What a difference a year makes. In August 2015, shares of Valeant Pharmaceuticals (NYSE:BHC) were trading north of $250. Today, they're struggling to find support around the $25 level. It's extremely rare to see a company that had practically achieved a megacap valuation fall back down into mid-cap status in just a year's time frame.
These big-name investment funds have gobbled up Valeant's stock
Yet, in spite of Valeant's numerous woes, there's ample support for the company by some very prominent investment funds and money managers. Last week was the deadline for investment funds with more than $100 million in qualifying assets to file Form 13F with the Securities and Exchange Commission. Form 13F discloses a fund's most recent positions as of the end of the previous quarter. Though the data can be a bit outdated, these filings with the SEC give Wall Street and investors a good idea of what some of the smartest money managers have been up to over the past three months.
According to data found on WhaleWisdom, which aggregates 13F filings, 337 funds that filed a 13F in the second quarter owned shares of Valeant stock, including 21 that had Valeant as a top-10 holding. As an aggregate, 219.9 million shares of Valeant were held by big money managers as of June 30, 2016, down from 268.9 million shares as of March 31, 2016. However, four specific funds continue to hold out hope for a Valeant turnaround.
These four prominent shareholders include:
- Bill Ackman, of Pershing Square Capital Management, whose fund owns 21,591,122 shares of Valeant stock.
- John Paulson, of Paulson & Co., whose fund owns 19,072,000 shares. Paulson & Co. added almost 5.8 million shares of Valeant in the second quarter.
- FMR LLC, known more commonly as Fidelity Asset Management, which owns 15,545,539 shares. FMR wound up adding more than 10 million shares of Valeant to its portfolio during Q2 2016.
- Jeffrey Ubben of hedge fund ValueAct Holdings, whose fund owns 14,994,261 shares.
Combined, these four funds own 71.2 million shares of Valeant stock, which is good enough for about 20% ownership of all outstanding shares.
Why these big investment funds expect a rebound
You might be wondering what these money managers see in Valeant. My suspicion is that it boils down to three factors.
First, we can't overlook Valeant's valuation, despite all of its troubles. Valeant's second-quarter earnings showed that Valeant is sticking by its full-year profit guidance of $6.60 to $7.00 per share. Based on its closing price of $28.74 this past Friday, we're looking at a price-to-earnings (P/E) ratio of around four, which is exceptionally inexpensive. By comparison, the majority of Valeant's profitable drugmaking peers are valued at P/Es commonly in the 20s. Valeant's price-to-book and price-to-sales are also well below its peers'. In short, from a fundamental perspective, Valeant looks attractive.
Second, wealthy money managers are probably expecting Valeant's business model to look remarkably healthier once it sheds noncore assets. Valeant announced plans during Q2 to sell noncore assets that generate about $2 billion in annual revenue, or about 20% of the midpoint of its 2016 sales forecast. In Q2 it began this process by selling its EU rights to autoimmune drug brodalumab, its Synergetics USA original equipment manufacturing business, and its North American rights to Hereditary Angioedema drug Ruconest. All told, these asset sales generated $181 million in up-front cash, and could produce another $329 million in specific approval and sales-based milestones for Valeant in the future. Valeant's management team believes these noncore assets could yield $8 billion in cash for the company, which it'll use to pay down its $30.77 billion in debt.
Last, money managers are probably feeling confident about CEO Joseph Papa's ability to turn things around. Papa successfully ran over-the-counter drug giant Perrigo for a decade prior to taking the helm at Valeant, pushing Perrigo's sales up more than 200% and substantially improving its profitability. Having a fresh face at the reins of Valeant has led some money managers to believe a turnaround is more likely. Furthermore, investors and consumers typically forgive and forget PR flubs after some time.
If Valeant can indeed turn things around, then its current P/E of four would prove to be an incredible steal.
The biggest factor standing in the way of Valeant's turnaround
Of course, the biggest investor concern that Valeant is going to need to overcome is its $30.77 billion in debt.
Having filed both its 2015 annual report and Q1 2016 report late, Valeant's creditors began pressuring the company with notices of default. Valeant avoided defaulting on its debt by eventually filing its reports before reaching creditor deadlines, and by working out new terms with its lenders. These terms included a 1 percentage point increase on its lending rate, as well as a $50,000 fee for every $10 million financed. In return, Valeant's EBITDA-to-annual-interest-cost-coverage ratio was relaxed from 3-to-1 to 2.75-to-1.
However, the company's latest full-year forecast called for $4.8 billion to $4.95 billion in EBITDA (earnings before interest, taxes, depreciation, and amortization). Compare this with the $892 million in net interest costs through Q2 2016. Extrapolated out, Valeant is dangerously close to coming in below its 2.75-to-1 ratio in fiscal 2016, which could possibly lead to more debt default notices from its lenders.
The solution for Valeant is pretty straightforward: It needs to sell assets. Selling assets should allow it to reduce its debt, which would presumably ease its debt burden. However, selling assets also means reducing its EBITDA. It's also not inconceivable to assume that Valeant could struggle to get a fair price for its assets with its peers fully aware of its debt issues. There's no reason to pay a high price for Valeant's assets when the company is not in a strong position to bargain on price.
If Valeant were able to hang on to its highest-growth core assets, such as Bausch & Lomb and Salix Pharmaceuticals, it would give credence to optimists' thesis that Valeant can still deliver substantial growth. But it will admittedly be difficult for Valeant to make significant headway on its debt without touching these core assets. The Catch-22 is that if Valeant sells too much and gets its debt levels under control, it'll hamper its future growth prospects, and if it doesn't sell enough, it runs the risk of continuing to violate its debt covenants.
Only time will tell if Valeant can escape this Catch-22.