGN) employees are under to produce. It also allows for a view of the vulnerabilty we have relative to the Teva & PFE deals. Any thoughts on the presidential stumping, more specifically, the Trump Corportate Tax plan and if the campains themselves would derail the mergers? Not asking for personal political opinion but more resding daily about the buzz from the campaign about the "tax inversion"
Initatives and how that might factor into shareholders approval/disapproval going forward.
Thanks again!

 

[anonymous]

http://www.forbes.com/sites/matthew...ld-learn-from-valeants-collapse/#2984c21f6098

 

[P551]

Insightful and scary. This explains the enormous pressure we (AGN) employees are under to produce. It also allows for a view of the vulnerabilty we have relative to the Teva & PFE deals. Any thoughts on the presidential stumping, more specifically, the Trump Corportate Tax plan and if the campains themselves would derail the mergers? Not asking for personal political opinion but more resding daily about the buzz from the campaign about the "tax inversion"
Initatives and how that might factor into shareholders approval/disapproval going forward.
Thanks again!

One final thought. The comments in these threads are not meant to be truly alarming - but more food for thought. I'm the first to admit that the business of corporate accounting is very complicated. Simple analogies that we might draw on from personal lives almost never come close to capturing the complexities of corporate accounting. Add to this the issues surrounding acquisitions and taxation and it gets really messy. There are many good reasons why goodwill and intangibles exist and should therefore not be alarming.

For example, in my day job company we have alot of money invested in IP and considering that as an asset has real value in terms of minimizing current taxes owed (the expenses would otherwise be recognized when they occur) and also providing a means for later disposal through an asset sale (as opposed to having to sell the entire company for someone to acquire the intangible IP asset). So I don't want to oversimplify and potentially vilify companies based on B/S and P&L analysis. But if you look at these items on a relative basis (i.e. compared to other peers) then some insight can be gleaned. If you compare an AGN who has lots of acquisitions vs a company like Amgen or Biogen then you will see differences strictly because of the business models. At the end of the day though, all companies, no matter what their business model, have to be able to generate enough revenue to provide cash to pay expenses and invest. If this can't be done then the real problem shows up. You either generate your own revenue, buy revenue or do combinations of both. The fundamentals need to make sense in the end. I think VRX confused alot of people because they had them convinced that somehow fundamentals didn't matter or that with enough obfuscation you could maybe believe they were fundamentally OK. That is the lasting message in my mind.

Regarding tax issues and the "deal"- I don't think any political actions will make a difference in the short term. A tax overhaul is required and that topic is a religious discussion between Dems and Republicans. I don't think it will make a difference in the end relative to PFE and AGN. I think the only roadblock, and it's a biggie, is whether or not the deal can actually be "sold" to shareholders. As Dan keeps reminding us, this is a big issue. So far the companies have been unsuccessful at doing this. The political/tax piece seems like a distraction from the real issue. Maybe if PFE/AGN announced that a split was much more imminent - and facilitated by the merger - then shareholders could sink their teeth into the deal a bit more. That announcement would make for some interesting posts!

P551

 

[400 Horsham]

Hi Shoham,

Thanks for the enlightening commentary.

The easy answer to one set of your questions is Tora! Tora! Tora! is a movie with Martin Balsam and Jason Robards, "Houston we have a problem" is Apollo 13, and "Game over, man" is the ever delightful Bill Paxton in Aliens.

GC is a tough one. It is, of course, the big issue with all companies which have very high debt and replaceable product - i.e. products which doctors could stop prescribing just because - that if you drop revenue, cashflow coverage drops. And from there it is a short step to GC.

I personally don't think the company would have released Q4 without being pretty certain of the numbers.

The question about GC is that it is "semi-predictive" and auditors don't like to be put into that spot. There are no material debt redemptions until 2018, there is a fair bit of cash in the door before then, even on lowered 2016 forecasts, and if they were able to get a small sale done while waiting, then that changes things.

My feeling is that one cannot dismiss the importance of the AHC. We don't know the mandate but the last thing the board wants to be accused of is looking at the now defunct Philidor without looking at other things. There is no chance that they would come out and say, "Well.... we're mostly done and we're pretty sure there's been no fraud, but we'll only be able to finish it up next month, but to avoid the technical default with the revolver, we're putting it out this week." Further, even if they find nothing else wrong - only Philidor - and everything else is squeaky clean, they will want to come up with a remedial action so the board can be seen to be "making sure it never happens again" because the last thing they want is more risk factors in the footnotes.

I agree with a poster who I have seen post elsewhere that the numbers themselves in the main statements are not the problem. Footnotes and risk factors and contingent liabilities are the problem. From there, it is eventually but a step to GC. But unlike the large number of shale E&P companies defaulting on debt payments or about to, triggering GC statements in their 10Ks (like Peabody the other day), Valeant has a couple of years of runway until a major debt redemption payment is due.

Debt covenant rewrites with a one-off 'bonus payment' so as to avoid technical default are not that uncommon. It is just that most equity investors never see them.

The problem with the bondholders putting this into default is it would need a great heaping amount of DIP financing to keep the business alive - expenses would go way up as they'd need more RMs and more people going around the care providers to keep them prescribing to keep revenues up so they could sell the assets.

If the assets are 'distressed' by a combination of the workout process, the bad press, and the "Hillary tweet" factor - i.e. the multiples paid to acquire these assets are not the multiples which would be paid now because the system is not as squeezable as before - then the time needed for the DIP financing to help sponsor what become, in effect, run-off businesses in many cases, is significant and expensive to the debt holders.

Bondholders don't like default. Certainly not at 70cts on the dollar. At 20cts on the dollar it becomes really interesting and the vultures come in and buy the debt, pay the DIP, and work their magic because even if they only recoup 80cts on the dollar, it was a great trade. But for most people, default and workout is expensive, time-consuming, painful, uncertain, and if you waive or extend a timeline on a filing just to avoid a technical default, and you can get paid a point for that, it's easy money. Don't worry, if it is going to go bust on an actual non-technical default, kicking the can down the road by a quarter will harm no-one.

But skewering a company and the value of its assets (which you hope to recoup by selling to people who know that you don't want to own them) by calling a technical default on a filing is not something ANYBODY wants to do when debt is trading at 70cts on the dollar. It's just not worth anyone's time.

 

[anonymous]

Great Post Shoham. Very much enjoyed your Going Concern analysis theory. Seems very plausible.

The other issue it could be is accounting shenanigans related. There could be additional restatements, etc. They may even be related to a going concern problem.

After Arthur Andersen, the accountants have become more conservative. I would imagine that PWC would be careful and conservative in their audit rather than all the partners risking their partnerships and careers on one client.

 

[Shoham]

Hi Shoham,

Thanks for the enlightening commentary.

The easy answer to one set of your questions is Tora! Tora! Tora! is a movie with Martin Balsam and Jason Robards, "Houston we have a problem" is Apollo 13, and "Game over, man" is the ever delightful Bill Paxton in Aliens.

For those less familiar with classical movies; "Tora! Tora! Tora!," specifically refers to the Japanese code word to launch the attack on Pearl Harbor, broadcasted in an emotional but controlled tone; "Houston, we have a problem" was the calmly voiced radio transmission from the malfunctioning Apollo 13 spacecraft to mission control; and "Game over, man" were the words of a hysterical space marine upon realizing that vicious man-eating aliens have him and his squad cornered. In all 3 instances, the utterance signaled the onset of perilous and likely lethal conditions where the protagonists will only have very limited control over their destiny.

Going Concern Disclosure is the accounting equivalence of all three happening together.

And now for the question you didn't ask (and I didn't even need to look that one up):

400 Horsham is Philidor's original address (formed by BQ6 Media)

The question about GC is that it is "semi-predictive" and auditors don't like to be put into that spot. There are no material debt redemptions until 2018, there is a fair bit of cash in the door before then, even on lowered 2016 forecasts, and if they were able to get a small sale done while waiting, then that changes things..

With Enron comparisons flying everywhere, PWC knows that if they fail to put in a GC and Valeant implodes, they are going to be compared to Arthur Anderson for a very long (or maybe very short ) time. Potential massive liability too. Accounting firms don't make so much money as to be able to absorb the kind of liability that an implosion this size can generate.

My feeling is that one cannot dismiss the importance of the AHC. We don't know the mandate but the last thing the board wants to be accused of is looking at the now defunct Philidor without looking at other things. [...]

I do dismiss the AHC, because they were formed by a spineless board for the purpose of whitewashing the Philidor bad press. At about the time of the AHC formation, the Valeant investor communication machine (after they regained their bearings) went into overtime saying everything is fine. You can't have it both way, either you are legitimately investigating or you are whitewashing; not both at the same time. Maybe, in the current environment, the (enlarged) board, and thus AHC, will find a (belated) spine. But I think we are past the point it even matters.

Notwithstanding my opinion about the AHC, they are not in any way part of the independent audit. PWC didn't ask for them and they don't report to PWC. By no stretch of the imagination, can one argue that the independent auditors' report is delayed because the AHC isn't finished. PWC is perfectly capable of forming their own investigations, when they need to, and making sure they finish on time.

Going into company-threatening default is almost the worst place you want to be. Valeant is in this position voluntarily -- they can release the audited financial statements and be out of this situation today. UNLESS, the audited financial statements will put them in an even worst place than they are now -- which is why I'm speculating GC.

I agree with a poster who I have seen post elsewhere that the numbers themselves in the main statements are not the problem. Footnotes and risk factors and contingent liabilities are the problem. From there, it is eventually but a step to GC.

I think the released 2015 numbers are not going to change in any huge way (so why not release the 2015 report).

The basis of my GC premise is that a conservative analysis of the cashflow into the multi-year future shows that there is not enough money coming in to service the debt as it becomes due. In the past, this didn't give rise to GC. There was enough cash on hand to pay the next 12 months liabilities, enough (alleged) growth to take care of the distant future, and enough capacity to borrow or raise capital to refinance between now and then. So, no GC. This has now changed. Maybe there is still enough money to pay the next 12 months (mostly because nothing big is due), but there is neither sufficient cash flow nor financing capacity much beyond that. In times of calm weather, the auditors might say that if the plane is not going to hit the ground in the next 12 months, we are not going to give a GC; we will check again next year, however, in the current storm, the fact that the plane has a lot less gas in the tank than is enough to reach safety, is a GC -- even if it is based on a multi-year analysis.

[...]Bondholders don't like default. Certainly not at 70cts on the dollar.[...]

It just takes one spoiler to crash this party.

Dan.

 

[anonymous]

Check this article that just came out from Barions. Pretty much echoes what 551 posted about yesterday.

http://www.barrons.com/articles/valeant-write-downs-next-1458360050

Thanks 551 and Dan

 

[400 Horsham]

Shoham/Dan,

You only asked about the movie titles so I only gave that. I studied Pacific theater history for my major and subsequently lived in Japan for a couple of decades. FWIW, as an aside... I read years ago that the quote in Apollo 13 was actually misquoted from the tape ever so slightly (was a space race wonk when younger). But it sounds good. Bill Paxton is a favorite of mine.

FWIW, "400 Horsham" has been my SeekingAlpha handle since this blew up last fall. I have signed posts on CP in any number of ways (usually A Non-E Mouse, or similar). Early on in October I did a lot of work on BQ6 Media, and the principals there as they started and built Philidor and the various entities used to expand their business/relationships out west and down south.

• 400 Horsham Rd, Suite 109, Horsham PA 19044 was the address for BQ6 Media and the HQ for Philidor as it started, before Philidor expanded its operations several blocks over (and ended up being the registered address for a number of the LLCs which were formed to own options in other pharmacies (like Lucena and Isolani and others).
• BQ6 also had another tiny office across the road (a couple of hundred meters away).
• The major principals of BQ6 and Philidor all live (and some (specifically AD, MD, and GB) play golf) quite close by.

Usually, GC is a an 'imminent' threat - i.e. within 12 months. If not within 12 months, it would normally go into risk factors. The amounts of debt to be repaid this year and next are relatively limited. I certainly don't exclude GC being the issue, but the lack of significant debt payments to force default near-term make me hesitate to agree. There is a wide bid/offer on this I think.

I know of and understand the separation of AHC and PWC audit. The board, however, is stuck with both. PWC is also 'stuck' here a bit.

• The AHC may have relied on an expanded PWC audit to come up with the accounting reconciliation portion of its audit, or may have asked someone else to do it. This is important.
• If PWC signs off on the 10K and the board releases it, and a week later the AHC says "there was fraud", it makes both the board and PWC look bad. If the AHC is anywhere near completion, PWC would wait.
• If the AHC says "the restatement was a simple error by a junior, no harm no foul" and the board OKs it with remedial action on oversight, then PWC comes out and finds that there was fraud in the compilation of end-2014 financials, the board looks bad. And so does the AHC's independent leadership. And so would a separate independent auditor if AHC had hired one to investigate.
• Basically, the AHC and PWC are tied together at the hip. Neither can afford to be "wrong" disagreeing with the other, so they will agree. hey will make sure they are on the same page before releasing conclusions.
  • They have to come to the same conclusion on the restatement, and on control procedures, and they have to recommend a way out of the wilderness.
  • Or AHC recommends a way out of the wilderness and PWC throws the company under the bus. AHC can live with that. PWC could not live with it the other way around.
• If the AHC says "there was fraud" and now the restated numbers look OK, the appropriate people have been reported to authorities, and Valeant will be pursuing claims/damages, and the company has put in place new levels of internal controls, and PWC agrees with statements (because it has done its own work) and internal control processes in COSO Opinion, then AHC can release, and PWC can release, and everyone is fine, then they work hard to get out of the ditch.
• The question may be a matter of "risk factors" and how that bridges the gap between PWC wanting to CTA with a GC or not.
• Do I think the board has done a good job to date? Absolutely not.
• Do I think the board is trying to save their own personal reputations here? Absolutely yes.
• Do I think the board would throw MP, AK, everyone who has resigned, Philidor principals, and others under the bus to save their own reputations? Absolutely yes. I think they would say "there was fraud and it was carefully executed and we could not know and they all signed off on SOX and our audit didn't find anything and PWC did not either last year..." and so on.

In any case, as I mentioned above, you may be right on GC, but I think the intersection of AHC and PWC is actually key. Just my $0.02.

 

[Shoham]

Shoham/Dan,

You only asked about the movie titles so I only gave that. I studied Pacific theater history for my major and subsequently lived in Japan for a couple of decades. FWIW, as an aside... I read years ago that the quote in Apollo 13 was actually misquoted from the tape ever so slightly (was a space race wonk when younger). But it sounds good. Bill Paxton is a favorite of mine.

As it happened, not by any plan, I watched Forest Gump, for the first time, just before I saw Apollo 13 (the first on tape, the second in a theater). It was a bit of a jarring juxtaposition, with Tom Hank playing a cold-war-era national hero in both; but with a very different level of sharpness. I kept waiting for him to say something Gump-ish (like "after that, space shot was easy ")

Usually, GC is a an 'imminent' threat - i.e. within 12 months. If not within 12 months, it would normally go into risk factors. The amounts of debt to be repaid this year and next are relatively limited. I certainly don't exclude GC being the issue, but the lack of significant debt payments to force default near-term make me hesitate to agree. There is a wide bid/offer on this I think.

Usually, yes; but not always. Usually, if there is enough money to pay 12 months obligations, but afterward things get dicey, the auditors will suffice with a note (written by management) saying how the company is planning to address the future cashflow issue and associated risks they won't. However, if the Auditors believe that there is no realistic way forward, the GC can (must) be immediate.

Imagine, I have a fresh new company -- no assets, no liabilities, and token equity. I borrow $1M, at 10% per year, with 10 years maturity, planning to build my business (in real life, fresh companies are funded first with equity, no one will lend me money in this situation; but let's just say). After I spent $100K on formation costs, I realize that the business plan is hopeless and there is no alternative or fix available. I still have the other $900K in the bank. Will the auditors give me a GC? You bettcha! Even though I am not going to run out of money for another 9 years, I owe $1M, and I only have a way of paying back $900K. That's a GC (at which point the debtholders will have the right to get their remaining $900K back rather than me burning more of it over the next 9 years).

I am speculating that we are in something like this now with Valeant. PWC did an independent valuation of the assets and concluded that they can neither be sold for, nor generate sufficient cashflow, to pay back the debt. In other words, liabilities exceed assets. With the shareholder equity negative, they can't borrow or raise capital either; and there is no path or set of actions that can change this. The 12 months bar is irrelevant. The king may have 13 more moves, but it's still a checkmate.

The only way Valeant might be saved, assuming my speculation is right, is if PWC is wrong; and Valeant can prove it by selling something big for a lot more than PWC gave them credit for (and enough to bring them back to positive shareholders' equity, at least for the sold asset). For example, they bought Sprout (Addyi) for $1B, all borrowed money. It's been selling ridiculously little. PWC may impair the Sprout assets (particularly Goodwill), lets say, down to $100M. That's negative shareholder equity ($1B debt, $100M asset) If Valeant can find someone who is willing to buy Sprout from them for $1B or more, then they would have proven this for-instance PWC impairment wrong and show they are not GC after all. I have to believe that this is Valeant's play right now: Don't release the audited statement, try to sell something for a lot more than PWC valued it, and then go back to PWC and ask them to remove the GC (and even if PWC does not, management can add a 2016-post-facto explanation saying that the GC is now outdated because it was based on overly-low asset valuation that has already been debunked).

I know of and understand the separation of AHC and PWC audit. The board, however, is stuck with both. PWC is also 'stuck' here a bit. [...]

• Basically, the AHC and PWC are tied together at the hip. Neither can afford to be "wrong" disagreeing with the other, so they will agree. hey will make sure they are on the same page before releasing conclusions.
  • They have to come to the same conclusion on the restatement, and on control procedures, and they have to recommend a way out of the wilderness.
  • Or AHC recommends a way out of the wilderness and PWC throws the company under the bus. AHC can live with that. PWC could not live with it the other way around.

I just have to disagree here.

There are really only two reasons PWC would not have an audit completed in time:
1. Management is not cooperating (in which case a qualified, or even adverse, opinion is in order), or
2. Management ordered them to wait.

Waiting for the AHC is not one of those reasons.

Imagine the following conversation between PWC and Valeant:
PWC: We finished the audit, we are sorry to inform you it includes a Going Concern Disclosure.
Valeant: But you haven't seen the AHC report.
PWC: We don't need to see it, we did all investigations we needed to be able to reach our opinion.
Valeant: But we really do want you to see it before you complete the audit.
PWC: Ok, show it to us.
Valeant: Emm, it's not finished yet. Would you mind waiting?
PWC: Well, it's your dime and your deadline that's going to be missed here. We'll wait.
Valeant: Thank you. We'll file with the SEC that the Audited financial are delayed pending release of the AHC report.
PWC: Disgusted chuckle.

I guess I am not prepared to get past the thinking that PWC are serious auditors whereas the AHC are a bunch of spineless whitewashers (or, at least, so is the board that created them), so if there is anything to discover, PWC wouldn't be losing sleep at night fearful that the AHC would discover it and they won't.

Speaking of fraud, as per my writings at the time I did my own mini investigation; I don't think there is any accounting fraud per-se (as Andrew Left alleged), at least not a lot. I think the AHC was created to "discover" that there is no accounting fraud, because Valeant already knew that there wasn't any to discover. There was massive insurance fraud (which technically makes it also accounting fraud, because any type of undisclosed liability is automatically also accounting fraud); but it wasn't the type of fraud that AHC was asked to look for (which is why I refer to them as a whitewash).

In any event, the GC that I believe they are getting has very little to do with fraud (accounting or insurance) or Philidor or any of the issues the AHC is looking into; it has to do with the assets worth less than the debt. It has to do with years of piling on Goodwill assets while destroying value. Kicking the ball down worked so long as they were (allegedly) growing or acquiring or raising prices or having access to the capital and debt markets. With all those shut off, the party is over and the GC is here.

[...]

In any case, as I mentioned above, you may be right on GC, but I think the intersection of AHC and PWC is actually key. Just my $0.02.

Here is the bottom line:
1. PWC does not miss deadlines.
2. The AHC was not requested by or reports to PWC.
3. Therefore, not withstanding the lack of AHC report, PWC has presumably finished the audit.
4. The audited report has not been released.
5. Therefore, the non-release is by management decision, not lack of completion.
6. Missing the deadline is predictably calamitous, to include debt covenants breaches.
7. Management is willing to accept all this pain, to include expensive demands by bondholders.
8. Therefore, whatever is in the audited report is even more calamitous and covenant-breaching (or else management would just release it).
9. Hard to imagine what, other than GC, could possibly be in the audited report that releasing it would cause more pain than that which management is willing to suffer as the price of not releasing.

Dan.

 

[anonymous]

great reading about Valaent/GC & negative equity.
Not trying to distract But, back to Pfizer/AGN. Legislation put forth by Sanders yesterday (congress is only way to blunt inversion); here's article. May be just fluff but as Dan has reminded us, many mergers fall apart at the last minute. Thoughts on the bill? Thanks!
Sanders takes aim at Pfizer-Allergan inversion - Washington Examiner https://apple.news/A3pKk12bFNCyWT1Fw3p6KkQ

 

[Shoham]

great reading about Valaent/GC & negative equity.
Not trying to distract But, back to Pfizer/AGN. Legislation put forth by Sanders yesterday (congress is only way to blunt inversion); here's article. May be just fluff but as Dan has reminded us, many mergers fall apart at the last minute. Thoughts on the bill? Thanks!
Sanders takes aim at Pfizer-Allergan inversion - Washington Examiner https://apple.news/A3pKk12bFNCyWT1Fw3p6KkQ

I don't want to talk about candidates and policies -- there are plenty of forums for that -- but I can comment a bit about tax policy and inversions.

Basically, the US is stuck with a tax law anachronism that can't be easily (or maybe at all) fixed. The US is the only country in the world that taxes worldwide profits. Everywhere else, only in-country profits are taxed. This puts the US, as far as corporate residency is concerned, in a distinctly uncompetitive position. In the post-WWII, cold war, pre-WTO days, when countries around the world (including the US) had blatantly protective trade policies, this was a reasonable tradeoff: If you want your company to be inside the protectionist walls of the world's largest economy, where the legal system is stable, the climate is pro-business, and the communists are not within an armor thrust distance from the capital; live by its tax rules. If any other country tried to do the same, they would have immediately lost all their big corporations (who would run to the US), so they had to limit their taxation to in-country profits.

However, today, the location of registration is inconsequential. All major corporations are global and do business largely the same way regardless where they are registered. Politicians and officials can howl all they want, but there is really no solution that would keep the outflow of corporate registrations. If you start disallowing deals, or passing all sort of complicated legislations, then companies could be sold in parts; or investors will just shift growth funding away from those companies that didn't flee the US before the door shut and toward those outside the US. One way or another, so long as this tax rule discrepancy remains, economic forces will motivate the continued outflow of the legal domicile of the remaining US global corporations.

The only real solution is to change the US tax code to harmonize with the rest of the world. At which point, there would be no further tax incentive to change corporate domicile. The problem with that solution, from a treasury point of view, is that it will effectively give every US corporation the benefit of inversion, including those that weren't going to get around to doing it for some years. Even small corporations, with modest global presence, who might not be ready for an inversion for a very long time, would get the inversion benefit -- all at the expense of US tax receipt.

So, there we are. The only solution to an outflow of tax revenues is to swallow all the tax losses upfront. I suppose some complex phase in schedule that will be slow enough to absorb the losses no faster than they would have happened anyhow; but fast enough to take the winds out of the inversion value proposition sails, could be contemplated. But even that would be tricky to institute and perhaps not have any substantial effect.

I would like to point out that most large US corporations (including Pfizer), for many years, have been behaving as if already inverted by not repatriating foreign profits (keeping profits made outside the US from returning to the US, thus not paying US taxes on them). Inversion won't "cost" treasury revenues that were previously earned, but rather the revenues that would have been earned whenever those stored foreign profits would have returned (which might be never).

Dan.

 

[anonymous]

Excellent discussion!

 

[P551]

I don't want to talk about candidates and policies -- there are plenty of forums for that -- but I can comment a bit about tax policy and inversions.

Basically, the US is stuck with a tax law anachronism that can't be easily (or maybe at all) fixed. The US is the only country in the world that taxes worldwide profits. Everywhere else, only in-country profits are taxed. This puts the US, as far as corporate residency is concerned, in a distinctly uncompetitive position. In the post-WWII, cold war, pre-WTO days, when countries around the world (including the US) had blatantly protective trade policies, this was a reasonable tradeoff: If you want your company to be inside the protectionist walls of the world's largest economy, where the legal system is stable, the climate is pro-business, and the communists are not within an armor thrust distance from the capital; live by its tax rules. If any other country tried to do the same, they would have immediately lost all their big corporations (who would run to the US), so they had to limit their taxation to in-country profits.

However, today, the location of registration is inconsequential. All major corporations are global and do business largely the same way regardless where they are registered. Politicians and officials can howl all they want, but there is really no solution that would keep the outflow of corporate registrations. If you start disallowing deals, or passing all sort of complicated legislations, then companies could be sold in parts; or investors will just shift growth funding away from those companies that didn't flee the US before the door shut and toward those outside the US. One way or another, so long as this tax rule discrepancy remains, economic forces will motivate the continued outflow of the legal domicile of the remaining US global corporations.

The only real solution is to change the US tax code to harmonize with the rest of the world. At which point, there would be no further tax incentive to change corporate domicile. The problem with that solution, from a treasury point of view, is that it will effectively give every US corporation the benefit of inversion, including those that weren't going to get around to doing it for some years. Even small corporations, with modest global presence, who might not be ready for an inversion for a very long time, would get the inversion benefit -- all at the expense of US tax receipt.

So, there we are. The only solution to an outflow of tax revenues is to swallow all the tax losses upfront. I suppose some complex phase in schedule that will be slow enough to absorb the losses no faster than they would have happened anyhow; but fast enough to take the winds out of the inversion value proposition sails, could be contemplated. But even that would be tricky to institute and perhaps not have any substantial effect.

I would like to point out that most large US corporations (including Pfizer), for many years, have been behaving as if already inverted by not repatriating foreign profits (keeping profits made outside the US from returning to the US, thus not paying US taxes on them). Inversion won't "cost" treasury revenues that were previously earned, but rather the revenues that would have been earned whenever those stored foreign profits would have returned (which might be never).

Dan.

PFE does have a deferred tax liability on the B/S which represents the taxes owed on money it planned to bring to the US. It also has significant profit (and corresponding cash) that is not planned to come to the US (otherwise the deferred liability would be larger). As Dan correctly points out, the political rhetoric on these "tax dodging" companies is overblown as most of the money stashed overseas is not ever planned to be repatriated. So there can't be tax dodging on profit that was never going to be taxable. It's all being overdone for political reasons.

Time to overhaul the tax code if we want to compete globally. This is not going to happen any time soon!

P551

 

[anonymous]

Dan and 551,

I read in some articles that the PFE/AGN deal is an inversion and I also see it referred to as a reverse merger. Which is it and is there a difference?

Thanks

 

[400 Horsham]

Dan/Shoham,

You make a truly excellent (cogent and reasonable) and reasonably convincing case for this being a GC situation. The hypothetical back-and-forth you showed was, however, biased on your assumption that it is a GC situation where PWC will ding it. You could be right. I certainly see issues in that selling assets while under a Going Concern threat will make things difficult, and makes a GC issue almost self-fulfilling if assets have to be disposed of in a fire-sale. If the PWC gives them a qualified opinion or an OK with significant risk factors, I think it could be a matter of time anyway. Once you start down the slope it gets awfully slippery.

I will do more digging on my part. I may actually have to come around to your POV. Perhaps I have simply misjudged the board's understanding of PWC and AHC. It is possible the board is even less competent than I gave them credit for (and in management/oversight terms, I didn't give them much). That said, if this were a GC issue, the board would have known about it months ago I expect, and would have made efforts of any kind to avoid it (some asset sales, etc). A GC issue would not have popped up suddenly Feb28. For that, I am surprised we haven't seen asset sales announced, or more progress on the Walgreens deal (any additional sales revenue helps VRX on both SOTP asset valuation for PWC and cash flow near-term for creditors even if it is done at lower margin).

I agree with you on the likely lack of significant accounting fraud. I believe there are possibly insurance fraud issues, but I think the liability for that is probably years away, and I think is probably relatively limited in size.

Eventually though, I think Valeant's key role as over-leveraged avatar of the healthcare 'bezzle' is what has endangered it. Valeant overpaid for its collection of sub-prime assets using sub-prime loans - a lot of them. And we know what happened in 2008 and 2009 - the equity tranche of those subprime loans got the short end of the stick.

 

[400 Horsham]

Dan/Shoham,

The other possibility I am entertaining (other than GC) is a substantial write down of goodwill at Valeant as per what P551 was mentioning above.

• Lower revenue in Q1 "proves" lower earning power of existing assets. And the significant fall in the share prices of the whole sector is "proof" that assets are deemed to be worth less.
• Also, MP stated in his review of Q4 2015 and Q1 2016 that Valeant would not be hiking prices the way it used to do, which means that the future revenue support of goodwill/intangibles as recorded would possibly be limited.

• And as long as that is a negotiation between the board and PWC, then this can get delayed until it can't be any more. Then the board just gives up and releases.

As far as I know the debt covenants do not include an asset value or book value/ratio trigger so it wouldn't have imminent repercussions, but it might make a financing roll a bit more difficult in 2018, and it would likely impact the perceived selling value of those assets which had just been marked down if Valeant needed to raise cash before that, so MP and the board would probably fight as hard as they could against that.

We'll see.

 

[anonymous]

Dan and 551,

I read in some articles that the PFE/AGN deal is an inversion and I also see it referred to as a reverse merger. Which is it and is there a difference?

Thanks

Would like to also understand this concept. Is AGN buying PFE with funding lended to AGN and then PFE, as the holder of that debt, takes control? Is this why BS is not CEO as has been the case with all the other mergers? Will the role BS assumes look similar to the role of Paul Bisaro, former CEO of Actavis? I ask these questions because as an Actavis employee, we were gutted in the "synergies" and wonder if the same phenomenon will prevail going forward.
Lastly, anyone see "The Big Short"? Is there an analogy to be made with all the sub-prime lending/buying by Valaent. Thanks