In our prior article on Allergan (NYSE:AGN), we asserted that Allergan was in violation of the SEC’s rules regarding permissible non-GAAP performance metrics because the company included in its “non-GAAP EPS” calculation add-backs for amortization of intangibles and other (mostly non-cash) items in such a way as to transform this metric into a per-share cash flow, or “liquidity”, measure. SEC rules, however, specifically state that “non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission”. The rationale for this rule is that the SEC does not want investors to confuse per share cash flow or liquidity measures with per share net income or earnings measures; i.e., the commonly-accepted earnings per share, or EPS, metric. Unfortunately, this is precisely the confusion that Allergan has created with its “non-GAAP EPS” calculation (now known as “performance net income per share”). As we demonstrated in our prior article, investors, analysts and data providers alike, not to mention the company, refer to the company’s non-GAAP cash flow measure as if it accurately represents real economic net income per share (indeed, the company’s chosen title for the metric refers to “net income”, rather than “cash flow” or “liquidity”).

In this article, we first follow up on what has transpired with respect to the above issue since our initial publication. Second, we more closely examine the add-backs Allergan uses in calculating its non-GAAP numbers to determine whether such add-backs are justified. Finally, we propose a non-GAAP EPS calculation for the company that we believe reflects economic reality, rather than wishful thinking.

A. Allergan’s (Mis)Use Of Non-GAAP Financial Metrics

Warren Buffett, 2001 Shareholder Letter – “When stocks are rising…both questionable accounting and management chicanery often go undetected.”

In early January of this year, the SEC stated the following in a letter Allergan (source):

We note…that you continue to view your non-GAAP adjusted net income attributable to shareholders, including its presentation on a per share basis, as solely a performance measure. While we do not agree and believe that the measure you present is clearly and closely related to cash flows, we recognize that how you characterize it is a matter of significant judgment. While we also recognize that other companies, particularly in your industry, make these types of significant adjustments, it does not suggest that the magnitude of your departure from GAAP results nor the resulting similarity to cash flows is at all common. In light of our observations, we suggest that you carefully consider Question 102.05 of the updated Non-GAAP Compliance and Disclosure Interpretations and consider ending your practice of providing the per share data. If you choose to continue providing this per share data, please make the following changes:

  • Retitle the measure to more clearly reflect the extent of its departure from the concept of earnings. For example, the title should be consistent with the fact that you typically exclude more than half of all operating expenses;
  • Quantify the cumulative excluded cost of acquiring the intellectual property associated with revenue recognized (e.g., accumulated amortization for products currently being sold); and
  • 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.

Finally, in light of our discussions about this matter, we will evaluate the industry practices you described to us and consider whether additional comprehensive non-GAAP staff guidance is appropriate. [emphases added]

So how did Allergan attempt to address these instructions when it issued its Q4 2016 financial results press release on February 8, 2017? The company made a minor cosmetic alteration to their terminology, changing “non-GAAP EPS” to “non-GAAP Performance Net Income”, but leaving all of the underlying calculations exactly as they had been previously. In addition, nowhere in their press release did Allergan follow the SEC’s instructions to (1) “(c)learly state that (the company’s) 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” or (2) “(q)uantify the cumulative excluded cost of acquiring the intellectual property associated with revenue recognized” (Allergan only shows the amortization for the applicable period in its non-GAAP reconciliation, not the cumulative amortization to date for its revenue generating products). Finally, it is highly debatable whether tweaking the name of the metric to “non-GAAP Performance Net Income” “more clearly reflect(s) the extent of its departure from the concept of earnings”, since the company still includes the words “net income” in the nomenclature used-and “net” income, under any reasonable interpretation, means gross income “net of” (or “minus”) all normal expenses.

The following exchange regarding the issue took place near the end of Allergan’s Q4 2016 earnings call (see full transcript here):

Umer Raffat – Evercore Group LLC I just wanted to get more color on the change in accounting nomenclature to the performance net income. And I was just curious why the change if metrics are identical and whether SEC had feedback on the accounting for upfronts for R&D payments or something else. Thank you.

Maria Teresa Hilado – Allergan Plc – So our discussions with the SEC really have been limited towards the change on nomenclature and additional disclosures. There was no other conversation, and so therefore there was no change in the calculation methodology.

Umer Raffat – Evercore Group LLC – Got it. Tessa, so why change it then from non-GAAP net income?

Brenton L. Saunders – Allergan Plc – We could debate this, if you want, for hours.

Maria Teresa Hilado – Allergan Plc – I think the simple answer is we wanted to provide clarity that in fact this is a performance measure and this is the measure that we use as a management team. If you look at the industry, there really isn’t any one standard in our conversations with them. We wanted to comply with a change in the name, so it was easy.

Easy indeed. Apparently the company decided to roll the dice and do virtually nothing, daring the SEC to stop them. Perhaps they view the likelihood of any enforcement or other action as low, given that the SEC, as stated above, now intends to do a full review of “the industry practices you described to us and consider whether additional comprehensive non-GAAP staff guidance is appropriate”. Allergan could thus argue that it would be premature to drastically change their non-GAAP disclosures. However, despite this theoretical defense we continue to believe that sooner or later the company will be forced to comply with the SEC’s rules substantially as previously promulgated.

B. Scrutinizing Allergan’s “Adjusted Performance Net Income” Metric

Allergan has asked investors to ignore over $5.1 billion in 2015 GAAP charges and $5.5 billion in 2016 GAAP charges to arrive at its “performance net income” of $13.20/share and $13.51/share for those years, respectively. Indeed, if one accepts these non-GAAP add-backs, one could reasonably conclude that the company’s shares are fairly valued at current levels. Analysts have adopted Allergan’s metrics as valid; however due to their conflicts of interest (their employers stand to reap large fees from Allergan’s dealmaking), extreme skepticism is warranted. We believe a reasonable investor should independently examine each of the add-backs in Allergan’s GAAP metrics to determine whether they represent “real” costs to the company or simply “one-off or unusual items” that can be safely ignored in determining the company’s normal earnings power. Below is (1) Allergan’s reconciliation for “performance net income” from its Q4 2016 earnings press release and (2) our analysis of the reasonableness of each of the items added back in the reconciliation.

Three Months Ended

Twelve Months Ended

December 31,

December 31,

December 31,

December 31,

2016

2015

2016

2015

GAAP (loss) from continuing operations attributable to shareholders

-$41.90

-$790.20

-$941.10

-$2,945.80

Adjusted for:

Amortization

1,638.50

1,584.80

6,470.40

5,443.70

Acquisition and licensing charges

800.4

517.2

1,593.60

3,673.10

Accretion and fair-value adjustments to contingent consideration

-143.5

8.4

-64.2

95.7

Impairment/asset sales and related costs

456

282.9

748.9

783.6

Non-recurring [gain] / losses

-9.5

10.7

8.9

52.9

Legal settlements

17.3

10.6

117.3

31.1

Income taxes on items above and other income tax adjustments

-1,242.20

-229.3

-2,432.20

-2,029.60

Non-GAAP performance net income attributable to shareholders

$1,475.10

$1,395.10

$5,501.60

$5,104.70

Diluted (loss) per share from continuing operations attributable to shareholders- GAAP

-$0.12

-$2.00

-$2.45

-$8.01

Non-GAAP performance net income per share attributable to shareholders

$3.90

$3.36

$13.51

$13.20

Basic weighted average ordinary shares outstanding

356.8

394.2

384.9

367.8

Effect of dilutive securities: Dilutive shares

21.8

21.5

22.3

18.8

Diluted weighted average ordinary shares outstanding

378.6

415.7

407.2

386.6

1. Amortization of Intangibles

In the above reconciliation, Allergan begins with the aforementioned large add-back for amortization of intangible assets, adding back the entire GAAP amount for this line item. What the company is basically saying is that amortization is not a “real” expense, presumably because it is a non-cash expense. However, we strongly disagree with this viewpoint. Under GAAP accounting, the value of these assets is assumed to decline over time because this reflects economic reality for must companies. Therefore, unless the “real” economic value of Allergan’s intangible assets actually is not depreciating, then it would be incorrect to add-back the entire amortization figure in the non-GAAP calculations. Instead, the proper way to calculate the add-back would be to include only that portion of the amortization of intangibles that does not reflect a “real cost” to the company. For example, if a company purchases a valuable trademark and establishes an intangible asset on its balance sheet for it, it would be incorrect to consider the amortization of this asset as a true cost, so long as the company was spending enough on product quality, customer service and advertising and other promotion to preserve the value of the trademark.

But what do Allergan’s intangibles represent? They represent intellectual property and other product rights, licenses and customer relationships acquired via acquisitions. Generally speaking, they represent the present and future right of the company to sell certain branded drugs in various jurisdictions. However, common knowledge tells us that branded drugs enjoy limited lifespans before their patents expire and they succumb to generic competition. Thus, the right to sell such drugs must be a depreciable and depreciating asset–i.e., a “real cost” to the company. Much as an oil producer drills new wells to make up for the limited productive life of its existing wells, a drug company such as Allergan must spend money to develop new drugs to replenish its existing branded drug portfolio, otherwise its revenues will inevitably dry up over time. This cost under GAAP accounting is the depreciation of intangible assets. Therefore, Allergan’s implicit message in its “non-GAAP Performance Net Income” metric that people should ignore this cost because it is “non-cash” does not reflect economic reality. Cash must be spent roughly in line with the annual amortization figure or the company’s revenues will erode.

Indeed, Allergan’s 2016 Form 10-K (page 91) specifically states that the company establishes intangible assets on its balance sheet and depreciates them in a way that is expected to match the (declining) underlying cash flows of the assets over time:

Our product rights and other definite-lived intangible assets are stated at cost, less accumulated amortization, and are amortized using the economic benefit model or the straight-line method, if results are materially aligned, over their estimated useful lives. We determine amortization periods for product rights and other definite-lived intangible assets based on our assessment of various factors impacting estimated useful lives and cash flows. Such factors include the product’s position in its life cycle, the existence or absence of like products in the market, various other competitive and regulatory issues, and contractual terms. [emphasis added]

There is one caveat to the above argument regarding amortization of intangibles, however. Theoretically, one could argue that, at least with respect to the combination of Actavis and Allergan in 2015, the intangibles placed on the balance sheet represent in significant part those attributable to Botox, which (again, at least in theory) might be considered a highly “durable” asset which is largely immune from the “depleting oil well” comparison above. In essence, Allergan could argue that Botox represents an asset with no decline curve, hence there should be no amortization of its intangibles-at least, if GAAP didn’t mandate such a charge. However, investors should note first that legacy Allergan’s portfolio was not simply Botox for cosmetic use, but also included Botox used for therapeutic use. The latter should be subject to depreciation, since generics should inevitably encroach on these indications as patents expire over time. Legacy Allergan also had many branded drugs, such as Restasis. In fact, almost half of legacy Allergan’s 2014 revenues were attributable to its eye care segment (see page 46 of the company’s 2014 Form 10-K filing), so at a bare minimum half of the intangible amortization that can be traced to the Actavis / Allergan combination should not be added back when calculating Allergan’s non-GAAP performance net income. Given that Botox’s cosmetic and therapeutic revenues represented just one-third of Allergan’s Q4 2016 overall revenues, we believe that the maximum amount of intangible amortization a reasonable investor should add back in determining a non-GAAP EPS number for the company going forward should be one-third of the total amount. Even this is pushing the envelope, since as stated above Botox therapeutics revenues should be open to patent challenges over time, and hence should have depreciation charged against the assets producing such revenues.

2. Acquisition and Licensing Charges

Next we examine Allergan’s exclusions for “acquisition and licensing charges” in the non-GAAP reconciliation. Presumably these items are not considered “real” costs to the company because they are supposedly nonrecurring. However, Allergan’s “Open Science” business model depends on substantial recurring acquisition activity. On its website, the company describes its business model as follows [source]:

Allergan has sought to follow a different R&D path than other companies. We embrace an Open Science model. It defines [Allergan’s] position in this new ecosystem-as a magnet for game-changing ideas and innovation. A large percentage of our pipeline is sourced by partnering with biotech companies, academia and other pharmaceutical companies globally. Through this Open Science model, we drive strong R&D productivity by delivering innovative therapies that create long-term shared value for Allergan, for customers and for patients.

Thus, acquisition and licensing charges are clearly recurring in nature and should be expected to be large as a percentage of non-GAAP net income. In Q4 2016, for example, such acquisition and licensing charges amounted to $800 million, a significant increase year-over-year over the already substantial $517 million in Q4 2015. Such charges should not be added back in determining Allergan’s “performance net income per share”.

3. Accretion and Fair-Value Adjustments to Contingent Consideration

The line item for accretion and fair-value adjustments to contingent consideration appears reasonable to exclude from a non-GAAP reconciliation, since the amounts can arbitrarily swing in either direction and do not appear to reflect the underlying performance of Allergan’s business.

4. Impairment/Asset Sales and Related Costs

Impairment/asset sales and related costs should not in our opinion be added back to obtain the non-GAAP net income since these amounts have been significant and seem to recur. In both 2015 and 2016, for example, these costs amounted to well over $2/share. In any event, if these were truly non-recurring expenses, there would be no real need to exclude them since, by definition, they would go away over time on their own.

5. Non-Recurring Gains and Losses

The line item for non-recurring gains and losses appears reasonable to exclude from a non-GAAP reconciliation, however Allergan does not disclose enough information to make an informed decision on this point.

6. Legal Settlements

Legal settlements should not be excluded, as these amounts appear to recur. However, to give Allergan the benefit of the doubt we will nevertheless add them back in our calculation of “real” non-GAAP net income below.

C. A Realistic Method of Calculating Allergan’s True Economic Earnings

Given the above discussion, we believe that the following items from Allergan’s non-GAAP performance net income calculation are acceptable to add back:

  • one-third of the company’s amortization of intangible assets;
  • all of the company’s accretion and fair-value adjustments to contingent consideration;
  • all of the company’s self-described non-recurring gains and losses; and
  • all of the company’s expenses for legal settlements.

Thus, we obtain the following result for Allergan’s true “adjusted” economic earnings:

Three Months Ended

Twelve Months Ended

December 31,

December 31,

December 31,

December 31,

2016

2015

2016

2015

GAAP (loss) from continuing operations attributable to shareholders

-$41.90

-$790.20

-$941.10

-$2,945.80

Adjusted for:

Amortization

545.62

527.74

2,154.64

1,812.75

Accretion and fair-value adjustments to contingent consideration

-143.5

8.4

-64.2

95.7

Non-recurring / losses

-9.5

10.7

8.9

52.9

Legal settlements

17.3

10.6

117.3

31.1

Total Add-Backs

409.92

557.44

2,216.64

1,992.45

Income taxes on items above and other income tax adjustments (using 20% tax rate)

-81.98

-111.49

-443.33

-398.49

Non-GAAP performance net income attributable to shareholders

$286.04

-$344.25

$832.21

-$1,351.84

Diluted (loss) per share from continuing operations attributable to shareholders- GAAP

-$0.12

-$2.00

-$2.45

-$8.01

Non-GAAP performance net income per share attributable to shareholders

$0.76

-$0.83

$2.04

-$3.50

Basic weighted average ordinary shares outstanding

356.8

394.2

384.9

367.8

Effect of dilutive securities: Dilutive shares

21.8

21.5

22.3

18.8

Diluted weighted average ordinary shares outstanding

378.6

415.7

407.2

386.6

Based on our revised, more realistic calculations, Allergan’s non-GAAP net income would have been just $2.04/share for 2016, which means that Allergan would currently be trading at over 115X trailing adjusted EPS, an extremely high earnings multiple. If one factors in Allergan’s recent share repurchases and thereby reduces the diluted share count to just 355 million, the non-GAAP net income figure for 2016 would have been a still anemic $2.34/share and Allergan would currently be trading at over 100X trailing adjusted non-GAAP EPS.

Moreover, even if we were to add back all of Allergan’s acquisition and licensing charges, non-GAAP net income would only have been $5.17/share for 2016, which means that Allergan would currently be trading at over 45X trailing adjusted non-GAAP EPS, as evidenced by the following calculations:

Three Months Ended

Twelve Months Ended

December 31,

December 31,

December 31,

December 31,

2016

2015

2016

2015

GAAP (loss) from continuing operations attributable to shareholders

-$41.90

-$790.20

-$941.10

-$2,945.80

Adjusted for:

Amortization

545.62

527.74

2,154.64

1,812.75

Acquisition and licensing charges

800.4

517.2

1,593.60

3,673.10

Accretion and fair-value adjustments to contingent consideration

-143.5

8.4

-64.2

95.7

Non-recurring / losses

-9.5

10.7

8.9

52.9

Legal settlements

17.3

10.6

117.3

31.1

Total Add-Backs

1,210.32

1,074.64

3,810.24

5,665.55

Income taxes on items above and other income tax adjustments (using 20% tax rate)

-242.06

-214.93

-762.05

-1,133.11

Non-GAAP performance net income attributable to shareholders

$926.36

$69.51

$2,107.09

$1,586.64

Diluted (loss) per share from continuing operations attributable to shareholders- GAAP

-$0.12

-$2.00

-$2.45

-$8.01

Non-GAAP performance net income per share attributable to shareholders

$2.45

$0.17

$5.17

$4.10

Basic weighted average ordinary shares outstanding

356.8

394.2

384.9

367.8

Effect of dilutive securities: Dilutive shares

21.8

21.5

22.3

18.8

Diluted weighted average ordinary shares outstanding

378.6

415.7

407.2

386.6

D. Our Valuation of Allergan’s Common Shares

Having determined above a realistic calculation for Allergan’s true economic net earnings using what we believe are fairly generous add-backs for non-cash and other supposedly nonrecurring items, we now can calculate a realistic valuation for Allergan’s common shares. Again, erring on the side of being generous, we apply a fulsome 50X multiple to Allergan’s trailing $2.34/share non-GAAP earnings (including the effect of share buybacks) and we obtain a valuation of $117/share as our base case. The 50X multiple is more than ample to account for the touted superiority of Allergan’s “Growth Pharma” business model. Note that even if we bend over backwards completely and credit Allergan with $5.17/share trailing non-GAAP earnings by adding back all acquisition and licensing charges (even though they are substantial and recurring), the company’s shares still trade at a nosebleed valuation, leaving extremely little room for error in an environment where the government and third-party payors are pushing back more and more on aggressive drug pricing practices in the United States.

E. Bull Case

To be fair to the bulls, Allergan’s valuation would be reasonable if analysts’ non-GAAP net income estimates were realistic and rational. At $16/share forward non-GAAP earnings, the company’s shares would only be trading at a 14.75X P/E multiple, well below the multiple of the overall market. Of course, we do not accept these earnings estimates as realistic and rational, and therein lies the rub.

In addition, Allergan has engaged in a number of transactions recently, any of which could potentially pay off in a large way for the company. For reference, below is a list of the acquisitions the company has made in just the past seven months, per its 2016 10-K filing:

  • ZELTIQ® Aesthetics, Inc. – On February 13, 2017 Allergan entered into a definitive agreement to acquire ZELTIQ® Aesthetics, Inc. (“ZELTIQ”) for a price of $56.50 per share, or $2.475 billion. ZELTIQ is focused on developing and commercializing products utilizing its proprietary controlled-cooling technology platform. The transaction is expected to close in the second half of 2017 and is subject to customary closing conditions.
  • LifeCell Corporation – On February 1, 2017, Allergan completed the acquisition of LifeCell Corporation (“LifeCell”), a regenerative medicine company, for approximately $2.9 billion in cash. The acquisition combines LifeCell’s novel, regenerative medicines business, including its high-quality and durable portfolio of dermal matrix products with Allergan’s leading portfolio of medical aesthetics, breast implants and tissue expanders.
  • Lysosomal Therapeutics, Inc. – On January 9, 2017 Allergan entered into a definitive agreement to acquire Lysosomal Therapeutics Inc. (“LTI”). LTI is focused on innovative small-molecule research and development in the field of neurodegeneration, yielding new treatment options for patients with severe neurological diseases. LTI-291, LTI’s lead program, aims to stimulate the activity of glucocerebrosidase in the brain. Under the option agreement, Allergan purchased an option right directly from LTI shareholders to acquire LTI following completion of a Phase 1b trial for LTI-291. In addition, Allergan provided a separate upfront research and development payment. The net payment of $145 million will be recorded as a component of R&D expense in the year ended December 31, 2017. Allergan and LTI will establish a joint development committee to oversee the development activities for LTI-291.
  • Tobira Therapeutics, Inc. – On November 1, 2016, Allergan acquired Tobira Therapeutics, Inc. (“Tobira”), a clinical-stage biopharmaceutical company focused on developing and commercializing therapies for non-alcoholic steatohepatitis (“NASH”) and other liver diseases, for an acquisition accounting purchase price of $570.1 million, plus contingent consideration of up to $49.84 per share in contingent value rights (“CVR”), or up to $1,101.3 million, that may be payable based on the successful completion of certain development, regulatory and commercial milestones (the “Tobira Acquisition”). The CVR had an acquisition date fair value of $479.0 million. The Tobira Acquisition adds to Allergan’s pipeline Cenicriviroc and Evogliptin, two differentiated, complementary development programs for the treatment of the multi-factorial elements of NASH, including inflammation, metabolic syndromes and fibrosis.
  • Vitae Pharmaceuticals, Inc. – On October 25, 2016, Allergan acquired Vitae Pharmaceuticals, Inc. (“Vitae”), a clinical-stage biotechnology company, for an acquisition accounting purchase price of $621.4 million (the “Vitae Acquisition”). The Vitae Acquisition strengthens Allergan’s dermatology product pipeline with the addition of a Phase II orally active RORyt (retinoic acid receptor-related orphan receptor gamma) inhibitor for the potential treatment of psoriasis and other autoimmune disorders. In addition, as a result of the Vitae Acquisition, Allergan expanded its pipeline with the acquisition of a Phase II atopic dermatitis drug candidate.
  • · ForSight VISION5, Inc. – On September 23, 2016, Allergan acquired ForSight VISION5, Inc. (“ForSight’), a privately held, clinical-stage biotechnology company focused on eye care, in an all cash transaction of approximately $95.0 million (the “ForSight Acquisition”). Under the terms of the ForSight Acquisition, Allergan acquired ForSight for an acquisition accounting purchase price of $74.5 million plus the payment of outstanding indebtedness of $14.8 million and other miscellaneous charges. ForSight shareholders are eligible to receive contingent consideration of up to $125.0 million, which has an initial estimated fair value of $79.8 million, relating to commercialization milestones. The Company acquired ForSight for its lead development program, a peri-ocular ring designed for extended drug delivery and reducing elevated intraocular pressure (“IOP”) in glaucoma patients.

In addition, the company has entered into a number of licensing agreements recently, which could also boost revenues and earnings going forward.

Finally, as shown by the fact that Pfizer was willing to pay well over $300/share in its own stock in order to acquire Allergan, a deep-pocketed suitor could attempt to take over the company at a premium, especially if the Treasury Department’s rules regarding tax inversions are relaxed and/or comprehensive corporate tax reform in the U.S. is delayed due to partisan gridlock

F. Conclusion

If price is what you pay and value is what you get, we believe that Allergan investors today are getting just $117/share of value for stock recently trading at $236/share. Our valuation is based on a generous multiple of 50 times our conservatively calculated 2016 non-GAAP economic net income of $2.34/share, which gives effect to recent share repurchase activity. While Allergan has decided to ignore the SEC’s instructions regarding permissible non-GAAP financial metrics by continuing to present a per share liquidity / cash flow measure as if it were an acceptable non-GAAP per share net income measure, we believe that eventually the company will be forced by the SEC to adjust its non-GAAP figures drastically downward to comport with economic reality (and be more in-line with our calculations). Assuming our $117/share valuation is reasonable, this implies that Allergan’s common shares currently have an expected downside risk of approximately 50%, which should make any prudent investor cautious.

Disclosure: I am/we are short AGN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.



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