Valeant Pharmaceuticals Intl., Inc. RATING SELL

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1 October 27, 2015 Valeant Pharmaceuticals Intl., Inc. RATING SELL Ticker TSX-VRX; NYSE-VRX Current Price C$152.69/US$ ACCOUNTING ALERT FLASH Dimitry Khmelnitsky and Howard Leung MAXIMIZING THE CHANNEL Valeant took a week to respond to the multiple concerns raised by market participants, including us. In our opinion, yesterday s call failed to alleviate our overriding concerns: 1. The allegedly improper dealings of Valeant s specialty pharmacies with third party payors; and 2. The potentially improper accounting disclosure related to Philidor and its network of associated pharmacies in VRX s financial statements. We don't know what the authorities will find if anything, however we do know that an adverse outcome in any of the challenges that VRX faces could be materially negative. Based on the work we have done over the past four years, we advise clients to stay clear from an investment in Valeant at this stage. In this report, we address the following issues: Key allegations and risks that, in our opinion VRX has failed to address Another potential pharmacy that we have identified and which may be involved with Philidor Cambria Pharmacies Inc Deficiencies related to VRX s disclosure of its Philidor relationship in its filings VRX s potential exposure could be well above its $133M net investment to acquire an option to buy Philidor. RELATIONSHIP WITH PAYORS AND OTHER KEY RISKS We believe that the following allegations/risks, if true, could have extremely serious consequences on VRX: The allegation that Philidor is operating without a valid license in California and perhaps other states. The alleged use by Philidor and/or other related entities, of other pharmacies identification numbers (instead of Philidor s own ID and without the other pharmacies knowledge) to obtain reimbursements from payors when Philidor was allegedly filling and shipping prescriptions. The risk of an SEC investigation into the omission of material information related to VRX s relationship with Philidor and the web of specialty pharmacies associated with Philidor. (More on VRX s disclosure requirements under the VIE guidance later.) The alleged use of fake names by VRX employees working at Philidor, exposed in Wall Street Journal. Coupled with the ongoing federal investigation into VRX s product distribution, patient assistance programs, communication provided to the Centers for Medicare and Medicaid Services and pricing decisions, the above allegations may not bode well for VRX. Although management provided an 88 slide deck to support its dealings with Philidor, Valeant failed to alleviate our concerns about the appropriateness of its sales to external parties and, more specifically, the reimbursements from payors and the related subsidies to patients, which may or may not include Medicare/Medicaid. Specifically, we believe that VRX failed to address the following issues: Alleged misuse by Philidor of other pharmacies IDs to process and obtain reimbursements from payors. Valeant s answer: we understand that Philidor denies this allegation is not a substitute for a definitive response, especially 1

2 since VRX took almost a week to address the allegations and it seems that Valeant directs the activities of Philidor through its own employees and other contractual relationships Valeant also did not address the reasons why Philidor needs to have pharmacies with a license to operate in overlapping jurisdictions and the need for a complex web of entities. VRX failed to disclose the outcome of payor s audits of Philidor. This is important given that audit failure could lead to payors refusal to transact with Philidor. Philidor allegedly dispensed drugs without a local license, for example in California. According to VRX s presentation: We understand that Philidor has agreements with affiliated pharmacies that have California licenses and those pharmacies have dispensed products to patients in California. However, this statement seems to contradict R&O s claim, which alleges that Philidor or other related entities filled prescriptions for R&O without its knowledge and even before the purchase and sale agreement with R&O was concluded. The reason for Philidor s license denial in California. We find it odd that almost one and a half years after the original decision by California s Board of Pharmacy, VRX does not have the answer, especially given its involvement in Philidor s operations. Instead, Valeant referred the issue to the ad-hoc committee. VRX failed to clearly disclose whether any of the Company s employees were simultaneously active at Phildor. It is also unclear whether VRX has appointed any of its own employees to key Philidor positions including advisor to Philidor s CEO, head compliance officer, in-house lawyer etc. The alleged use of pseudonyms by VRX s own employees working at Philidor. Instead of providing an answer, VRX referred the issue to the ad hoc committee. Provision of financial benefits to doctors to route VRX prescriptions. While VRX claims that the company does not provide any financial benefits to doctors, VRX failed to note whether Philidor does. Although VRX claims that the dispute with R&O is a collection issue, based on R&O s court filings, it seems to us that the issues raised extend far beyond collection problems. (See our Oct 23 report.) VRX did not address the crux of the R&O compliant that is, the alleged use of Mr. Reitz s pharmacist IDs without his knowledge or consent. Instead VRX noted: We understand that Philidor denies this allegation, which, in our opinion, is not definitive. POTENTIAL EXPOSURE As we now know, VRX is the primary beneficiary of Philidor and it seems that Valeant has the power to direct Philidor s activities and operations through its ability to appoint key Philidor officers and its participation in the joint steering committee. Therefore, if any of the allegations leveled at VRX/Philidor thus far, including the issues we uncovered in our Oct 23 and Oct 21 reports are proven, it is hard for us to see how VRX s legal liability could be limited to its net investment in Philidor of $133M. Furthermore, the allegations related to VRX s involvement with Philidor, if true, suggest material deficiencies in VRX s internal controls, which puts into the question investors ability to rely on the Company s financial and operational disclosures. DISCLOSURE SHORTCOMINGS Until October 2015, VRX failed to disclose what we believe were material facts necessary for investors to assess VRX s risk exposure and the sustainability of its revenue and earnings growth. VRX has failed to disclose the complicated nature of its relationship with Philidor and the related network of satellite pharmacies. VRX contends that Philidor was not specifically discussed in K or other filings as it has not been material to consolidated financial statements, adding that Philidor was below 1% of total assets and 7% of net revenues. Management indicated that Philidor s net sales have amounted to $111M, as of the end of However, despite the insignificant materiality argument put forward by management, VRX s board, including the entire Audit and Risk Committee, went to tour Philidor facility in person ahead of completing the transaction to acquire an option to buy Philidor. If the Philidor operations were so insignificant, we doubt that such an extensive representation would have been warranted. However, we note that some of the transactions that VRX did choose to disclose in its 10K and other filings such as press releases and earnings presentations have revenue levels similar to, or even below Philidor s F14 results of approximately $111M. Specifically, according to management s own estimates PreCision Dermatology was estimated to provide approximately $100M run rate in sales at the time of acquisition in February In addition, Solta s TTM Q3-F13 revenue amounted to $150M, the last public reporting period for the company - not far away from Philidor. 2

3 Furthermore, according to management, the secrecy about Philidor was necessitated by the proprietary nature of these relationships, which management wanted to keep away from competition. Except, in VRX s own words, use of specialty pharmacies in dermatology is common and VRX specifically identified certain other companies using similar types of entities to distribute their products. Therefore, the lack of disclosure appears to have very little to do with the sensitive competitive information. Based on our review of the US GAAP guidance (ASC 810) and VRX s K, we found a number of what, we believe to be material deficiencies in VRX s disclosure related to Philidor. Based on our read of the relevant US GAAP standards and our knowledge of their interpretation, we believe that VRX should have disclosed fairly detailed information about its VIEs in its K report. Below, we highlight key deficiencies in VRX s disclosures. Methodology for determining the primary beneficiary Under the US GAAP, VRX consolidated Philidor at the end of 2014 because management has determined that Valeant was a primary beneficiary of the VIE. According to US GAAP, VRX is required to disclose its methodology for determining the primary beneficiary, including significant judgments and assumptions. Because VRX concluded that it was the primary beneficiary and hence, decided to consolidate Philidor on December 2014, VRX was also required to disclose the primary factors that caused the change [in conclusion as VRX did not consolidate Philidor before Q4-F14] and the effect on the financial statements. In its K, VRX failed to outline how it determined that Philidor should be consolidated. It simply disclosed the following generic statement: The consolidated financial statements include the accounts of the Company and those of its subsidiaries and any variable interest entities ( VIEs ) for which the Company is the primary beneficiary. In its K financial statements and notes, management did not elaborate of its methodology and the factors considered in consolidating such VIEs as Philidor. Further, VRX failed to disclose the primary factors that caused it consolidate Philidor, given that management did not mention the Option Purchase Agreement the key factor that likely necessitated consolidation - to acquire Philidor anywhere in its financial statements. Carrying Amounts &Qualitative and Quantitative Information about VRX s VIEs Beyond the carrying amounts of the assets and liabilities related to the VIE, under the US GAAP, VRX has to also disclose qualitative and quantitative information about the reporting entity s [VRX s] involvement with the VIE, including, but not limited to, the nature, purpose, size, and activities of the VIE, including how the VIE is financed. In its K, VRX aggregated the disclosure of Philidor s results with other non-vie acquisitions such as PreCision Dermatology and Solta Medical, without calling Philidor by name or explaining its nature. Therefore, it was impossible for users of the statements to quantify the standalone results or qualitatively assess Philidor s operations. Any meaningful discussion of the nature, purpose, size, and activities of the VIE was also omitted. According to US GAAP, in determining whether to aggregate VIEs, VRX should disclose the different risk and reward characteristics of each VIE and the significance of each VIE to the entity. Although Solta and PreCisison are not VIEs, VRX chose to include Philidor together with these other companies that clearly have a very distinct risk and reward characteristics from Philidor. Unlike Solta and Precision, Philidor is a distribution/payor reimbursement channel, and VRX can appoint important positions at Philidor without owning a majority stake. The different risk/reward profile between Solta/PreCision became apparent in light of the allegations of potentially improper transactions with payors discussed in our recent reports (Oct 21 and Oct 23) coupled with the allegations by the Wall Street Journal related to the use of fake names by certain VRX/Philidor employees. Provision of Financial/Other Support Under the US GAAP, VRX is required to disclose: whether the reporting entity [VRX] has provided financial or other support to the VIE that it was not previously contractually obligated to provide or whether the reporting entity [VRX] intends to provide support, including the type and amount of support and the primary reasons for providing the support. Clearly, VRX failed to disclose the existence of the $100 million upfront payment to acquire an option to buy Philidor and the $33M paid thus far in respect of the sales-based milestones of up to $133 million. In addition, VRX failed to disclose the existence of the steering committee, its ability to appoint advisor to Philidor s CEO, Head Compliance Officer, In-house lawyer, Head IT officer and any other employees. 3

4 Another Potential Pharmacy Involved We uncovered one other pharmacy Cambria Pharmacies Inc (Cambria)- that could be affiliated with Philidor/VRX because Mr. David Ostrow is an owner of Philidor and also an owner of Cambria. We found out Mr. Ostrow s NPI (National Provider Identifier) by searching the NPI Registry, which tracks pharmacists unique IDs. According to the data from the NPI Registry, the related business practice location address is indicated at 3169 N 5TH ST, Philadelphia. A further search led us to other NPI records that share the same phone number, which ultimately led us to Cambria. We believe that VRX management needs to name all entities involved in the complex web of Philidor/VRX pharmacies. OTHER MATTERS In addition to increased media scrutiny, VRX has also undergone increased legal scrutiny in the past two months, according to the note in its Q3-F15 10Q. Between September 10 and October 16 this year, VRX disclosed that had received four separate investigation letters or subpoenas from six different US District Attorneys and Regulatory Bodies as follows: The first, on September 10, 2015, was a letter from the US Department of Justice Civil Division and US Attorney s Office for the Eastern District of Pennsylvania. It details an investigation on Biovail s (a wholly owned subsidiary of VRX) treatment of certain service agreements with wholesalers when calculating and reporting Average Manufacturer Prices in connection with the Medicaid Drug Rebate Program. The second, on September 15, 2015, was a subpoena from the US Department of Justice. It seeks information on payments and agreements between B&L and medical professionals related to its surgical products Crystalens IOL and Victus femtosecond laser platform. This subpoena was issued in connection with a criminal investigation into possible violations of Federal health care laws. The third, on or about October 14, 2015, was another subpoena from the US Attorney s Office for both the District of Massachusetts and the Southern District of New York. The subpoena relates to documents with respect to the Company s patient assistance programs, and also include requests relating to financial support provided by the company for patients, distribution of the Company s products, information provided to the Centers for Medicare and Medicaid Services, and pricing decisions. The final investigation, on or about October 16, 2015, was a voluntary request letter from the FTC regarding its investigation into VRX s recent acquisition of Paragron Holdings I, Inc. We continue to believe the broadest and most serious investigation outstanding is the subpoena from the US Attorney s Office for the District of Massachusetts and the Southern District of New York, issued on or about October 14, According to VRX, the subpoena requests documents with respect to the Company s patient assistance programs, financial support provided by the company for patients, distribution of the Company's products, information provided to the Centers for Medicare and Medicaid Services, and pricing decisions. VRX has also disclosed a potential shareholder class action lawsuit. Two securities class actions were filed in the US District Court for the District of New Jersey on October 22 and 23, respectively this year. The steps in this class action are very preliminary and we do not expect a resolution from this action very soon but they could be material. CONCLUSION Valeant remains a SELL. We expect additional investigations into VRX s operations including the SEC. We reiterate the conclusion from our July 2012 report: VRX s disclosures are a convoluted moving target, and therefore, verification, and in our opinion, investment is a matter of faith. We advise clients to remain on the sidelines. 4

5 ANALYST: DIMITRY KHMELNITSKY, CPA, CA Veritas Investment Research Wellington St., W, TD West Tower Toronto ON M5K 1E Veritas Investment Research Corporation ("Veritas") its directors, officers, employees and their immediate families are prohibited from trading any position in the securities profiled in a report thirty (30) days before and five (5) days after the publication date where the report involves coverage initiation or a change of opinion. Veritas has not offered any consulting, financial advisory, investment banking or underwriting services to the companies mentioned. Veritas does not accept research fees from the companies profiled herein. The information contained in this report has been obtained from sources believed reliable however the accuracy and/or completeness of the information is not guaranteed by Veritas, nor does Veritas assume any responsibility or liability whatsoever. All opinions expressed are subject to change without notification. This report is for information purposes only and does not constitute and should in no way be construed as a solicitation to buy or sell any of the securities mentioned herein. The contents of this research report do not, in any way, purport to include any manner of legal advice or opinion. The intention of this report is to provide a forthright discussion of business, accounting and financial reporting issues, as well as generally accepted accounting principles and the limits of their usefulness to investors. As such, please do not infer from this report that the accounting policies of any company mentioned herein are not allowed within the broad range of generally accepted accounting principles, or that the policies employed by that company were not approved by its auditor(s). This report may not be reproduced in whole or in part without the express prior written consent of Veritas. Veritas is a 100% employee owned firm Veritas Investment Research Corporation. 5