John-DV-150x150For most of its existence, Valeant Pharmaceuticals International, Inc. (NYSE: VRX) has been anything but a household name.

But, add in a billionaire hedge fund manager, short sellers sniffing around like sharks who smell blood in the water, a management team under assault, and public concerns about drug pricing… and Valeant’s stock has had more drama recently than an episode of Real Housewives.

The great thing about the stock market is that there are more than 8,000 stocks to pick from. You can literally avoid thousands of stocks, and still have your pick of the litter. So when a stock like Valeant captures the public’s attention – and this was before it fell some 80-90% – it’s probably best to avoid it.

Just ask yourself this: Do you really need to own a stock with more questions than answers?

It came down to more than just a popularity contest, however. There were many other clues that Valeant’s stock was about to burst. Whether or not it was worth shorting is another story for another time.

Fact of the matter: there is a lot to learn from Valeant’s fall from glory.

I’ll just focus on one aspect of the stock’s recent demise, which I think makes for a great case study. It revolves around revenue, and specifically revenue recognition.

In my newsletter, Forensic Investor, we focus intently on the quality of revenue that companies report. They have more ways to manipulate revenue that you can possibly imagine.

And if they do, it’s usually because something went wrong. The quality of revenue has likely deteriorated.

That’s a huge concern for a business. Revenue is the key to financial performance. Everything flows down from the top line. Nowadays, companies will do whatever they can to sweep that stuff under the rug.

In an extreme case, if a company recorded fictitious revenue, then the entire financial model would be bogus.

At that point, who cares what the earnings per share are?

Valeant most certainly had concerns surrounding its revenue recognition. There was more than one red flag in this regard.

The easiest one to spot was the fact that it excluded Bausch & Lomb’s (B&L) generics revenue from its calculation of organic growth.

Valeant acquired the company for $8.7 billion in 2013 to get into the eye-health-product space. In 2014, Bausch & Lomb contributed over 40% of Valeant’s revenue. Then in 2015, they stopped disclosing the company’s contribution.

That’s a little weird. Why should you take any comfort knowing a company is providing less information?

But then the company went so far as to exclude Bausch & Lomb’s generics business from its calculation of organic growth. Turns out, its robust growth in 2014 became a major headwind in 2015.

By June 2015, the company was reporting organic growth for Bausch & Lomb (again, a big piece of its overall revenue) of 8%.

However, had they included the generics revenue in the calculation, the growth rate would have dropped to negative 1%.

With a single stroke of a pen, Valeant was able to make negative growth look like high single-digit growth.

They were able to make their organic growth rates seem better than they were.

That alone is enough to take a pass on a stock. It shouldn’t matter too much what other issues surrounded the company.

In the annals of red flags, excluding revenue from a certain part of your business ranks way at the top!

And remember, this is just one factor.

The company also had controversy surrounding its acquisition of Salix Pharmaceuticals… the departure of its CFO before the stock price imploded… inventory concerns… along with other revenue recognition changes.

So, the next time a company in the news captures your attention, and the Masters of the Universe are in a tug of war over the stock, do a little homework. Make sure the quality of earnings they’re reporting are true and sustainable.

If there’s even a remote question about the quality of the financials, take a pass. After all, there are thousands of other opportunities in front of you.


John Del Vecchio

Editor, Forensic Investor

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John Del Vecchio
In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.