Allergan's Roll-Up Is Not Breaking Even (SEC Letter Response)

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By SigmaCap :

On February 13, The Wall Street Journal broke news of a recent letter from the SEC to Allergan ( AGN ), highlighting its concerns about AGN's non-GAAP earnings practices. This letter corroborates my concerns about AGN's approach. In its earnings, AGN excludes the amortization of its acquisitions, and is therefore ignoring the enormous costs ($100B+) it took to create its roll-up. The roll-up, colloquially known as "New Allergan," includes Warner Chilcott, Watson, Actavis, Forest, "Old Allergan," and a multitude of smaller acquisitions.

It is clear the SEC shares these concerns, when it instructs Allergan to:

Clearly state that your non-GAAP results have not been, and never will be, burdened with any of the costs to acquire the underlying products that are currently generating revenue.

Long story short: Allergan's non-GAAP performance drastically overstates the quality of its earnings. It has a huge, consistent delta between its true earnings power and what these non-GAAP figures portray as its earnings power.

While the SEC says this practice is common in the biopharma space (and is also unacceptable), it doesn't usually move a company from severe GAAP unprofitability to strong non-GAAP profitability. Allergan seems to be the most severe case of this, along with Valeant ( VRX ) (its biopharma roll-up "cousin").

I think of it this way: when a PE firm buys a company, they measure their profit and return by comparing the future cash flows they generate (and are entitled to), against the money they spent to buy the company. Once the cumulative FCF they are entitled to eclipses what they spent for the company, they have broken even on their investment.

AGN's non-GAAP "earnings" reflect the yearly FCF generation of the accumulated businesses (that owners are entitled to), but by not including amortization (which applies the cost of acquisitions to the income statement at some reasonable interval), it completely misrepresents the profitability and return of the entire Allergan roll-up venture. Without the amortization, you get a totally false sense for the overall profitability and return of New Allergan's business model.

To this point, Allergan's roll-up will only reach break-even when it becomes consistently GAAP positive. If it never becomes consistently GAAP positive, "New Allergan" will have cumulatively lost money.

This is why growth is such an important component of the story pitched to investors. Without growth, how can AGN reasonably argue it will "out-run" its amortization, which includes a premium paid for each company?

These types of roll-ups are normally quite dangerous investments, but become especially difficult in the biopharma space, because the acquisitions have fixed patent lives. This means they don't have unlimited time to make a product's cumulative FCF cover what was spent to buy the revenue stream. This is why Allergan longs promote speculation that Botox could have a never-ending patent life (which is silly).

The combination of premiums paid and limited patent lives makes the roll-up approach even more daunting than usual, because your initial cost is larger and therefore harder to break even against, and you have limited time to do it. Valeant found itself in an even tougher spot, once its ability to drastically raise drug prices was halted, but the prices it had paid to acquire assets (and the debt it used to do it) were based on the continuation of that practice.

Allergan's non-GAAP earnings are at best deceptive, because they completely exclude the money expended to put the revenue streams together. These are real cash expenditures, and are basically equivalent to a lump-sum R&D cost of greater than $100B in the period of 2013-present.

Normally these things blow up when too much debt accumulates, combined with a failure of the acquired businesses to grow or create cost synergies. In AGN's case, the sale of Actavis to Teva ( TEVA ) may have saved it (i.e., given the company a fresh start of sorts), but it will likely be temporary, and only buy it another round on what is ultimately a very difficult model to break even with (because when you pay a premium to buy a company, it is actually more expensive than a normal biopharma's R&D).

To be honest, I am just stunned by the market's herd mentality in how they assess the company. Valeant had an almost identical situation with its accounting (and while non-GAAP was not the driver of its meltdown), it is an element of why its business model is questionable, misunderstood, and overvalued. At the very least, AGN and VRX are way less profitable than most people think (and their non-GAAP earnings imply).

Please keep in mind, that if the market continues to value biopharma companies on non-GAAP earnings, then these conclusions will not affect the stock price. If the market wakes up and realizes the extent of AGN's true unprofitability, then look out below.

Buyers beware.

See also Gladstone Commercial Corporation 2016 Q4 - Results - Earnings Call Slides on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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