Valeant's Numbers: Are They As Good As They Seem?
Worry that Valeant Pharmaceuticals (NYSE: VRX) could struggle to pay back debt has made its stock one of the market's worst performers since 2015. However, its shares have rocketed higher this month after management increased its full-year EBITDA guidance. Does this new guidance suggest Valeant Pharmaceuticals will soon be back to its winning ways?
In this clip from The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by Todd Campbell to discuss Valeant's past struggles, its current guidance, and what investors should really be paying attention to when it comes to this company.
A full transcript follows the video.
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This video was recorded on May 17, 2017.
Kristine Harjes: Todd, which one do you want to start with?
Todd Campbell: Let's start with Valeant, because of the two, that's the one that's been beaten up most. If you've been an investor in Valeant, you're probably looking at this stock and going, "Oh, boy, what's he going to say next?" The stock has gone from about $260 to around $13 per share. But it dropped below $10 or something like that. It's been tough sledding for the stock, and there's a lot of reasons, we covered it before, Kristine, on the show. As a refresher, there was a lot of push-back regarding pricing decisions that they had made in the past that led to scrutiny that led to the closure of their specialty distributor. Push-back as a result of that and declining sales volumes has caused income to drop, and as a result, there has been a lot of fear that they might have a hard time paying off their debt load. So heading into the first-quarter earnings results, a lot people were watching to see what management would say, and see if they provide some indication that the corner is turning.
Harjes: By the reaction the market had, it seemed like people were pretty happy with their earnings, which they released on May 9. The stock is up 40% since they released those earnings. On the surface, the headline was pretty good. They had their first profit that they posted in six whole quarters, but there's kind of an asterisk there where they reported a GAAP net income of $628 million, but that was almost entirely due to this one-time tax benefit of $908 million, which was attributed to non-cash internal restructuring. So they're fudging the numbers a little bit, not in a nefarious way, but there's a huge difference for this company between their GAAP numbers and non-GAAP numbers.
Campbell: Right. You almost have to be a CPA to be able to dig in here and figure out what's going on behind the scenes, to have to reconcile the GAAP versus non-GAAP, and figure, quarter for quarter, what is going on with the company. You mentioned that they'd reported top-line GAAP profitability. As you've said, that was all due to this one-time benefit from this tax item, so don't count on that going forward. You have to X that out. Revenue, the top line, did fall again. It was down 11% to $2.11 billion. So you still have deterioration in the top line, and we'll get into why in a minute. But without a doubt, Kristine, if you were a shareholder going into earnings last week, right now you're smiling a lot bigger than you were last week, especially if you were one of the fortunate ones to have been able to pick this thing up at the low.
Harjes: Right, indeed. This is something where, I guess, if you timed it correctly, you could have made quite a profit. But I do imagine that the vast majority of shareholders are still sitting on a pretty big loss here.
Campbell: I think that's probably true. Unfortunately for those long-term investors who have ridden the stock down, when I dug into the numbers and started really going through the puts and the takes here on balance, I had to walk away a little bit unimpressed. Their crown jewel is Bausch + Lomb. That's their biggest segment. It does $1.1 billion roughly in quarterly sales. But that crown jewel gained no ground year over year. Sales were essentially flat on a reported basis. Sure, if you back out currency, operational growth was 4%. But currency is something that these international companies deal with quarter after quarter. The reality is, sales for Bausch + Lomb were flat. And if you dig a little bit deeper, U.S. volume for Bausch + Lomb declined and was offset by some emerging-markets overseas growth. So Bausch + Lomb, we'll call it a push for the quarter. Branded Rx, sales continued to drop there, fell 9% to $604 million. Then, because of generic competition and some pricing woes, their U.S. diversified business got absolutely clobbered. Sales fell 37% year over year to $355 million. Unfortunately, the threat of generics is not going away -- this is going to remain a headwind for this company over the coming year.
Harjes: Right. Pricing is going to be a huge issue for them, because of all the bad publicity that they got way back in 2015, when this whole controversy started about their cardiovascular drugs that they boosted the prices on by hundreds and hundreds of percents. They kind of can't do that anymore, and that was a big part of how they were making money. So now, when you look at their portfolio, a lot of drugs are either hit or about to be hit by patent expirations, and they don't really have the option anymore of raising prices to compensate for lower volume.
Campbell: Yeah. So we have a situation where we have a company that's still seeing a lot of pressure on its top line. There was a little bit of evidence of some price stability in branded Rx, to be fair. So that's somewhat good news. But on balance, you look at this, and it's like, this wasn't that great of a quarter. Why on Earth is the stock up 40%-50% since the report?
Harjes: Yeah, and I know you have an interesting theory about this.
Campbell: Yeah. It's really all tied to the size of the short position, in my view, and a $50 million bump-up in its guidance for the year in EBITDA.
Harjes: Right. Let me take the latter thing you just said and expand on that a little bit. People are very concerned that Valeant is going to default on its debt. It has a humongous debt load, and for a long time, it's been kind of unclear whether or not they would be able to meet this debt. So when they say they are going to up their EBITDA guidance, that is a great thing for people that are concerned about the debt. So when you trace that back to the first thing you said, which was the short position, that is where you start to get people potentially exiting their shorts.
Campbell: Yeah. Again, as a refresher, if you're going to short a stock, you're borrowing from your broker, you'll selling it with the hope of buying it back cheaper and then replacing the shares that you borrowed. So as a stock rallies and people who have sold it short see that happening, you end up getting a domino effect where, "Oh, it's rallying, I have to cover, now I have to cover, and I have to cover." If you look at the short ratio, which is simply the percentage of shares that are sold short toward the shares that are out there that can trade, it was at a record high leading up to the earnings. A record high.
Harjes: Right, 15%.
Campbell: Yeah. So it wouldn't take a lot to move the needle here. And it really didn't. The bump up in EBITDA guidance was $50 million. They went from basically guidance of 3.5%-3.65% to 3.6%-3.75%, a $50 million improvement. But, again, the big thing here is the debt. They have over $30 billion in debt. They've knocked about $3 billion off that. That's good news, because what that does it is it, theoretically, improves their interest coverage ratio. And now we're getting really wonky.
Harjes: It's a wonky company.
Campbell: Yeah. When you have all these creditors, they want to know they're going to be paid back. And one of the ways they do that is calculate your interest coverage ratio, which is simply EBITDA divided by interest expense. So you have debt, you're paying interest expense on it. Are you generating enough EBITDA to cover that interest expense? Typically speaking, if you get below 2-to-1, it starts to get you a little bit nervous.
Harjes: Right. At the end of Q1, they were at 1.83, which is below that 2 threshold, but it is above what their newly renegotiated level is, which is 1.5, which is what their lenders need to see.
Campbell: Wow. There are so many rabbit holes we could chase here. They had to renegotiate a lot of these covenants lower because they were going to run into a risk of default, because they weren't going to make the 2-to-1 ratio. So you had various ratios that range from 3-to-1 and 2-to-1. They've knocked those ratios down to 1.5-to-1, so they're still OK. And by bumping up the EBITDA guidance, that led people to believe, if EBITDA improves, then it's less likely that creditors are going to end up knocking at the door demanding payment, because that interest coverage ratio falls below the threshold. It gets even more complex than that, though, Kristine, because you have to look at where that EBITDA improvement is coming from. And frankly, I'm not convinced that's it's coming from a material improvement in the business.
Harjes: Right, and that's really what it comes out here, to bring it back to a little bit of a higher level -- this is a company that needs to find a way to come up with money. They need to service their debt. They can do that by having a better top line. We've already dug into the different business segments, and it's questionable whether or not they'll be able to do that in any significant way. Or, their other option is, they can sell some of their assets. But everybody else out there that could be a potential buyer for these assets knows exactly the situation that Valeant is in, so they're not going to pay a premium for some of these assets. Then you get hit with a double whammy, if you're Valeant, of, I'm trying to get a good price for some of my portfolio. In order to get a good price, you need to sell the best stuff, and that's exactly the stuff that's going to bolster your top line.
Campbell: Right. And Kristine, just to make things even worse for them, that has a negative impact on EBITDA. So you have to make sure you're paying off enough debt to lower your interest expense, at the same time you're selling these things that are generating out earnings. And one of the concerns I have going forward here is, they're selling one of their prized assets, Dendreon, which makes a prostate cancer drug called Provenge, they're selling that later this year, and their EBITDA guidance, it says right in the report that it doesn't include that sale in its calculation.
Harjes: Right. So take out the sales from Provenge, and all of a sudden you get EBITDA lower.
Campbell: Right. You say they paid down $3 billion in debt, so their interest expense has to be falling. But because they had to renegotiate all of these deals, they're ending up having to pay more in interest. So you shaved $3 billion off your debt, but at the same time, your interest expense actually went up year over year. Now, eventually, hopefully, if you look at the maturities on the debt, they're pretty manageable until about 2020. But you have a lot of issues here, and I think it's maybe a little bit premature for investors to look through that report, see shares running, and say, "Oh, OK, the corner has turned and the stock is going to go back to $100."
Harjes: And it would be easy to do so, too, because by almost every metric, this is a very cheap stock. It's really just gotten clobbered by the market. But after having this discussion, hopefully it's pretty clear to our listeners that it's kind of for good reason. This could be a turnaround story, but personally, I don't think I would sleep at night if I bought shares of this company.
Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. The Motley Fool has a disclosure policy.