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In the National Football League, we have "Deflategate" as the controversy that simply refuses to go away. In the stock market, we have the soap opera-like saga of Valeant Pharmaceuticals (BHC 0.35%), which in less than a year has seen its market valuation wither from about $90 billion to just $7.4 billion, a six-year low, as of Wednesday's close.
The embattled drug giant, which has grown throughout the years primarily through acquisitions and inversions, has seen its business model put in jeopardy by two key problems.
Valeant's problems, in a nutshell
First, Valeant Pharmaceuticals' pricing practices came under heavy fire following privately held Turing Pharmaceuticals' purchase of toxoplasmosis drug Daraprim in August, and its subsequent 5,500% price hike the following month. If the name sounds familiar, that's because it was formerly run by the "Bad Boy of Pharma" himself, Martin Shkreli.
While Valeant wasn't exactly raising the price of drugs it acquired by 5,500%, it has been known to drive its top and bottom line by increasing the prices of drugs it acquires. Case in point: Cardiovascular drugs Nitropress and Isuprel, which Valeant increased by 525% and 212% in price following their February 2015 acquisition. Long story short, Valeant's pricing power has been called into question, and regulators are observing its pricing practices very closely.
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The other issue for Valeant is its enormous debt load, which has stymied any efforts the company has of expanding its product portfolio. The company's $31.3 billion in debt is a result of its aggressive M&A that allowed it to acquire franchises such as Bausch & Lomb for $8.7 billion and Salix Pharmaceuticals for $11 billion.
Unfortunately, since September we've learned of improper revenue recognition totaling $58 million between Valeant and its now-former drug distributor Philidor Rx Services that resulted in a delayed annual report filing, and a late first-quarter filing. These late filings triggered debt default notices from Valeant's secured lenders, who've begun to worry about the safety of their loans. Valeant wound up working out new covenants with its secured lenders before filing its annual report at the end of April.
This duo of woes has left Valeant with little choice other than to consider selling off some of its core assets, or spinning off key business components, to reduce its debt to manageable levels.
Valeant could be one quarter away from a debt default
Wall Street's focus since Joseph Papa took the helm at Valeant after stepping down from his leading role at over-the-counter pharmaceutical giant Perrigo is trying to figure out what combination of assets Valeant will sell or spin off to make its debt situation more manageable. However, many on the Street could be missing the more immediate issue: Valeant's debt covenants.
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Valeant's lenders gave the company money in return for it paying interest and maintaining certain financial requirements. These requirements are put in place so the lender feels comfortable about getting repaid. Think of it this way: You probably wouldn't give your friend a $10,000 loan if he or she could repay only $100 a month, and lenders don't want to lend out their money if there's a good chance they won't collect.
When Valeant first began going into debt, it was healthfully profitable and had relatively low annual interest costs. Nowadays, Valeant is on pace to pay around $1.7 billion in annual interest expenses. Originally, Valeant's debt covenants required the company to stay above three times EBITDA-to-interest costs, which has previously been pretty easy for Valeant to do. However, with its growth stymied by probes, and additional credit closed off to make acquisitions, Valeant has pulled back the midpoint of its fiscal 2016 sales by about $2.6 billion over the past six months and reduced the midpoint of its EPS by nearly 50% to $6.80. Ultimately, this has pushed its EBITDA forecast for 2016 down to about $5 billion, give or take $100 million.
When Valeant renegotiated with its secured lenders a few months prior, it agreed to add fees and higher interest rates onto what it already owed. In return, its EBITDA-to-interest cost coverage was reduced from 3-to-1 to 2.75-to-1. Based on its recently reduced guidance, Valeant's EBITDA-to-interest coverage is down to about 2.94-to-1 after coming in at 3.3-to-1 in 2015. In other words, one more bad quarter that results in a downside earnings revision could put Valeant back into default of its debt covenants (including the $1.6 billion tranche due in 2018) regardless of whether it files its quarterly reports on time.
Selling assets may not help, either
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Making matters worse for Valeant, selling its assets may not help. Selling assets would allow Valeant to retire debt, which would reduce its interest cost and presumably allow it to gain a healthy EBITDA-to-interest cost buffer. However, selling off its assets also means a reduction in EBITDA, meaning Valeant may not see much of an improvement in this ratio at all, especially if it parted ways with its core assets, such as Salix or Bausch & Lomb.
Furthermore, I find it unlikely that Valeant would recognize anywhere near fair value for the assets it wants to sell. Its peers are well aware of Valeant's debt woes and are therefore less likely to getting into a bidding war over its assets or pay top-dollar. If Valeant's peers wait, they may be able to pick up its assets at a discount, especially if it winds up breaching its debt covenants.
Essentially, Wall Street, investors, and Valeant's secured lenders are going to take a fine-toothed comb to the company's second-quarter earnings report, to ensure that its fundamentals haven't deteriorated so badly that it's now in default of its debt covenants. Considering that Valeant has twice dramatically lowered its forecast over the past six months, I don't have a lot of confidence that it can successfully halt its full-year EBITDA slide. My position now, as it's been, is to suggest investors keep a safe distance between their money and Valeant Pharmaceuticals' stock.
