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Scrutinizing a financial statement is like panning for gold. Often, you spend a lot of time sifting through small bits, only to find rocks and dirt.

For the first instalment of our new column, How to Read, we look at the Q3 2015 income statement, balance sheet and cash flow statement for Valeant Pharmaceuticals International Inc. The statements, covering the quarter ended September 30, 2015, came out as the Laval, Que.-based firm had grown into one of the world’s largest pharmaceutical companies.

It was also just before Valeant stumbled, big. Revelations emerged about a concealed network of mail-order pharmacies used to support prescriptions for the company’s drugs. That was on top of the company’s surging drug prices and rapid, yet questionable expansion fuelled by debt and acquisitions.

The financial statement in question, filed in October 2015, was the first quarterly report to mention Philidor, a specialty pharmacy that filled prescriptions for Valeant’s high-priced drugs and helped customers with insurance claims. Also reflected in the following financial tables is Valeant’s $11-billion purchase of Salix Pharmaceuticals Ltd. in early 2015. Afterwards, the company raised the price of its diabetes pill, Glumetza, by about 800% in less than four months, with insurers usually picking up the tab (all currency for this story in U.S. dollars).

Valeant’s shares fell 85% over 2016, a year in which its CEO stepped down and the company shut the Philidor pharmacies after allegations of fraud. Valeant’s stock once sold for more than $250 per share, and now, for a company still under investigation by U.S. regulators, it’s available for less than $15.

The company says it’s cleaned house. It’s created a committee to review drug pricing, changed its management team, and now says it’s focused on execution. “Investing in R&D and developing innovative products that improve people’s lives continue to be priorities as we enter 2017,” new CEO Joseph Papa said in a January statement.

For investors at the time, it was unclear what was happening behind the numbers, says David Amsellem, senior research analyst specializing in pharmaceuticals at Piper Jaffray in New York.

“Number one, the business was really opaque. No. 2, we got into this environment where the stock was doing well, access to capital was cheap and a lot of M&A was getting done, and a lot of people—analysts and investors—just were not asking deep questions,” he recalls.

“They were buying a lot of mature assets, and nobody could say [… it] was sustainable. Nobody could even say with any certainty what the real, organic, underlying growth of the business was,” Amsellem says. “That is no way to go about investing in equities.”

The income statement

The income statement shows revenues coming in during the quarter (or year) and any associated costs. Typically, the income statement is topped with total sales, or revenues. Under revenues is a detailed list of expenses, such as interest paid on debt, restructuring costs, administration and the cost of producing the goods sold.

Lower on the income statement is net income, indicating the profit or a loss. Typically, you want to compare the quarterly income statement to the same quarter in previous years to skip over seasonal swings for the business.

Product sales

Perhaps the first thing to look at on an income statement is whether sales of the company’s products or services are rising or falling, and by how much. Review previous statements to see the trend over two or three years and quarter-to-quarter for more recent indications. The Q2 statement (not shown) indicates sales barely moved from quarter to quarter (they rose from $2.70 billion in Q2 to about $2.75 billion in Q3). Compare this change in sales to the change in trade receivables to see how well the company is bringing in billings (see “Consolidated balance sheets,” page 18).

Net income

Valeant’s profit for the period is $51.7 million, what analysts call “low quality” for a company of its revenues. Net income for the nine-month period is only $74.6 million. The profits are low compared to companies with similar levels of revenues and assets, says Caryn Rothman of Manulife Asset Management. With profits this low, analysts and investors had to look at the company’s business plan to forecast future earnings, or attempt to understand its non-GAAP numbers, such as adjusted EBITDA, as provided in press releases and other statements.

R&D

An important line for firms in the pharmaceuticals industry, this shows expenses for innovation and the development of new products. Valeant’s R&D for the three quarters of the fiscal year is $238.5 million, low for a pharmaceuticals company bringing in $7.59 billion in sales revenue over the same period. Large pharmaceuticals typically spend 10% to 20% of revenues on R&D.

Interest expense

This reflects quarterly expenses for interest payments and is particularly important for a company taking on a lot of debt. Valeant’s interest expenses are $420 million, a substantial number relative to earnings from operations for the quarter (operating income), which are $447.8 million. Interest expenses for the nine-month period are, again, almost as much as operating income. “All that they’re making is going to interest expense, in a low interest-rate environment,” says Maxim Jacobs, director of healthcare research for Edison. “That’s not a great sign, when all of your money is going to pay the interest. […] What happens if the junk bond market crashes? Instead of paying 6% on your debt, you’re paying eight, nine, 10%.”

The statement of cash flows

The cash flow statement also covers a specific period, showing the cash flowing in and out of the company during it. In theory, many line items in the cash flows can be reconciled with items on the income statement and balance sheet, but in practice that’s not often the case with many public companies’ accounting.

Acquisition of businesses, net of cash acquired

This line, under cash flows for investing activities, shows spending of $14 billion in the nine-month period up to September 30, reflecting the acquisition of Salix.

Net income

Note that net income, or profit, is listed on the income statement and cash flow statement.

Deferred income taxes

Coming in at a negative $91.4 million, this is an example of financial statement opacity that even experts can’t fully penetrate. The number may represent a tax overpayment. For instance, taxes may be paid or carried forward that are not yet reflected on the income statement.

Net cash from operating activities

Quarterly net operating cash of $737 million and $1.64 billion over nine months are mediocre numbers for a company of this size. Net cash from operating activities, or the cash inflows from the company’s business, rose by $118 million from the same quarter a year earlier. “This was a stock at the time that was about $200 [per share],” Amsellem recalls. “If you look at their operating cash flows, it implies to me a stock that was way too expensive relative to the actual cash they were generating.”

The balance sheet

While the income statement covers earnings over a period, the balance sheet is a snapshot in time. In this case, it’s at the end of the quarter. Assets and liabilities are compared to produce the balance at the bottom, shown as shareholders’ equity (i.e., book value). Note that Valeant’s doesn’t provide a year-over-year comparison in this statement.

Cash

This is the company’s cash and any assets that can be converted quickly for cash. Compare this to previous quarters for a sense of whether the company’s cash is depleting or accumulating. The Q2 statement shows Valeant’s cash rose from $958 million on June 30, 2015, to $1.42 billion three months later at the end of Q3. That’s a low amount compared to debt and total liabilities (see “Debt,” below). “Their cash isn’t all that big. Is it enough to get by on? That’s a very judgmental question,” says John Tracy, co-author of How to Read a Financial Report.

Debt

Debt was continuing to balloon, nearly doubling in less than a year to $30.18 billion. Jacobs says that, at one point, he charted Valeant’s GAAP earnings per share (EPS) against its debt per share, going back to about 2000. The chart lines showed GAAP EPS nearly flat while debt soared. “They were making bigger and bigger acquisitions every year, and usually around the one-year mark from the last acquisition, which kind of signalled to me they were using acquisition accounting to kind of mask what was really going on in their business,” he says. Although the company would break out its organic growth in separate, non-GAAP numbers, that again meant taking the company at its word.

Working capital (current assets minus current liabilities)

This indicates whether the company’s short-term assets are enough to cover its short-term debt. Find working capital by subtracting current liabilities (in this case $4.65 billion) from current assets ($7.0 billion), which leaves $2.35 billion. So, Valeant’s working capital is positive. Negative working capital can indicate near-term problems with creditors. Compare working capital to previous quarters to see if it’s going up or down.

Trade receivables

These are Valeant’s billings for goods and services, showing a $620-million gain from the end of 2014. That’s roughly in line with sales, as reflected on the income statement, which rose $725 million from the same quarter a year earlier. But, sales should be growing faster than billings. Checking the numbers against the previous quarterly report shows that Valeant’s trade receivables rose by $325 million quarter to quarter, while sales gained by only $53 million. It’s a bad sign when receivables start to outpace sales. “Sometimes, it can be indicative of channel stuffing,” says Jacobs, noting there was criticism at the time that Valeant’s specialty pharmacies were dispensing medication before getting it covered by insurance. “There was something going on in the channel, where they weren’t getting paid for stuff.”

Intangible assets

Intangible assets are traditionally paid-for patents and trademarks, though R&D is sometimes recorded as an intangible. On an acquisition spree, Valeant was reporting higher and higher intangible assets, here reaching $22.38 billion. “That’s a huge amount,” Tracy says. “It’s such a large part of the asset base of the company. You could say the whole thing is smoke and mirrors.” Adds Rothman of Manulife: “Most of the value of that acquisition [of Salix] was attributed to goodwill, and an increase in intangible assets.”

Goodwill

This includes intangible assets acquired through acquisitions, like brand value, reputation, patents and customer relations. Goodwill rose $8 billion from the end of 2014, likely reflecting the company’s purchase of Salix earlier in 2015. The goodwill was a big number that further clouded attempts to understand the underlying business. “They had this hyperaggressive acquisition strategy,” Amsellem says. “It’s very difficult to know what the underlying growth or health of the business is when you’ve got such a rapid pace of acquisitions.”

by Simon Doyle, an Ottawa-based financial writer.

Originally published in Advisor's Edge Report

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