Israel-Medical-Healthcare

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Paint by numbers at Taro
08.11.2005 | 12:33
Uri Ronnen

Tomorrow, on Wednesday, Taro Pharmaceutical Industries (Nasdaq: TARO) will be publishing its third-quarter results and will afterward be holding the traditional conference call with analysts. It will be interesting to see if William Blair analyst Rich Watson will demand clarification of DSO, days sales outstanding, as he did after the second quarter.

It will be even more interesting to see whether chief financial officer Kevin Connelly will deign to address the genuine concerns the investment community has about DSO at Taro.

DSO is a ratio that estimates the average period of time from recognizing revenue to collecting cash from the customer. Analysts usually calculate it by dividing outstanding payments by the quarterly revenues and multiplying the outcome by the number of days in the quarter.

That gap in time, estimated by DSO, can grow longer for two main reasons. One: customers are delaying payment because of financial difficulties. Two: the company is recognizing revenues earlier, or recording more than the client is willing to pay.

Asking for trouble down the line

The first reason, bankruptcy by a key customer and suchlike, is non-recurring in nature and is certainly not reason for analysts to get upset about growing DSO, or DSO that exceeds the sector's norms.

The second is a clear alarm signal. Recognizing revenues earlier and earlier, or recording too much, spells trouble down the line, when revenues can't be inflated any more.

For Taro, the first cause – customers in trouble – is irrelevant. It sells most of its drugs to huge U.S. wholesalers and retailers. Yet in his answer to Watson, Connelly talked only about the financial health of the wholesalers, which may be a tad belated in payments because of their sheer size, which can impact DSO. He didn't mention the second possibility.

Yet the truth in the generic drugs industry is that DSO tends to lengthen because of overly permissive revenue recognition policy. Sometimes the companies push merchandise to wholesalers, or they chintz on provisions for price adjustments. Generic drug companies tend to correct prices of goods already supplied to wholesalers, for instance because the price of a drug already in the supply chain has fallen.

Wholesalers who accept surplus merchandise pay the manufacturer only when they deliver the drugs onward in the supply chain. That can take months on end, so such product stuffing causes DSO to grow longer.

According to accounting regulations, the manufacturer must record anticipated price adjustments along the supply chain as a provision from outstanding payments on the one hand, and from current revenues on the other hand. Therefore, under-booking provisions for price adjustments raises DSPO and is equivalent to inflating revenues.

Remember when Taro stock crashed?

When a manufacturer has to make up provisions neglected over quarters on end in a given financial statement, revenues for that quarter plunge.

Who can forget the pummeling Taro stock took on July 29, 2004, the day the company admitted that its second-quarter 2004 revenues had plunged 40%? Ten different class action motions were fired against Taro. The cases have been consolidated into one giant claim being handled by Lerach Coughlin Stoia Geller Rudman & Robbins LLP, a giant firm with 150 partners.

In August 2004 the lawyers filed the primary suit and noted that during 2003, Taro's generic drug sales to wholesalers had exceeded actual demand by hundreds of millions of dollars. Since the company neglected to book provisions for price declines and returns, its DSO became bloated.

The mushrooming DSO in 2003 was a clear warning signal that revenues were about to collapse. But in conference calls for the third and fourth quarters that year, Connelly persuaded analysts that the inflation was due to a few days' delay in payment by a major customer.

He said much the same in the last conference call, in response to concerns that Watson raised regarding DSO. Given the implosion of revenues and the share price in 2004, and Lerach's claims, one might have expected Connelly to relate to Watson's concerns that revenue recognition issues might have inflated DSO. One has to wonder if Taro is not repeating past mistakes.

But this time around, Watson seems to have been unconvinced by Connelly's arguments. After the conference call, he wrote a report for William Blair saying that second-quarter DSO had reached 180 days, almost three times the average for the industry.

Painters and Builders vs Taro

DSO is one warning signal. Another is the creative accounting that Taro used when buying product lines in 2004. What it did inflated its provision for price adjustments by 40%, which reduced outstanding payments and DSO without impacting revenues. The one-time termination of that influence may have also boosted DSO in 2005.

Taro should have published its third-quarter financial statement on October 27, 2005, but surprisingly postponed publication to November 9. Postponements of that kind usually make investors queasy and Taro stock did react accordingly.

Taro stock




As the share price weakened, Merrill Lynch wrote two weeks ago that it does not believe the delay is suspicious, nor is it aware of any change in the company's process of closing its books for the third quarter. But it did not rule out the possibility that when it files tomorrow, Taro will disappoint.

Even if it doesn't, it may have a surprise to spring by announcing an U.S. Securities and Exchange Commission probe into its revenue recognition and provisioning for 2003. That would indeed be a surprise: Taro is registered as a foreign issuer and the SEC doesn't usually delve into companies like that, especially Israeli ones. Both Lumenis (Nasdaq:LUME.PK) and Mercury Interactive (Nasdaq:MERQ), which have come under the SEC microscope, are registered as American companies . Amdocs (NYSE:DOX), which revealed in 2003 that the SEC was looking into the circumstances of its extreme earnings warning in 2002, is registered as a foreign non-Israeli company.

The SEC avoids investigating foreign companies for budgetary and political reasons. Budgetary - because investigating a company outside the U.S. is awkward, expensive and sometimes outright impossible; political - it assumes that most of the investors involved aren't American anyway.

Neither reason applies to Taro. It is run from the U.S., which is the country responsible for 87% of its revenues. Also, the class action plaintiffs are claiming flawed revenue recognition regarding sales in the U.S. alone. Investigating that should be no different from looking into any American company.

The second reason doesn't apply either, because Judge Richard M. Berman of the U.S. District Court of the Southern District of New York recently ruled that the lead plaintiffs will be the International Union of Painters and Allied Trades Industry Pension Funds, and Locals 302 and 612 of the International Union of Operating Engineers-Employers Construction Industry Retirement Trust. Blue-collar painters and builders, salt of the earth.

If the investigation by Lerach et al finds convincing evidence of fraud, the SEC is not likely to sit about twiddling its regulatory thumbs while American blue-collar workers struggle desperately to save their pensions.

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