Valeant Pharmaceuticals was on an acquisition spree before accounting problems brought down its stock. But sometimes the “roll-up” model can work. (Richard Drew/AP)
On May 3, Valeant Pharmaceuticals International (TSX: VRX) installed its new CEO, Joseph Papa, and began what is sure to be a long climb back to respectability. A new boss won’t solve the company’s problems, but perhaps a change in direction will. One thing analysts want to see is whether Papa will continue the firm’s torrid acquisition pace, a key part of its pre-meltdown business model.
Valeant is hardly the first company to mask accounting irregularities in fast-paced M&A. WorldCom, which went bust in 2002, bought more than 65 companies during its seven-year lifetime. Nortel Networks scooped up 20 operations in eight years. In both cases, experts said in hindsight that their acquisitiveness should have been cause for concern.
Nonetheless, there are many more examples that show rolling up one’s industry can be a valid and even sustainable growth strategy. It’s not easy to expand organically, especially in today’s low-growth world, and as soon as a deal is done, the target company’s revenues and profits can be added to the buyer’s balance sheet. The trickier question is whether the deal is ultimately accretive to the combined operation’s earnings—that the merger represents a more efficient deployment of capital than keeping the firms separate. “M&A is so difficult to understand,” says Vishal Patel, a portfolio manager with Dynamic Funds. “There’s so much accounting involved. It’s hard, even for a professional.”
One of the ways companies fudge numbers is around one-time charges, says Richard Liley, an analyst at Leith Wheeler Investment Counsel. When reporting earnings, a company might steer investors to ignore costs for acquisitions, restructuring charges, transaction fees and intangibles such as brand recognition. They then don’t include these items in their earnings reports that need not adhere to Generally Accepted Accounting Principles. The more deals get done, the more costs are ignored, and the harder it is to tell what’s really going on.
When Liley looked through Valeant’s financial statements, these are the kinds of omissions he saw. They made him question the cash flow the company expected to generate from its investments. He did the math and kept coming to a number that didn’t jibe with what management was saying. “It was absolutely clouded by the fact that they were doing acquisitions so quickly,” he says.
Liley is not averse to consolidation as a strategy, though. The difference between the good and bad practitioners, he says, comes down to three things: management, math and debt. Invest with CEOs you trust, who own company stock and make moves for the long-term gain of the business. Look at management’s history—have its acquisitions worked out?—and its compensation. If executives are rewarded for short-term earnings gains or if they’re paid with stock options, then be wary.
As for math, make sure earnings growth and free cash-flow growth match up. The earnings of Constellation Software (TSX: CSU), another serial acquisitor, have grown from $4 a share to $17.15 over the past six years. Its free cash flow has grown by nearly the same amount, says Liley. By contrast, Valeant’s free cash flow only grew 56% over the past five years, he says, lagging behind earnings. Also look for where the cash-flow boost is coming from; cost savings will be more sustainable than price hikes resulting from reduced competition.
Finally, it’s always better when a company pays for a purchase out of cash flow rather than borrowing. The businesses that tend to run into trouble are the ones that spend more than their cash flow. With or without debt, there should be a plan. A smart consolidator employs the strategy to improve its market position and profitability. “At the end of the day, it’s about prudent capital allocation,” says Patel.
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