You are on page 1of 6

Comparative Financial Analysis A comparison of Biovail's earnings release against income statements of two competitors (Abbott Laboratories and

Cephalon) highlights several performance areas requiring managerial attention. In addition to confirming soft product revenues, low investments in internal development, and the failure to report foreign exchange losses, the analysis reveals the following:

Biovail's amortization and write-down of assets represented 21.4% and 13.1% of revenues for 2001 and 2002 respectively. More than double its competitors', these values indicate a form of expensing substantial acquisition costs and a high level of recognized losses in tangible or intangible assets. Earnings per share are lower than the competitors' EPS from 2001 to 2002, giving Biovail's investors yet another reason to be concerned about their investment returns. The company's cost of goods sold is rising at a greater rate than its product sales, indicating that earnings per unit sold are going down. While internal development costs fell to only 6.6% of sales, acquired R&D expenditures reached 21.3% of annual revenues in 2002, significantly higher than that of the competitors included in the analysis. Biovail's records do not report that any dividend payouts have been made to investors. Total operating expenses nearly doubled from 2001 to 2002, fueled by the large R&D acquisition expense and the growth of sales and administration costs by over 50% (for product revenue growth of only 23.9%). As a result, operating earnings fell by nearly 20% during that timeframe, while net earnings remained flat.

It is worth noting that although the company was criticized for reporting an unsustainably low tax rate, the competitors used for comparison also reported equally low tax rates against earnings. Biovail's Current Performance Looking at Biovail's own financial records and trends for the 2006 to 2007 period, the following conditions exist:

Product revenues are falling, while cost of goods sold continues to rise. Internal R&D is up to 14% of sales, and no acquired R&D investments are reported. SGA expenses, while still 19% of revenues, were reduced by a third during 2007. This savings contributed to an overall reduction of operating expenses by nearly
1

8%.

The drop in operating expenses did not compensate for lower sales, so both operating and net earnings showed a dramatic year-to-year drop of 35% and 9% respectively. Net earnings fell by less than operating earnings due to favorable foreign exchange rates and the reduction of debt-related and amortization expenses in 2007. Despite criticism of an already low tax rate, Biovail's most recent taxes on earnings have surprisingly fallen below 2% (to a 2006 low of 1.4%).

The profitability ratios provide a picture of how well the company's assets and shareholder equity are working to generate profit and should be compared to alternative uses which might generate profits greater than 10% and 13% respectively. Although they have dropped, Biovail's liquidity ratios remain strong, with one exception. The extent to which the company's working capital is tied up in inventory has risen due to the significant drop in current assets reported in 2007. The company's leverage ratios all show strong improvements from 2006 to 2007, indicating that efforts to reduce debt and strengthen the ability to meet debt obligations have had a substantial impact over the past year. Other indicators of operating performance include the effectiveness with which the company uses its assets. While still at an acceptable level, each of these variables has dipped since 2006. In addition, the average collection period for receivables has increased by 3 days from year to year, showing reduced effectiveness in collecting payments for completed sales. Importantly, Biovail's increased price-to-earnings ratio shows that market perception of the company has improved, despite a significant drop in cash flow per share. Strategy Formulation Corporate Governance As of February 2008, Melnyk no longer holds an affiliated role with Biovail or any of its subsidiaries. Since Melnyk's retirement from the board of directors in 2007, Dr. Douglas Squires has served in the role of Executive Director. He has been on the board since 2005. William Wells has been appointed CEO by the Compensation, Nominating and Corporate Governance committee. It falls upon these new leaders to assure the investment community that the company's past conduct will not be repeated in the future. By adopting and committing to an acceptable set of corporate values and by using corporate governance mechanisms, Biovail has an opportunity to
2

manage and improve its relationships with stakeholders. Managerial interests can prevail when governance mechanisms are weak, and opportunistic behavior is more likely when leaders have a significant amount of autonomy to make strategic decisions. The separation and specialization of ownership and managerial control can maximize returns for owners, but requires the proper monitoring of managers. And the diffusion of ownership across a large number of shareholders with small holdings produces weak monitoring of management decisions. Assuming that this is the case at Biovail, the company's board of directors must take adequate measures to deter managerial opportunism. To earn the trust of investors, Biovail's board of directors needs to be more forceful in its oversight role, control managerial autonomy, and establish strong governance mechanisms so that the company's strategies better reflect shareholder interests and maximize returns on their investments. To strengthen its ability to monitor and control management decisions and behaviors, Biovail should reduce the percentage of board members drawn from the internal pool of top executives. Directors chosen from active top-level managers inside the organization have a propensity to be influenced by former peers and lack the independence necessary to best represent shareholders. As founder of the company, Melnyk possessed an elevated level of dominance and was able to use concurrent positions of CEO and chairman to appoint sympathetic board members who would continue to allow unfettered control of company actions. Keeping the CEO role separate from that of the chairperson can overcome this threat. And installing impartial outside directors offers an external perspective to compliment internal knowledge. Thoughtfully managing the degree of ownership by directors will also promote independent oversight of strategic decisions, and strengthening internal management and accounting control systems will improve the effectiveness of Biovail's board of directors. One of the greatest sources of power for directing the company is the board's control of reward systems for top managers. Properly formed, the Compensation, Nominating and Corporate Governance committee can retain independence of action, make strategically-based appointments to fill key leadership positions, and align the interests of managers and owners through salaries, bonuses, and long-term incentives. Compensation of directors and executives alike can promote behaviors which maximize benefits to shareholders, especially when the use of stock options is reduced or eliminated altogether. Fraudulent behavior is linked with stock option incentives held by board members and managers who are in a position to take actions which influence stock values for short-term gain. Although designing executive pay packages to align with shareholder interests is complicated by a variety of interrelations and uncertainties, long-term performance-based compensation is the best incentive for top managers to make decisions which will meet shareholder expectations and increase the value of the firm. Again, the use of stock options is
3

discouraged. Organizational Controls Formal operating procedures direct patterns of organizational activity. Where significant responsibility and authority lie in the hands of top management teams, control mechanisms encourage and support ethical organizational behavior and enhance strategic competitiveness. Organizational controls guide the use of strategy, indicate how to compare actual results with expected results, suggest corrective actions to take when the difference is unacceptable, and determine the appropriate amount of managerial discretion to allow. They are necessary for achieving desired outcomes, and when properly designed, provide clear insights regarding behaviors that enhance firm performance. Using both strategic and financial controls yields a path for future viability as well as financial stability and wealth creation for investors. Strategic controls. Top level managers are charged with the formulation and implementation of the company's strategies. Strategic controls will aid in determining if the company is using appropriate strategies matched to external conditions and internal capabilities. Adding strategic measures of success along customer, internal process, and developmental lines enriches the process of monitoring performance. Financial controls. Demonstrated by the financial analysis above, financial controls are used to evaluate performance against previous outcomes as well as against competitor performance and industry averages. To facilitate oversight, many sophisticated software tools are now available which can automate the processes needed for executive and financial officers to analyze performance results, insure compliance with policies and regulations, and certify corporate financial records. Strategic Leadership Effective leadership is the foundation for any organization's strategic success. Good leaders have the ability to anticipate, envision, maintain flexibility, execute plans through others, and lead in complex and uncertain environments. A transformational leadership style is most effective for motivating employees to exceed expectations, continuously enrich their capabilities, and to place the values and interests of the organization above their own. Rather than using its management ingenuity to manipulate perceptions, it is imperative for Biovail's top managers to create goals that guide and stretch members of the organization to continually improve performance. At present, these goals must include increasing product revenues and achieving continued downward pressure on operating expenses. Using a management team to make strategic decisions helps prevent problems which come from excessive CEO decision-making autonomy. As the company learned during Melnyk's tenure, the overconfidence and limited checks associated with CEO duality lead to harmful strategic decisions. Similar to the value of a mixed
4

board composition, a heterogeneous top management team expands the knowledge base and resource pool. It can provide a broader range of perspectives to enhance decision making, so long as it does not stray so far away from an understanding of core functions and business needs. And, as discussed above, the company needs an independent board structure to enhance its ability to positively affect strategic direction and oversight. Organizational Culture Not only in reaction to external scrutiny, but with a sense of ethical obligation, Biovail must recognize that a change in organizational culture is needed to instill integrity and ethical behavior throughout the company. Ethical practices must be an integral part of organizational culture to shape the firm's decision-making processes and to properly influence employee judgment and behavior. Promoting a value-based culture is the most effective means of ensuring that employees comply with the firm's ethical requirements. It depends upon top-level support and the placement of people in key roles who demonstrate that they embrace the desired values. Opportunistic behavior is more likely when expectations regarding ethical behavior are lax, but leaders will integrate ethical values of the organization into their decision making and behavior when the company has explicit ethics codes which have been incorporated into the business through extensive training. A change in organizational culture is difficult to achieve, but has a greater likelihood of success when the following actions are taken.

Establish and communicate specific goals to describe the firm's ethical standards and practices. Receive and integrate input from employees and stakeholders to continually shape the code of conduct. Develop and implement procedures to achieve ethical standards. Create and employ explicit reward systems which measure achievement of goals which are linked to new core values. Provide the safe means for reporting ethics violations that are suspected or observed.

The strategic decisions managers make are non-routine, have ethical implications, and significantly influence the company's ability to earn above-average returns. Biovail can certainly learn from its mistakes and past failures. Difficult managerial decisions can be improved by reducing uncertainty, complexity, and internal conflict. The analysis above provides strong recommendations for Biovail to move the
5

company forward, improve its reputation in financial markets, and meet shareholder expectations. Biovail needs to accept the findings of the regulatory authorities and to settle claims with shareholders for the calculated liability. The situation is on track to be determined by the courts, and however it is resolved, the company will suffer. Biovail is going to have to take the hit -- bottom out if necessary -- before it can rebuild. The fastest and most positive approach is to negotiate an agreement with shareholders. (In fact, Biovail may be able to preempt a lawsuit by communicating directly with the shareholders.) A forthright approach and full disclosure to shareholders will signal the organization's intent to "turn the page". Proactively accepting responsibility and making good with investors is also a sign of the company's new emphasis on fiduciary and ethical values. Future earnings releases should be based on GAAP statements. The company must learn to accept the consequences of its true successes and failures. In good part, it was the company's inability to meet earnings forecasts which yielded the unsavory behavior by Melnyk and his peers. So, it is important to establish realistic earnings expectations to remove the pressure to issue false and misleading statements about the state of Biovail's business. Successful implementation of strategic recommendations includes the suggested changes in human resource policies, leadership style, control systems, and shared values. And the importance of an effective board of directors cannot be overstated. Finally, there is a high level of trust required in companies responsible for products related to customer health. The public's perception is as important as the investor's. Shareholder value is reflected by the company's stock price, which is a measure of investor confidence in the company's management direction. But market value is reflected in product sales, which are the lifeblood of the organization.