Medicis' Accounting Error Puts Spotlight on Solodyn Weakness; Allergan Rejoices
Medicis stock tumbled roughly 16 percent yesterday after it announced that it would restate six years of its numbers due to an accounting error.
But the magnitude of the fall seems to have drawn attention not to the vanity pharma company's inability to count beans, but the weakness of its key Solodyn acne franchise, and the fact that Allergan, the company's chief rival, is poised to pounce with a rival product. (Some history of Medicis' current predicament can be found here.)
A closer look at the accounting indicates that -- at least at first blush -- it may not be all that significant in terms of the overall health of Medicis' business. So the market's loss of confidence makes a lot more sense if it was triggered by worries over Solodyn than by the bookkeeping problem. Let's look at the accounting first, and the Solodyn issue second:
In a statement that only an accountant could love, the company described its error -- involving its "sales return reserve" -- this way:
The Company's prior accounting method, with respect to sales return reserves, accrued returns at replacement cost rather than deferring the gross sales price ... the Company is in the process of revising its reserve calculations to defer the gross sales value of the returned product.Everybody clear? Thought not. I'm not even going to pretend that I understand how to calculate the sales return reserve, but I can tell you that is to do with how the company prices goods that were shipped out and then returned to the company. And that price is determined in part by whether the company can repackage those goods and sell them as new, or whether, like fruit, the goods expire and must be written down completely.
Such a recalculation could potentially affect cost of goods sold, inventory, net accounts receivable and -- the bottom line -- net income. Curiously, the company said one piece of its books would not change, its cash flows:
The restatement is not expected to have an impact on the Company's cash flows or Cash and Cash Equivalents balances for any of the affected periods.So I went to the company's web site to take a look at its cashflow statement for the last quarter and, interestingly enough, they didn't publish one in their release. They just gave the income statement and the balance sheets. That just seems odd. But you can find the cashflow statement on the SEC's website, here. It's quite healthy -- Medicis generates about $100 million in cash every six months. By saying that it does not expect cashflow to change, the company seems to be indicating that the way it counts actual cash-on-hand is accurate; only the way it recognizes revenue and expenses per period will change.
But if you look at the cashflow statement, it contains lines for returns, accounts receivable and inventory -- the very items you'd expect to be affected if you're altering your returns numbers. Those expenses were $542,000, $10 million and $6 million, respectively. So I will be extremely interested to see how Medicis recalculates its returns without changing its cashflow statement. Note the returns are just $542,000, a small sum. One presumes that the accounting problem is some magnitude or factor of that. We'll see.
So, did Medicis lose investor confidence based on a miscalculation of a budget line that's only $542,000? Of course not.
The Wall Street Journal's take on the matter gets to the real heart of Medicis' problem - the potential nixing of its Solodyn patent by Impax, a challenger. It is not clear if or when the FDA will allow Impax to make a generic version of Solodyn, but the problem has been hanging over Medicis' head since last January.
The issue came up in Medicis' second quarter earnings call. CEO Jonah Shacknai's responses were interesting. He started by saying:
We spend a great deal of time in our efforts strategizing around the SOLODYN franchise and predicting the timing to the best of our knowledge of the occurrences. There is not a clear picture of how the time line unfolds and there are many unknowns ... We anticipate being on the market with follow-on forms of SOLODYN in this calendar year 2008. This time line is of course subject to FDA approval.Lei Huang, an analyst at Summer Street, then asked whether the new line extensions of Solodyn would have patent protection. Shacknai replied:
I think we'll see when we get there.
Huang: Okay. So it's possible that you may have exclusivity on some of them?
Shacknai: Well, regulatory exclusivity no.That's it in a nutshell - Medicis' key revenue driver is under threat, the company doesn't know when that threat will arrive, and its plan for dealing with it may not work. And that's not a good position to be in when your chief rival, Allergan, just acquired a competing product, Aczone.
The accounting issue just seems to have been the straw that broke the market's back.