Investors in Salix Pharmaceuticals were treated to some unpleasant news on November 6th. The company announced they had misrepresented key drug inventories, and the CFO resigned. SLXP traded down -34% the next day and -46% from its September highs. I believe more accounting issues will be uncovered by the audit committee.
The company has all but admitted that it was channel stuffing, a practice used to inflate earnings, as discussed in my last post Was the Salix Blowup Predictable? This earnings inflating trick increased wholesaler inventories to levels way beyond their stated target, and much higher than industry norms.
Since the sell off, shares have rebounded. Investors are speculating either there is only one cockroach in Salix's kitchen, or it is still a takeover candidate despite the accounting issues. Indeed this company has a valuable GI drug franchise, and management with a credibility issue.
The setup seems ripe for M&A activity. Further bolstering this line of thinking is Salix was previously a target of both Actavis (ACT) and Allergan (AGN), but talks fell apart during due diligence around inventories. However, an audit committee composed of independent directors have been convened, and I believe that the audit committee will uncover more accounting problems. For those who still wish to wager on a Salix acquisition, I have outlined a strategy at the end of this article.
One of the most useful tools for detecting earning manipulation is the Beneish M-Score. Developed by Dr. Messod Beneish of the Kelly School of Business, and detailed in The Detection of Earnings Manipulation. The M-Score uses forensic accounting principles to produce a "Probability of Manipulation" or PMAN for any given company by comparing two 12 month periods.
I was first introduced to the Beneish M-Score in Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. This book is excellent and I wholeheartedly recommend it.
In the book, the authors relate a story about an MBA team from Cornell which used the M-Score to give a "sell" recommend on Enron, a full year before it's collapse.
So what does the M-Score and its Probability of Manipulation say about Salix Pharmaceuticals?
"Never is there just one cockroach in the kitchen" - Warren Buffett
In Quantitative Value, they noted the M-Score gave Enron a 30.5% PMAN. For 1Q14 Salix has a 50.8% PMAN. That is what I call a red flag. Even it's 2Q14 score of 5.8% is high enough to be considered a weak signal.
Let's do some more digging; what is the M-Score recognizing in Salix to give it such a high PMAN?
The Beneish M-Score is a multifactor model with eight variables, each being a hot spot of earning manipulating activity. The eight variables are below:
Lets look at the table below to see how Salix scored on these variables compared to peers:
Based on the table above, and information the company has shared, I expect the following outcomes from the audit committee:
In short, I believe investors should be very cautious on owning Salix shares until the audit committee releases their findings. An approach for those determined to make a bet on a Salix acquisition should consider a small starter position, with the intention to use the negative headlines from the audit committee as an opportunity to buy on weakness.
I have no position in Salix Pharmaceutics as of this writing, but may establish one in the future.
Could the blowup at Salix Pharmaceuticals been seen in advance? This is a Monday morning quarterback look at the financials in search for a tell.
Investors in the pharma and biotech space are accustomed to certain risks; Clinical, regulatory, and commercialization risk are at the top of healthcare investors mind.
Accounting shenanigans are not the sort of thing that keeps healthcare investors up at night. This is why the channel stuffing scandal at Salix Pharmaceutical has been so shocking, despite Bristol-Myers and Medicis having paid to settle channel stuffing allegations in the past.
With Q3 2014 earnings, Salix Pharmaceuticals announced that key product inventory levels at distributors are elevated to nine months, well beyond the levels previously disclosed. Adam C. Derbyshire, former Chief Financial Officer, has stepped down, and an independent audit committee has been convened to figure out what exactly went wrong.
The problem with channel stuffing (besides being misleading) is it steals sales from future periods. This approach could be used by management in a one-off scenario, with a low risk of being found out. However human nature leads them back to the same well until it is dry.
There are legitimate reasons for distributors to allow inventories to build. For example, expected price increases, supply issues, and rising demand. While these all could play a part, management has all but admitted to channel stuffing. Below is a great graphic on the pharma supply chain from ContracIQ.
Why would distributors accept more inventory than needed? Because the company incentivizes them to stock up, so that the company may meet their sales targets. This is typically done through special financing arrangements. Extended payment terms, and product discounts are typical.
A channel stuffing company would show an unusual rises in accounts receivable due to the extended payment terms, and timing. These deals typically occur near the end of the quarter, when management knows it won't hit sales targets on their own. Also look for some impact on gross margins, due to discounts offered to incentivize distributors.
I recommend What's Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Authored by a short bias fund manager, it exposes many of the accounting tricks companies pull, such as channel stuffing.
When evaluating receivables, you have to look at it relative to revenues, as a quickly growing firm would naturally have rising receivables. Furthermore, you have to look at the trend in receivables. Quarterly Year over Year comparisons smooth out seasonality, and is the preferred metric.
There few reasons AR can grow faster than sales:
The huge spike in Q1 2014 is suspect. Salix closed the Santarus deal on January 2, 2014. Could it be related the the Santarus acquisition?
Santarus had $43.5M in receivables in Q3 2013. Salix receivables rose from $146.9M in Q4 2013 to whopping $438.5M one quarter later Q1 2014. So that doesn't explain it. If there is a smoking gun, I would say Quarter Y/Y receivables growth is it.
These types of issues apparently scared off Allergan.
Furthermore, I haven't seen anything in the earnings calls or filings that explain the dramatic rise. Not that I would believe it now, coming from a disgraced CFO.
The overall level of receivables were also very high. Among a peer group of companies I created for this research, Days Sales Outstanding for Salix was the 3rd highest.
What about that other factor I mentioned, gross margins?
Margins have been impacted too. On this item, management had an explanation, however I would not be surprised if the audit committee ends up questioning this statement:
“The lower gross margin in the second quarter of 2014 was due primarily to the inclusion of sales of GLUMETZA, which carried lower gross margins than our other products.”
I find it particularly telling that in the Q1 2014 and Q2 2014 earnings call transcript, the word "discount" never appears. However, on the Q4 2014 call , the interim CFO had this to say:
"As we said, the shortfall is because of our prescription growth on our key products is less than we had expected and then because of the turnover in the Santarus sales force, wholesaler discounts higher than budgeted and higher-than-expected rebates on the Santarus products."
Going forward, what should investors focus on? We have the pending audit committee review, and this statement:
"...management believes that the company's accounting in relation to sales to wholesalers has been appropriate, and that any questions related to that have all been vetted. Our auditor, Ernst & Young, has conducted its quarterly reviews for each of the 3 quarters. They've also informed us that they stand by their unqualified opinion in respect to their 2013 audited financial statements."
This does not mean there will be no revisions to prior period financials, it does mean E&Y does not expect the revisions to be material in nature. While management has tried its best to assure there are no other issues, investors are applying the "one cockroach in the kitchen rule" and staying away. I missed the drop in Salix due to my focus on smaller firms. I currently have no position, but that may change, pending my research below.
In the next post, I will be exploring metrics that may be used to identify earnings manipulators, in the attempt to determine what other revelations Salix investors should expect from the audit committee, if any.
This is the personal blog of Emory Redd.
This blog is not investment advice. This is not a solicitation to invest. Don't take candy from strangers.
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