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Valeant Pharmaceuticals (VRX +1.99%) has been in the spotlight for more than a year now for all the wrong reasons. After peaking at $264 a share in the summer of 2015, Valeant's stock dipped below $20 at one point, with John and Jane Investor, along with some big-name money managers (see: Bill Ackman), feeling the pain.
Valeant's two issues in a nutshell
At the heart of Valeant's issues are its sudden lack of pricing power and its extraordinarily high debt levels.
Valeant's pricing woes began in September, shortly after the "Bad Boy of Pharma," Martin Shkreli, attempted to hike the price of a 62-year-old drug by more than 5,500% without changing its chemical formulation or manufacturing process. This turned lawmakers' and the public's attention to other drug developers and acquirers, like Valeant, that have a history of boosting their sales and profits through price increases.
As a perfect example, shortly after Valeant acquired cardiovascular drugs Nitropress and Isuprel in February 2015, it increased the price of the drugs by 525% and 212%, respectively, without changing the formulation or manufacturing process. Ultimately, Valeant's now-former CEO, J. Michael Pearson, wound up testifying at a Congressional hearing that he and Valeant had made mistakes with their aggressive pricing practices. Today, Valeant's pricing strategy is being watched with a magnifying glass, which is constraining its pricing power.
The other issue for Valeant, which is well documented, is the company's $30.77 billion in long-term debt as of the end of the second quarter. Valeant was no stranger to using M&A to fuel its growth, with its acquisitions of Bausch & Lomb for $8.7 billion and Salix Pharmaceuticals for $14.5 billion (including debt) being its crown jewels of future growth. Valeant regularly used debt to fuel its M&A activity, with the added EBITDA from its deals allowing it to grow its debt without worrying its lenders.
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However, following its pricing strategy criticisms, the discovery of $58 million in improper revenue recognition from now-former drug distributor Philidor Rx Services last year, and two late filings with the Securities and Exchange Commission (its 2015 annual report and first quarter 2016 report), its lenders have reined in Valeant's access to credit. Without available credit, and with its public image damaged and clearly hurting its sales, Valeant has been forced to go on the defensive.
Papa keeps the door open
One of the best moves Valeant has made in a series of missteps over the past year and change was the hiring of Perrigo's now-former CEO Joseph Papa. Papa successfully increased Perrigo's sales and profits over a decade-long tenure as CEO, and he'll bring a calming and fresh presence to Valeant as it attempts to navigate its debt dilemma.
During the company's second-quarter conference call, Papa suggested that the company's focus will be on selling non-core assets to reduce its debt. Ideally, Papa envisions Valeant parting ways with non-core assets totaling $2 billion in annual sales, or approximately 20% based on the company's $10 billion midpoint for fiscal 2016 sales. In return for giving up its $2 billion in annual sales, Valeant anticipates getting $8 billion back, implying the ability to sell its non-core assets for about 11 times EBITDA. During the second quarter Valeant wound up receiving $181 million in upfront cash from the sale of the North American rights to Ruconest, its Synergetics USA OEM business, and its EU rights to brodalumab, and it could net $329 million more if certain sales-based milestones are reached.
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However, Papa also went on record last week with CNBC's Closing Bell by suggesting that the door is still open to selling its core assets if it gets the right offer. In Papa's words: "Would we have to look at something if someone came forward with something (i.e., an offer for Bausch & Lomb or Salix)? Of course we would, because we're a public company and we have over $30 billion of debt."
Of course, Papa understands that B&L and Salix account for the vast majority of growth and EBITDA generation for Valeant, and he and his management team are unlikely to agree to a sale of either franchise without a fair price being offered.
The single most important Valeant Pharmaceuticals metric
This leads us to a key metric -- arguably the most important metric that can help determine whether or not Valeant Pharmaceuticals is worth buying: the company's EBITDA-to-annual interest costs on debt.
Prior to its woes, Valeant was able to maintain an EBIDTA-to-interest cost coverage ratio that was often 3.5 or higher. In easier-to-understand terms, it was generating at least 3.5 times in EBITDA what it was paying out to cover the costs on its debt each year. The higher the EBITDA-to-interest cost coverage ratio, the more faith lenders are liable to have in Valeant's ability to repay its debts.
However, when Valeant's M&A machine came to a grinding halt, and its pricing power was drastically reduced, its sales, profits, and EBITDA fell. Between mid-December and early June, Valeant wound up cutting its fiscal 2016 forecast twice. Originally expected to generate $12.6 billion in sales and $13.50 in EPS at the midpoint, Valeant's June update called for $10 billion in sales and $6.80 in EPS at the midpoint. With profits falling, so was the company's EBITDA forecast. As of the end of Q2, Valeant is anticipating EBITDA of $4.8 billion to $4.95 billion for fiscal 2016.
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Here's the problem: Valeant reported $892 million in first-half interest costs in 2016, which extrapolates out to nearly $1.8 billion in 2016. This would put Valeant on track to deliver an EBITDA-to-interest cost coverage ratio of around 2.75-to-1. The good news is newly forged lending agreements that'll see Valeant accept higher interest rates and pay concessionary fees should keep Valeant from violating its debt covenants (which had been set at an EBITDA-to-interest cost coverage ratio of 2.75-to-1). However, Valeant's EBITDA-to-interest cost coverage ratio could remain well below three for the foreseeable future.
As the company looks to sell assets, it should be able to reduce what it's paying annually in interest. But, its EBITDA will be reduced as well. The company's $2 billion in non-core assets that it's trying to sell generates in the neighborhood of $725 million in annual EBITDA. It may be tough for Valeant to get its EBITDA-to-interest cost coverage ratio back above 3.5 (i.e., what I'd arbitrarily consider a healthy level) without selling at least some of its core assets. Of course, if Valeant does sell core assets, its future growth could be compromised. Furthermore, it may be tough for Valeant to receive a fair value for its assets given its noted problems.
For the time being, Valeant's EBITDA-to-interest cost coverage ratio is giving investors every indication that this stock should be avoided. But, if we begin to witness steady improvement in this ratio with an eventual climb back over 3.5, it could be worth reevaluating Valeant as a possible buy.
