Putting Mylan’s Earnings Quality Under the Microscope: Greenberg

When Mylan Inc. held its analyst day a few weeks ago, it offered an earnings per share forecast for (wait for it!) 2018.

Mylan Inc.
Source: Mylan.com
Mylan Inc.

That’s six years from now. As one analyst said: The $6.00 forecast for 2018 is a “pretty big bogey” compared with the $2.75 analysts are expecting at the high end for next year.

I’m always dubious of long-term forecasts. IBM is perhaps most famous for putting up a five-year forecast, but at least it shows a detailed “road map” of how much of the target will come from such things as buybacks, acquisitions and genuine business.

Mylan merely lays out 11 general “growth drivers” such as “biogenerics,” “respiratory” and “neurology.”

Mylan has a history of three-year earnings per share targets — and meeting them. That gets to a bigger issue: Earnings quality, which should be scoured at any company that offers a long-term target, especially one as long as Mylan’s.

And that gets to an even bigger issue to watch at Mylan: The accounting surrounding its December deal to buy rights (or as Mylan CFO John Sheehan tells me, “intellectual knowledge”) from Pfizer to develop a generic version of Pfizer’s dry-powder asthma inhaler, currently sold by GlaxoSmithKline under the brand Advair.

Veteran forensic accounting expert Howard Schilit, who runs the Financial Shenanigans Detection Group, says that as structured the deal gives Myaln an opportunity (and a very legal one) to create earnings if there is a shortfall.

Let me explain (and I’m going to paraphrase):

According to Mylan’s 10-K, the company paid $22 million in cash for the Pfizer rights. The company says the total purchase price “consideration” is $348.

But the line item to watch on the balance sheet is something called, “Contingent consideration," which Mylan explains is the total liability it has assigned to the deal. Last year it was $376.1 million; it’s a line item that didn’t exist a year earlier. Schilit says the spread between the $376.1 million liability and the $22 million in cash is unusually wide.

And that’s where this gets interesting. That liability is based on a bunch of assumptions for such things as milestone payments, royalties and profit sharing. Key to understand: This number is that management has discretion over which assumptions to use.

In this case, while the upside of the product could be huge, the company also discloses that the product “has not reached technological feasibility” and if it does, it won’t start “generating a material benefit” to Mylan until 2016.

Every quarter management must reassess the value of that liability.

If the product is successful, “this could be a game changer for us,” Sheehan says. But there’s no guarantee it will be. So, every quarter management must reassess the value of that liability. With no technological feasibility and no anticipation of revenue until 2016, at the earliest, Schilit’s concern is that the company could revise that number lower or higher.

If it’s adjusted lower, given the magic of accounting, Schilit says there would be a corresponding reduction of expenses, which would result in a non-cash increase to earnings. Cash or non-cash, this number could help the company meet earnings guidance in any given quarter if it’s a few pennies shy. (Again, totally legal.)

“They’ve created the potential for $376 million in additional [non-cash] income by paying $22 million,” Schilit says. “You have this enormous reserve you’ve created.”

Here’s the tricky part for investors: You won’t know if that line item has changed until you see the 10-Q, which for many companies is filed well after stock popping (or dropping) earnings release is filed.

Sheehan says that in the pharmaceuticals industry, investors only care about “adjusted earnings,” which subtracts out non-cash items such as this kind of adjustment.

Maybe, but as Schilit says, those adjustments start with the only numbers investors should really care about: Those prepared in accordance with Generally Accepted Accounting Principles. “You would have to be a moron to ignore those,” he says.

Sheehan, meanwhile, says Mylan is confident in its ability to meet its 2018 target, but Cannacord Genuity analyst Randall Stanicky isn’t so sure.

“While the 2018 target was an unexpected curve ball and indicative of management's’ long-term confidence,” he wrote in a report, “we think it’s just too far out to get a meaningful traction at this point given the visibility challenges reflective of the industry and macro variables.”

Hard to argue with that. And based on the market’s reaction (or lack thereof) it appears Wall Street agrees.

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