Earnings season is in full swing, and while fourth-quarter earnings are expected to be an upside catalyst for most companies, shareholders of embattled drugmaker Valeant Pharmaceuticals (NYSE:BHC) are probably terrified. Valeant, which was at one time worth around $90 billion, has shed more than 90% of its value since the summer of 2015.
The big day for Valeant shareholders is tomorrow, Feb. 28, before the opening bell. According to Wall Street estimates, Valeant is expected to report $2.34 billion in sales in Q4, representing a 16% decline on a year-over-year basis, with adjusted EPS of $1.22, which would be a more than 50% decline from the $2.50 in adjusted EPS reported in Q4 2015. Valeant has missed Wall Street's profit expectations in each of the past four quarters, and it's lowered its 2016 guidance on three separate occasions over the past year, so optimism among investors isn't exactly high.
Here's what Wall Street will be watching
There are, unquestionably, a bounty of data points that Wall Street and investors will be keying in on when Valeant reports its fourth-quarter and full-year results.
For example, Valeant's total debt will be a highly monitored figure. The $30.4 billion in debt Valeant ended the third quarter with is a concrete block that continues to drag Valeant down. Valeant's CEO Joseph Papa, who took over last year, has repeatedly stated that the company will shed assets, as well as divert a lot of its operating cash flow, to reducing its debt in the quarters to come.
If there is good news on this front, Valeant did announce two deals in January at surprisingly attractive premiums. Valeant's debt situation doesn't put it in much of a position to bargain with possible asset acquirers over price, but it managed to net $1.3 billion from three skincare products sold to L'Oreal, and $819.9 million for its Dendreon assets, which were sold to Sanpower. The skincare products sold for 7.7 times their aggregate annual sales, whereas Valeant sold Dendreon's assets for a $375 million gain after acquiring them in 2015 out of bankruptcy for $445 million.
Clearly, investors are also going to be focused on how the company's core businesses are performing. Dermatology has been a flagship growth driver for Valeant, but sales of its core segment were down more than 50% in 2016. The drop in sales appears to be a combination of its new drug distribution deal with Walgreens Boots Alliance not working out as planned, and poor PR, which has hurt the company's image with insurers, consumers, and physicians. Investors will be looking for a stabilization in sales and some hint as to whether Valeant's pricing power, which is critical to the success of all drugmakers, is improving or still declining.
This is the only number that matters
However, the data Wall Street will be focused on this Tuesday should probably take a back seat to what I'd suggest is the only number in Valeant's report that really matters: its EBITDA-to-interest coverage ratio (which you'll actually have to calculate yourself, so have those calculators ready).
In simple terms, the EBITDA-to-interest coverage ratio examines how much a company generates in EBITDA (that is, earnings before interest, taxes, depreciation, and amortization) compared to how much it spends servicing the interest on its debt. For example, if a company generates $4 billion in full-year EBITDA, but spends $1 billion in interest on its debt, its EBITDA-to-interest coverage ratio would be 4-to-1.
While there are no concrete definitions of what represents a healthy company and what represents a company in trouble, Valeant has, on two separate occasions, had to renegotiate its debt covenants with lenders because of its falling EBITDA-to-interest coverage ratio. If Valeant failed to renegotiate these debt covenants, it would have been in default, potentially triggering the need to repay its debt at a much quicker rate. Initially, Valeant's EBITDA-to-interest coverage ratio was set at 3-to-1, but was subsequently lowered to 2.75-to-1 after agreeing to fees and higher interest rates. A second round of negotiations a few months later lowered this ratio even more.
If you extrapolate out the interest costs for a quarter over a full year (as opposed to adding up Valeant's interest costs over the trailing 12-month period) and compare it in a similar manner to the company's extrapolated EBITDA, Valeant's third-quarter ratio was 2.67-to-1. Comparatively, before the wheels fell off the metaphorical bus, this ratio was 3.5-to-1, or higher. Wall Street, investors, and most importantly Valeant's creditors, are going to want to see this figure move higher. The more this ratio moves up, the more financial flexibility Valeant should have.
Increasing the EBITDA-to-interest coverage ratio won't be easy
Of course, investors should understand that increasing the EBITDA-to-interest coverage ratio isn't as easy as flipping a switch. Valeant clearly has to divest assets to reduce its debt levels and appease its creditors; but in doing so it's also reducing the EBITDA it generates from those assets. Depending on what Valeant sells, it may wind up reducing its debt without making any progress on its EBITDA-to-interest coverage ratio.
Now, for one more ray of silver lining. It would appear, based on the 7.7 times sales figure Valeant received for its skincare products that were sold to L'Oreal, its initial divestments will have a positive impact on its EBIDTA-to-interest coverage ratio. The Dendreon sale is potentially a toss-up in terms of helping its EBITDA-to-interest coverage, but it may be a modest positive.
The other issue for Valeant is that selling its assets to make a dent in its debt and EBITDA-to-interest coverage ratio is probably going to take longer than expected. As previously noted, Valeant isn't in a position of bargaining power, which means acquirers aren't likely to pay a hefty premium or get in a bidding war for its assets.
This Fool isn't expecting a particularly positive report. However, it could be saved if Valeant's EBITDA-to-interest coverage ratio shows signs of improvement.
Circle your calendars, folks, because Tuesday, Feb. 28, is the big day.