Stock Doping

Stock Doping
By Karl Thiel (TMF Breaker Thiel)
February 17, 2006

I was interested to read the other day that U.S. skier Zach Lund was suspended from the Olympic games after testing positive for finasteride (the active ingredient in the Merck drug Propecia). Is this some new performance-enhancing chemical? Hardly -- it's meant to slow or reverse hair loss, which, apart from whatever boost in confidence the user might get, is not exactly an athletic edge. In fact, if it worked too well, the extra wind drag might actually slow you down.

But it does have a more nefarious use -- it can mask the presence of steroids in the body and is thus on the International Olympic Committee's list of banned substances.

Welcome to the world of sports doping. The desire to win can sometimes push aside considerations of ethics, fair play, and even good health. While it seems that Lund was unaware that the finasteride in his Propecia was a banned substance (um ... check the list, Zach, it's kinda important), others will knowingly take chemicals that give them an edge and then take still more to mask the fraud. Sounds like some companies I know.

If there's anything with a more powerful pull than athletic fame and glory, it's the almighty dollar. So inevitably, some companies will try to boost their income statements with a liberal dose of steroids, then gulp some finasteride in hopes of covering the whole thing up. Before you award a company the gold with your hard-earned investment dollars, be sure to check for stock doping.

Don't touch that dial!
Bristol-Myers Squibb (NYSE: BMY) was accused of an insidious form of stock doping in 2000-2001, when the SEC sued the company for inflating sales by "channel stuffing" -- pushing product to its wholesalers ahead of demand in order to meet quarterly and yearly revenue goals. The company didn't admit to any wrongdoing but settled with the SEC anyway and paid a massive $150 million fine.

By itself, this strategy can only create a short-term gain, boosting current accounts receivable or revenues (depending on how the company accounts for product that goes out if its doors) at the expense of future sales. (Hint: If accounts receivables are accelerating much more quickly than revenues, channel stuffing is a potential culprit.)

The metaphoric finasteride came into play in that BMS agreed to cover its wholesalers' carrying costs for the excess inventory and guarantee them a return on investment until the goods were sold.

In fact, if you study the drug wholesalers, you'll quickly get the idea that inventory and pricing games have long been a part of the way business gets done. Companies like McKesson (NYSE: MCK), Cardinal Health (NYSE: CAH), and AmerisourceBergen (NYSE: ABC) have traditionally made a percentage of their revenue by arbitrage -- buying a lot of drugs before a price increase and then selling them at a markup after the manufacturers raise prices.

By itself, this is not illegal, and I'm not by any stretch alleging that these companies are on the wrong side of the law. (I want to distinguish this from arbitrage in the secondary market -- purchase of overstocked or discounted drugs from third parties -- which the major wholesalers sometimes engage in but which has also been occasionally linked to reimportation or mislabeled/counterfeit drugs and, in such cases, is illegal.)

The line gets blurry here between channel stuffing and, um, let's call it channel gorging on the part of the wholesalers. It was a dance carried out on both sides for mutual benefit. It could even be argued that it helped consumers by giving wholesalers the flexibility to offer discounts to their retailers and thus help control drug prices.

The losers were investors trying to follow these businesses. When it came to drug wholesalers, the traditional model was to charge a percentage of goods shipped and to bundle a whole lot of services -- like packaging, inventory analysis, distribution, and more -- for free. That made the financial statements a bit of a black box. From a wholesaler's perspective, after all, a "rebate" for buying inventory you don't need is a cash flow unrelated to any actual sale. And these generally aren't broken out on the financial statement.

In the past year, drug wholesalers have been shifting away from this model. Whether they're to be applauded for this or not I leave up to you. The fact of the matter is that large retailers with increasing clout are putting pressure on the wholesaler's already thin margins. Bristol-Myers Squibb's channel-stuffing scandal -- including a $150 million fine from the SEC -- has apparently had a bit of a chilling effect on the rebate/discount/price hike model on the other end. Thus, wholesalers are increasingly turning to "fee-for-service" pricing of their add-on services -- which are often more profitable than the core distribution business.

Theoretically, that means less stock doping, more transparent financials, and investors who are better off, although the major wholesalers like McKesson still subtract rebates from the cost of inventory and recognize them as goods sold without specifying the amounts.

I needn't pick on merely Bristol-Myers Squibb, which has had a change of management since these past events, or the major wholesalers, which have done nothing wrong as far as I know. Just last month, McAfee (NYSE: MFE) finally settled charges relating to (among other things) channel stuffing that dated back to its days as Network Associates. The issue cuts across industries.

At the sophisticated end of things, well-coordinated channel-stuffing schemes can be hard to detect. Even at the more ham-fisted end of the spectrum, there's always a question of what is just aggressive sales, what simply falls into accounting gray zones, and what crosses the line. Sales that come late in the quarter shouldn't necessarily send you into a 'roid rage -- an SEC investigation into alleged channel stuffing at beleaguered stun-gun manufacturer Taser (Nasdaq: TASR), for instance, concluded just this past December that no enforcement action was warranted, despite some suspicious last-moment fourth-quarter 2005 sales.

Foolish bottom line
The best advice for investors is to follow the money. If you're sizing up a company, don't just stop at its financial statements. If possible, look at how the money flows through its customers and distribution channels. Look at accounts receivable. Look at days sales outstanding. Then you'll have a better idea of whether what you're looking at is a company on steroids.