No one can deny that hedge-fund manager John Paulson has great ideas from time to time.
In 2006, Paulson's hedge fund began to heavily bet against credit-default swaps because he smelled trouble within the housing and banking industries. In 2007, when subprime loans started to be the undoing of the U.S. economy, and those CDSs began to pay off, Paulson's fund wound up raking in an almost ridiculous $15 billion in profits. Paulson has had other prescient bets beyond CDSs, but his insight on mortgages in the U.S. years before the subprime crisis is what put him on the map.
Since the Great Recession, Paulson has had a few notably positive investments -- the SPDR Gold Trust and Citigroup are two good examples -- but he's also been fallible in many other respects. In fact, when it comes to picking healthcare stocks, Paulson has been downright terrible of late.
According to Bloomberg, of the nine largest healthcare holdings in John Paulson's hedge fund, eight of them were estimated to be underwater as of the end of the first quarter. Since cost-basis isn't disclosed in 13F filings with the Securities and Exchange Commission, we don't know with any certainty what Paulson's fund paid for the companies it owns. Nonetheless, his fund is down considerably on generic drug kingpin Teva Pharmaceutical Industries, and has lost nearly 80% from its investment in Endo International. But no company has cost Paulson more money over the past couple of years than Valeant Pharmaceuticals (NYSE:BHC).
Say what? Paulson just upped his stake in Valeant
According to first-quarter 13F filings and Valeant's share price at the time, it was estimated that Paulson's hedge fund had taken a nearly $2 billion bath on its Valeant holdings. This wasn't as bad as the $4 billion shelling that John Ackman's Pershing Square took on Valeant, but it's a sizable amount of money to have lost in a relatively short period of time.
Thus, you can imagine the surprise when a regulatory filing on Monday, June 26, showed that Paulson's hedge fund had upped its stake in the embattled drug giant. The disclosure shows that Paulson's hedge funds acquired 2.72 million shares on May 11 at an average price of $13.71 each, bringing his direct holdings to 6.3% of outstanding shares, or 21.8 million. It also shows the funds hold 862,500 cash-settled swaps, which further boost Paulson's economic stake in the company to 6.5%.
The share acquisition came a little more than a month before Paulson joined Valeant's board of directors, which was a move Wall Street cheered. After all, having an individual who's hedge fund is the company's single-largest shareholder on the board ties investors' interests to that of management.
Paulson certainty has a handful of reasons to continue believing in Valeant. The company first-quarter results saw it report its first profit in six quarters, as well as lift the top- and bottom-end of its full-year EBITDA forecast by $50 million. Core segment Bausch & Lomb also generated 4% constant currency growth, which was a noticeable improvement over its 1% sales decline in the sequential fourth quarter. With $3.6 billion in cumulative debt reductions since the summer of 2016, Paulson has reasons to believe in CEO Joe Papa and his turnaround plans.
Paulson is a glutton for punishment
While Valeant's stakeholders have to be thrilled to see Paulson increasingly bullish on the stock, this Fool isn't as convinced. In fact, it's possible Paulson and his investors could lose more than $2 billion when all is said and done.
Some of the issues with Valeant are readily apparent. For instance, its Branded Rx segment, which includes Salix Pharmaceuticals, saw sales decline by 9% during the first quarter. This is an operating segment that the company expects 2% to 5% growth from in 2017, suggesting that management may not have a good bead on, or is unwilling to come to terms with, the company's current operating performance.
But the bigger issue remains Valeant's debt and its shrinking EBITDA. Valeant ended the first quarter with $28.54 billion in debt, which is indeed $3.6 billion lower than its peak. However, much of Valeant's debt reduction has been due to the disposition of assets rather than by organically paying down its debt with positive operating cash flow. Though selling assets is very much a necessity right now for Valeant, it's not a sustainable long-term practice. Nor has Valeant been able to get its asking price on its assets. Its recent sale of iNova Pharmaceuticals for $930 million is lower than the $1 billion-plus price tag it once hoped to get for iNova.
Shrinking EBITDA, which is a function of selling off profitable assets and the result of weakness in its core businesses, is another major issue. EBITDA is used by Valeant's lenders to determine how "safe" their loans are. In addition to simply meetings its interest payments, Valeant is required to stay above debt covenants that are determined by the EBITDA-to-interest coverage ratio (i.e., EBITDA as a ratio of how much Valeant pays in interest and fees to service its debt). The company has, on numerous occasions, restructured its debt covenants and lowered this ratio requirement, but it just keeps falling. During Q1, Valeant spent $471 million in interest expenses and generated just $861 million in EBITDA for a 1.83-to-1 ratio. That's dangerously low. Every time Valeant restructures its debt, it accepts higher interest rates and fees, pushing its debt-servicing costs higher despite having $3.6 billion less in debt.
What's more, the token increase in the company's full-year EBITDA in its Q1 report won't last. A note in the press release points out that this forecast includes its Dendreon assets, including cancer immunotherapy Provenge. This high-margin product is being sold to China's Sanpower for $820 million, and the deal will soon close, removing this critical EBITDA from the equation.
Valeant remains in big trouble, and that's not good news for John Paulson's hedge fund or investors.