The 2 Likely Reasons Valeant Pharmaceuticals Surged by as Much as 15%

By Sean Williams Markets Fool.com

What happened

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Shares of Valeant Pharmaceuticals (NYSE: VRX), an embattled drug developer whose primary method of growth over the past couple of years has been via acquisitions and price hikes on its therapies, surged as much as 15% on Thursday for their third consecutive day of strong gains. The stock was up a more modest 9% as of the closing bell.

The likely culprits for this move appear to be carryover from its Tuesday morning earnings release and possible short covering.

Image source: Getty Images.

So what

On May 9, Valeant reported $2.11 billion in sales, which was down from $2.37 billion in sales in the year-ago period. However, a number of positives jumped to the forefront that really got investors excited.

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For starters, Valeant announced that it reduced its debt by another $1.3 billion during first-quarter 2017 and that its total reduction since it began taking debt reduction seriously is $3.6 billion. The $1.3 billion reduction in the first quarter is a direct result of its sale of three medicated skincare products to L'Oreal for $1.3 billion. Cash on hand and operating cash flow were also used to help reduce debt during the quarter, though to a far lesser degree.

Valeant also increased its full-year earnings before interest, taxes, depreciation, and amortization (EBITDA) forecast modestly to a fresh range of $3.6 billion to $3.75 billion. This was up $50 million on the bottom and top ends. EBITDA is of particular importance to investors since it's the measure that Valeant's secured lenders monitor to ensure that the company is generating enough earnings to service the interest on its debt.

We also saw modest constant currency growth of 4% in the Bausch & Lomb brand. For those who may not recall, Bausch & Lomb sales fell 1% in the fourth quarter, but Valeant's management predicted strong mid- to upper-single-digit sales growth for the brand in 2017.

And how can we forget the $908 million tax benefit that helped the company end a five-quarter streak of losses.

In addition, Valeant recently had as many as 47 million shares held by short-sellers (i.e., investors betting against Valeant). With its earnings report lighting a fire under the stock, these short-sellers may have been forced to sell under the weight of steep losses, further fueling Valeant's rally when they covered their positions.

Image source: Getty Images.

Now what

Though it's another great day for Valeant, the company still has a number of big questions to answer.

For instance, although it's been able to reduce its debt via asset sales, it's not made much headway in lowering its debt organically (with its operating cash flow). It certainly can't sell businesses forever, nor has it had much success in doing so. Many of its peers are aware of its current predicament, and they've mostly been unwilling to pay a premium for its products to this point, which is a concern.

Valeant's EBITDA-to-interest coverage ratio also continues to fall. Based on the $861 million in EBITDA it generated in the first quarter and the $471 million it paid in net interest expenses, this works out to a 1.83-to-1 ratio. A year ago, this ratio was around 3-to-1. The lower this ratio goes, the more danger Valeant could be in with regard to violating its debt covenants with secured lenders.

There are also few indications how the company will turn around its Branded Rx segment, where sales again fell 9% in first-quarter 2017 after a 17% tumble in fourth-quarter 2016. This is a segment that Valeant estimated could deliver 2% to 5% sales growth in 2017, and right now it's looking to be a mile off that prediction.

Valeant's management team certainly has its work cut out for it.

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Sean Williams has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. The Motley Fool has a disclosure policy.