A rough year for Valeant Pharmaceuticals (NYSE:BHC) and its shareholders just got even tougher on Wednesday, after the Sequoia Fund (NASDAQMUTFUND:SEQUX), the second-largest shareholder in Valeant Pharmaceuticals at the end of the first quarter according to 13-F filings with the Securities and Exchange Commission, announced that it had completely exited its position in Valeant. Mind you, Valeant represented the Sequoia's Fund's biggest position to begin the year.
What precipitated the sale is certainly up to debate, with a first-half note to shareholders from Ruane, Cunniff, & Goldfarb, which manages the Sequoia Fund, pointing out that new leadership following the retirement of longtime CEO and co-manager Robert Goldfarb at the end of March could very well have shifted the Fund's plan of attack. In the note to investors, Ruane, Cunniff, & Goldfarb also had this to say: "We can assure you that our goal is to be much less interesting in the months and years ahead."
The likely reason Valeant's second-largest shareholders jumped ship
But I'd suggest the reason for exiting its position is pretty clear: Valeant is mess, and there's no telling when it'll have its act back together.
Valeant woes can essentially be boiled down to two primary issues.
First, it's predominantly grown throughout the years through debt-financed mergers and acquisitions. This has not only allowed Valeant to expand its product portfolio and pipeline, but it's also used these acquisitions to boost prices on acquired drugs, in some instances without changing the formulation or manufacturing process. Two of these acquired drugs, Nitropress and Isuprel, had their prices increased by more than 500% and 200%, respectively, which drew the ire of lawmakers on Capitol Hill. Long story short, Valeant's pricing practices are now under a watchful eye of Congress, meaning it's lost a good portion of its pricing power.
The far bigger issue for Valeant Pharmaceuticals is the $31.3 billion worth of debt it's accumulated along the way. When Valeant had access to debt, it could use the profits from new acquisition to generate more EBITDA and stay well ahead of its annual interest costs and debt covenants with its lenders. However, when it lost a good portion of its pricing power, it also lost its source of EBITDA and profit growth, which meant its debt-financed M&A came to a grinding halt.
Making matters worse, Valeant wound up delaying the filing of its annual report because of a $58 million revenue recognition error tied to its now-former drug distributor Philidor Rx Services. While completely understandable that Valeant would want to ensure that its financials are correct before filing its annual report, it nonetheless triggered debt default letter from its lenders. Valeant eventually did file its annual report late, and then followed it up by also filing its first-quarter report late, too.
Valeant's debt issue isn't likely to go away anytime soon
On one hand, it's always possible Valeant could win back the trust of the medical community and regain some of its lost pricing power. If we've learned anything throughout history, it's that the public tends to have a short-term attention span when corporations make mistakes. In other words, unless prescription drug reform is genuinely on the docket in Capitol Hill (which I'd guess it's not), Valeant's pricing power woes should be relatively temporary.
Its debt issue, however, isn't going to go away anytime soon. Newly anointed CEO Joseph Papa, who'd manned the reins at over-the-counter drug giant Perrigo for a decade prior to taking his new post with Valeant, has been frank with Wall Street in suggesting that Valeant will need to sell some of its assets, potentially even core assets, to reduce its debt levels. But there's are problems with this simple solution.
First, Valeant has to walk a veritable tightrope when selling assets to ensure that it reduces its debt enough without giving away too much future growth. For example, Salix Pharmaceuticals' product portfolio and pipeline, along with Bausch & Lomb, are Valeant two most attractive assets. The company could easily sell both of these assets and probably cut its debt in half (if not more), but it would also be giving up the lion's share of its future growth potential. However, if it merely moves lesser important assets, it won't make a big enough dent in its $31.3 billion in debt to satisfy Wall Street and investors.
Then there are the asset sales themselves. Wall Street and Valeant's peers are completely aware of Valeant problems, and as such it seems unlikely that they'd get into a bidding war over Valeant's assets, or pay a premium for an asset from a distressed company. I struggle to see how Valeant will realize an attractive price for the assets it does sell.
Yet, the biggest debt concern of all could arguably be Valeant's pre-arranged debt covenants. Valeant's lenders originally required the company to maintain an EBITDA-to-interest coverage ratio of 3-to-1 or higher in order to avoid being in default. When Valeant's M&A machine was in high gear, this wasn't even a worry. However, with credit markets closed off to Valeant and its M&A strategy dead in the water, earnings revisions and EBITDA reductions have brought these debt covenants into question.
When Valeant renegotiated its lending terms a few months prior (during the period where it had delayed its annual filing), its lender reduced its prior EBITDA-to-interest coverage from 3-to-1 to 2.75-to-1 in order to give Valeant some breathing room. Yet, based on Valeant's updated and reduced full-year guidance for 2016, its EBITDA-to-cost coverage ratio may very well be below 3-to-1, putting the company dangerously close to defaulting on its debt.
Should you follow the Sequoia Fund's lead?
Valeant's woes don't look as if they'll resolve overnight, so should you follow the Sequoia Fund's lead and abandon ship? The answer largely depends on your risk tolerance and investment timeframe.
If you have a relatively weak stomach for risk, then Valeant Pharmaceuticals, even with its share price down 92% from August of last year, probably isn't a good stock for you to consider buying or holding. With possible asset sales around the corner, and ongoing probes by lawmakers, Valeant's stock should be expected to remain quite volatile.
But if you do have the ability to stomach Valeant's wild vacillations, and you have many years to allow your investment to sit in your portfolio or retirement account, then Valent might be worth a look. When the smoke eventually clears, I expect Wall Street to realize that Valeant's assets aren't worthless. Yet again, it could be difficult for Valeant to realize anywhere near full value for those assets given its current troubles.