Borrowing heavily to acquire drugs and then raising their prices was a fantastic business model for Valeant Pharmaceuticals (NYSE:BHC) -- until suddenly it wasn't. It appears the company's ability to generate increasing profits through price hikes is evaporating along with its ability to service the staggering $30.4 billion in debt on its balance sheet. It's no wonder has fallen stock about 86% so far this year. Investors are right to wonder if the nightmare is almost over, or just beginning.

Valeant Pharmaceuticals stock price falling

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Now that Valeant's stock is down to around 1.2 times its book value, it might be near a bottom. On the other hand, a $1.9 billion loss reported during the first nine months of 2016 suggests the situation could get much worse. Let's explore some arguments for both.

The case for optimism

Although allegations of specialty pharmacy skullduggery began hammering Valeant's share price in mid-2015, its operations have been churning out free cash flow at a rate not much lower than pre-crisis levels.

VRX Chart

VRX data by YCharts.

The big $1.9 billion loss recorded in the first nine months of the year was largely caused by about $3.68 billion in intangible asset and goodwill adjustments. In other words, the business is still generating profits, but the carrying value of things that you can touch, see, or feel is less than previously thought. These non-cash charges aren't entirely insignificant, but the overall reported net income loss this year isn't quite as awful as it appears.

Valeant finished September with short-term assets of about $1.78 billion in excess of its short-term liabilities. This isn't the strongest liquidity position, but with operations still generating profits, its new management team has some breathing room to examine paths forward.

The case for doubt

Unfortunately, the path forward is rocky. It finished the third quarter owing $30.39 billion to lenders, and interest payments on this crushing debt pile make investing in tomorrow's growth drivers seem next to impossible.

Valeant stock popped recently on news that Takeda was interested in purchasing its Salix business segment for a reported $10 billion, which would go a long way to reducing its debt load and interest expenses. Unfortunately, the brief rally fizzled after the Japanese pharma refused to make a satisfying offer for the line of high-margin gastrointestinal drugs.

The dissolution of the deal stoked fear that Valeant can't negotiate asset sales from a position of strength, which is particularly unsettling. Valeant's debts contain covenants that could result in a default if the ratio of profits to interest payments falls too low. Over the summer, creditors lowered the minimum ratio of profit (measured as EBITDA) necessary to just 2.0 times interest expenses.


VRX EBITDA (TTM) data by YCharts.

The amended EBITDA-to-interest ratio is much lower than before, but not low enough. If Valeant's debt holders aren't willing to bend on interest coverage, and competitors won't buy assets until it's a fire sale, it could have a hard time avoiding a default.

Valeant is indeed in a very tight spot. Adding to the threat of a swirling debt spiral are potential fines and brand tarnishing as federal prosecutors and the Securities and Exchange Commission (SEC) investigate allegations.

Delaying financial statement filings at the beginning of 2016 didn't just hurt the stock; it technically constituted a credit default. The SEC's recent accusations are related to some fancy accounting to make the non-GAAP figures, often called adjusted earnings, appear less grim than GAAP figures. The latest warning isn't likely to result in a fine, but it serves as a reminder that authorities are watching the company like a hawk.

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While the SEC fires shots across Valeant's bow, federal prosecutors in New York are preparing to argue criminal charges concerning a relationship between former executives of Valeant and Philidor Rx Services. According to the official criminal complaint, prosecutors will argue a Valeant vice president offered millions to Philidor's CEO to favor Valeant's drugs over lower-priced alternatives in return for kickbacks. If prosecutors lodge similar charges at the company itself, it could result in heavy fines.

The beaten-down stock looks incredibly cheap, but that doesn't mean it can't fall even further. Value-hungry investors might be better off waiting for a better stock.