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Valeant’s Eastern Front

Poland seems a most unlikely place for the next chapter of Valeant Pharmaceuticals’ saga to play out. Weighing in with about 3 percent of sales, the Polish operations are seemingly a modest contributor to Valeant’s fast-growing bottom line.

But Valeant’s Eastern European operations have recently been the source of a good deal of message board rumor, which in turn has prompted the company to quickly respond.

So the Southern Investigative Reporting Foundation set out to see whether Valeant’s units in Eastern Europe are as robust as their North American brethren. The foundation chose Poland to start with because it’s the third largest geographic segment and, along with Russia, a core component of the company’s emerging markets unit (which represented 25 percent of sales last year). Just as important, unlike Russia, Poland doesn’t have a rich civic tradition of killing investigative reporters or the people working with them.

There’s a lot more inventory in the corporate supply chain than meets the eye, and that’s rarely a good thing, at least in the long term. Moreover, this is occurring against the backdrop of a flat sales trend in Poland.

Given the complex Valeant Europe organizational chart, sussing this out wasn’t a walk in the park.

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On Nov. 10, Valeant’s chief executive officer, J. Michael Pearson, during a conference call, noted that Polish inventory levels were currently equivalent to four months’ worth of his company’s then average sales rate and were slated to be lowered. The call to discuss Valeant’s business came in the wake of its Philidor-driven controversies stories that the Southern Investigative Reporting Foundation’s readers will recall it was the first to report.

Translated from business speak, what Pearson meant is that Valeant’s Polish operations has sold four months’ worth of inventory to a series of distributors, who, in turn, will deliver the products to retailers. Most CEOs want to avoid having inventory levels spike in distribution channels because over time excess supply reduces demand, which in turn forces production cuts and ultimately lowers the price of the product. (See what Valeant said when the Southern Investigative Reporting Foundation asked it about Polish inventory issues.)

But the full picture is much more complicated than that.

In Poland, three of Valeant’s subsidiaries, ICN Polfa S.A., PF Jelfa and Valeant SP. Z O, account for 98 percent of its revenue. Of the three, Valeant SP is by far the largest, amounting to about 75 percent of the revenue. It’s not, as might be expected, a manufacturer but a wholesaler, buying drugs Valeant produces in Poland and elsewhere, and then selling it to other distributors.

While Valeant’s explosive revenue growth is what made the company so beloved of investors, that hasn’t made it to Poland yet. Through the third-quarter revenue from the three units, as measured by IMS Health data, was just under $187 million and on pace to slightly improve upon last year’s $270.3 million. In turn, 2014’s sales were off relative to $296.4 million in 2013.

According to filings, at the end of last year, the three subsidiaries had 95 days’ worth of sales in inventory on its balance sheet. (There’s not a hard and fast rule for determining how much inventory is too much, but when it’s just sitting on a balance sheet and not moving, it’s a safe bet that the higher the figure goes, the more management and investors should worry.)

Add that to the 120 days of sales that Valeant recently acknowledged having in the channel. That’s 215 days of Valeant’s production chain that hasn’t made it to the retail market. Since the end of 2013, IMS Health data shows Valeant’s inventory in the distribution channel increasing to four months’ worth of sales from under two months.

To answer the question of whether that’s standard or not, take a look at how much inventory other major pharmaceutical wholesalers keep on their balance sheet. The three companies below, Neuca, Pelion and Farmacol, control nearly 70 percent of the Polish wholesale pharmaceutical market:

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So Valeant in Poland is clearly moving inventory less rapidly than its peers and per above, has put additional product into the channel earlier this year given the increase to four months of sales. To be fair, the comparisons are not exact given that the other three companies are purely wholesalers and Valeant has manufacturing operations.

A spokeswoman for Valeant, Renee Soto of Sard, Verbinnen & Co., said Polish inventory levels as of yesterday were back to three months’ worth of sales.

The supply chain process in Poland for getting a drug to a pharmacy from the plant is fairly described as labyrinth. Evidence the first is an occasional fourth step in the supply chain process called pre-wholesale warehouses, which are owned by the wholesalers but aren’t tracked by IMS Health. This inventory essentially falls “off the grid” and it’s nearly impossible to see how much is in there or how long it stays.

Industry insiders in Poland say that pre-wholesale warehouses hold inventory from manufacturers and charge them between 1.2 percent to 2 percent of the value of the inventory per month as a fee.

Then there is Myslowice, a 138,000-square-foot warehouse located equidistant between Valeant’s two other facilities in Jelenia Gora (546,000 square feet) and Rzeszow (412,000 square feet). One cannot easily find the facility listed on the company’s website because it leases it from DHL, the giant shipping and logistics company whose Exel unit often leases properties to work with key clients.

A recently granted license allows it to operate as a pharmaceutical wholesaler but unlike the other two facilities its permit allows it to sell on consignment. While consignment sales are fully legal, from an accounting perspective they often raise earnings-quality questions. (Bausch & Lomb, then an independent company, was ensnared in a consignment sale scandal in the 1990s.)

Valeant says the facility is currently its main distribution hub for Poland and Eastern Europe and that it does a small amount — about $4 million — of consignment sales there for a hospital unit. Read its full response.

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