Before the opening bell on Tuesday, embattled drug developer Valeant Pharmaceuticals (NYSE:VRX) reported its fourth-quarter and full-year results. As you might have imagined by the 14% decline in the company's share price yesterday, Valeant's report didn't sit well with Wall Street.
Surprisingly, Valeant beat Q4 expectations
For the quarter, the company reported $2.4 billion in sales, which works out to a year-over-year decline of 13%. Valeant cited weakness in sales from its existing businesses (which exclude divestments and acquisition-related activity), as well as a 3% drop in realized pricing. Segment-wise, its flagship Bausch & Lomb brand saw sales decline by 1% to $1.18 billion in the fourth quarter, while Branded Rx sales suffered immensely and fell to $829 million from $1 billion in the prior-year quarter. The drop in Branded Rx sales was blamed on weakness in its Salix line and dermatology products.
In the profit column, Valeant delivered $1.26 in adjusted EPS, which is down from the $1.55 it earned on an adjusted basis in the year-ago quarter. Net cash provided by operating activities also fell 14% to $513 million.
Now here's the interesting thing: Both the $2.4 billion in sales that Valeant reported and the $1.26 in adjusted EPS, topped Wall Street's seriously reduced expectations. The consensus for Q4 had only been for $2.34 billion in sales and $1.20 in adjusted EPS. Valeant's 2017 sales forecast of $8.9 billion to $9.1 billion, representing a year-over-year decline of 7%, was also right in-line with the Street's expectation.
Here's the real problem
So why did Valeant's share price implode once again? Look no further than its 2017 EBITDA guidance (that's earnings before interest, taxes, depreciation, and amortization) for that clue.
As we headed into Valeant's fourth-quarter earnings report, my suggestion had been to ignore the company's sales and profit results and instead pay very close attention to its EBITDA guidance. Because Valeant has such a monstrous debt load, the company's EBITDA is what's used by its lenders to determine if it's bringing in enough profits to comfortably service the interest on its debt. If Valeant were to fall below predetermined debt covenants, it could trigger a debt default without actually missing a payment. A debt default would mean quicker repayments of debt, which in Valeant's case would essentially equate to a fire sale.
As the company looks toward 2017, it's forecasting EBITDA of $3.55 billion to $3.7 billion. Comparatively, Wall Street had been eyeing $3.88 billion in 2017 EBITDA, so this figure clearly missed the mark. Worse yet, we've seen Valeant's EBITDA decline from $5.37 billion in 2015 to $4.31 billion in 2016, to a midpoint estimate of $3.63 billion in 2017.
More importantly, Valeant spent $1.83 billion in 2016 simply servicing its debt (i.e., paying interest on its loans). During the fourth quarter, Valeant only wound up reducing its debt by $519 million, leaving the company with a still daunting $29.85 billion in debt by year's end. Though the company recently agreed to sell $2.1 billion worth of assets in two separate deals, its EBITDA forecast implies an EBITDA-to-interest coverage ratio that's getting dangerously close to 2-to-1 for 2017 -- and that's exceptionally low! So low, in fact, that Valeant may once again need to head to the table with its lenders to discuss its debt covenants.
Let's face the facts: Valeant is in serious trouble
Perhaps the biggest issue of all is that Valeant's forecast seems woefully out of touch with reality. While I would fully expect CEO Joseph Papa and his management team to paint as rosy a picture as possible, the company's 2017 forecast seems mostly unachievable.
For example, according to Investor's Business Daily, Valeant guided for 5% to 7% growth in its Bausch & Lomb business in 2017, with Branded Rx segment growth of 2% to 5%. However, during the fourth quarter, Bausch & Lomb sales fell 1%, and Branded Rx segment sales tumbled 17%. What's more, Valeant wound up reducing its EBITDA forecast on multiple occasions during 2016. All signs point to Valeant's management team being overly optimistic about its sales and EBITDA forecast.
It's also worth pointing out the importance of the "drop in realized pricing by 3%" noted in the press release. Pricing power is everything to drug developers. However, Valeant's pricing power has been compromised since it was caught red-handed increasing the price of cardiovascular drugs Nitropress and Isuprel by 525% and 212%, respectively, after both were acquired in February 2015 from Marathon Pharmaceuticals. Without strong pricing power, Valeant's Branded Rx segment will likely struggle to meet expectations.
And, of course, there's Valeant's debt load of $29.85 billion. Selling off assets will wind up reducing its debt, but it won't necessarily help improve the company's EBITDA-to-interest coverage ratio. Remember, every asset that Valeant sells means reducing its debt and EBITDA. For Valeant to get the type of worthwhile EBITDA premium it's looking for on asset sales, the company will have to be patient. However, the more patient the company is, the closer it moves toward peril as its existing businesses weaken. Having already adjusted its debt covenants twice, and accepted fees and higher interest rates in return, Valeant's lenders may not be so willing to budge the next time around.
In short, Valeant is in serious trouble, if seeing its share price fall 94% since the summer of 2015 didn't give that away. There's little to suggest that a turnaround is imminent, meaning investors are probably wise to remain firmly on the sidelines for the time being.