Valeant Pharmaceuticals Is Dangerously Close to Violating its Debt Covenants
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When it "less bad" news actually good? When we're talking about Valeant Pharmaceuticals (NYSE: VRX), of course, whose valuation had fallen a mind-numbing 91% from its all-time high through Monday's close. That all changed on Tuesday, when Valeant reported its second-quarter earnings results.
Valeant surges following a "less bad" quarter
For the quarter, Valeant announced that it generated $2.42 billion in sales, an 11% decline from the prior-year period, and $1.40 in adjusted EPS. Comparatively, both figures missed Wall Street's expectations, which had called for $2.46 billion in revenue and $1.48 in adjusted EPS. However, Valeant stood by its full-year profit forecast that it had previously issued of $6.60 to $7 per share in adjusted EPS. Mind you, Valeant's mid-March view had called for a midpoint of $9 in EPS, and in mid-December it had expected a midpoint of $13.50 in adjusted full-year EPS. The simple fact that Valeant didn't slash estimates once more has shareholders encouraged.
Also exciting for investors is that Valeant finally stopped talking about possible asset sales and began moving some of its non-core assets off the table. Valeant's business development update within its second-quarter earnings release points out that it divested its North American commercialization rights to hereditary angioedema drug Ruconest for an upfront payment of $60 million and sales-based milestones that could land Valeant an additional $65 million. Including the divestiture of its EU rights to brodalumab, and its Synergetics USA OEM business, Valeant raised $181 million in upfront cash in Q2 and could receive up to $329 million more if certain sales-based milestones are reached.
Holding firm on its guidance and announcing these non-core asset sales shot Valeant's share price higher by 25% on Tuesday.
But all is not what it seems. While I'll give credit where credit is due, Valeant is still in a lot of trouble, and it all begins with the company's massive debt load.
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Valeant's debt spiral
Valeant Pharmaceuticals ended Q2 with $30.77 billion in debt, up more than $500 million from where it ended fiscal 2015, and just $852 million in cash and cash equivalents, a $255 million increase from Dec. 31, 2015. That's essentially $30 billion in net debt, and it's crippling Valeant's ability to maneuver and operate as a company.
As a refresher for those who may not have followed Valeant's fall from grace, the company has predominantly grown in recent years via mergers and acquisitions and price increases. Recently, U.S. lawmakers have been critical of Valeant's drug-pricing decisions, causing the company to lose much of its pricing power, as well as its ability to continue to borrow to fuel growth. The result is declining profits, falling EBITDA, and dangerously high debt levels.
For its part, Valeant Pharmaceuticals and its relatively new CEO Joseph Papa, who manned the helm at over-the-counter drug giant Perrigo for a decade, have pledged to sell assets to reduce its debt load. Valeant expects, over the next 12 to 18 months, to move non-core assets that generate about $2 billion in annual revenue. These assets are expected (key word here) to generate a cumulative transaction value of $8 billion, or 11 times EBITDA. Allowing Valeant to keep its core assets, such as Bausch & Lomb and Salix Pharmaceuticals, would keep the all-important growth aspects of Valeant firmly in place, while also allowing the company to address its seemingly unsustainable debt levels.
The above figures from Valeant are probably a perfect-world scenario. Valeant is far from living in a perfect world. Its peers fully understand the direness of its debt situation, and I find it unlikely that they'll be willing to get into a bidding war, or pay top dollar, for assets from a company that appears desperate to raise capital.
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Valeant is dangerously close to defaulting on its debt covenants
But the company's debt is far bigger concern than most investors probably realize.
Earlier this year, Valeant failed to file its annual report (and subsequently its first-quarter earnings report) on time. Being late with its financial filings while having $30 billion-plus in debt was a recipe for its debt holders to file notices of default. Valeant did wind up making nice with its debtholders, but the amendments made to its loans cost the company in the process.
In April, Valeant agreed to pay a fee of $50,000 for every $10 million in loans it had outstanding with lenders, and to boost the interest rate paid on its loans by one percentage point. If Valeant hits certain financial milestones this increase in its interest rate could fall. More importantly, the deal allowed for a lowering of Valeant's debt covenant restrictions. Before the deal, Valeant had to generate at least three times more EBITDA than its annual interest costs on debt to satisfy debtholders. Under the new terms, this ratio dropped to 2.75-to-1, giving the company more breathing room.
According to Valeant's Q2 report, the company is on track to generate between $4.8 billion and $4.95 billion in EBITDA in 2016. However, it paid $896 million in net interest on its debt through the first-half of the year. Extrapolating out these interest payments, Valeant could border on $1.8 billion in net interest expenses in fiscal 2016. If EBITDA comes in between $4.8 billion and $4.95 billion, we're looking at an EBITDA-to-interest cost coverage ratio of 2.67-to-1 on the low end to 2.75-to-1 on the high end. In other words, even with Valeant standing by its forecast and filing its financials in a timely manner in Q2, it's dangerously close to being in violation of its debt covenants.
Valeant may be able to work out more favorable covenant terms with its lenders in the coming weeks or months since its lenders would rather ensure they get repaid than have Valeant default on its debt and not pay. However, there are no guarantees that Valeant will be able to further restructure its covenants, which would be bad news for Valeant and shareholders.
Furthermore, while selling assets will help reduce the company's debt load, it also, presumably, reduces EBITDA. If Valeant doesn't sell the right assets, it could actually reduce its debt load without making a dent in its EBITDA-to-interest cost coverage ratio.
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Valeant's underlying business model is struggling, too
Valeant Pharmaceuticals' underlying business model is mostly struggling as well. Though Valeant reported 10% sales growth in emerging markets, along with a 10% sales improvement in gastrointestinal drugs, the company's dermatology sales plunged 55% year over year.
At the heart of this plunge are Valeant's struggles with its new long-term drug distribution partner Walgreens Boots Alliance. Valeant has noted that the deal, which it expects to be a long-term catalyst, has resulted in some scripts filled at a loss, with reimbursements pacing well below expectations, especially within its dermatology products segment. Fixing this is a priority for both Walgreens and Valeant, but it also isn't an overnight affair. It could be multiple quarters before dermatology sales stabilize and begin heading in the right direction.
Although Wall Street is applauding Valeant's quarter, I'm still not too impressed. Valeant has pressing debt issues and a business model that's retreating instead of growing. With management's hands tied and divestments the company's only real strategy to improve its balance sheet, I'd have to urge investors to continue to keep their distance from Valeant Pharmaceuticals.
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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.
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