Nearly two years ago to the day, Valeant Pharmaceuticals (NYSE:VRX) would hit almost $264 a share in intraday trading and support a roughly $90 billion market valuation. The embattled drugmaker has lost approximately 94% of its value since reaching that all-time high.
Valeant's fall from grace, in a nutshell
A number of issues have plagued Valeant. For example, the company was chastised by a Senate committee for its drug-pricing practices. Among Valeant's commonly leaned-upon growth tactics was the acquisition of mature medicines that it could then raise the price of, in some cases substantially. When Valeant's now-former CEO J. Michael Pearson was being grilled during the Senate hearing over the respective 525% and 212% price increases passed along to cardiovascular drug Nitropress and Isuprel post-acquisition, he admitted that "mistakes" were made when pricing these drugs.
Valeant also had issues with a former drug distributor, Philidor Rx Services, which turned out to be a subsidiary of Valeant. There were questions as to whether or not Philidor was acting as a neutral party, or promoting Valeant's pricier brand-name drugs without disclosing its relationship to its parent. Valeant now has a drug distribution deal in place with Walgreens Boots Alliance that heavily favors the latter.
Perhaps the most commonly touted issue with Valeant is its astronomical debt, which at one point topped $32 billion. Valeant regularly used debt to finance its acquisitions, which wasn't a problem for its lenders when it had strong pricing power. However, with that pricing power now mostly gone, Valeant has had to sell off assets in order to reduce its debt. The company has also had to renegotiate the terms of its loans with lenders on multiple occasions.
Finally, these very visible problems have also hurt Valeant's business model and sales. Its acquisition of Salix Pharmaceuticals has failed to produce the desired results, with Branded Rx (home to Salix, and other businesses) sales plunging 9% in the first quarter of 2017 and 17% in 2016's fourth quarter.
Wall Street sees improvement
Despite this dismal series of events, Wall Street has given Valeant something of a golf clap in recent months. Its stock has essentially doubled from an intraday low in the $8 range to nearly $17 per share, where it sits today. Much of this boost is a result of the company's efforts to reduce its debt.
When Joe Papa was pilfered from Perrigo to become Valeant's new CEO, he made it clear that the No. 1 goal for the company would be to reduce its total debt by $5 billion by February 2018. Through the first quarter of 2017, $3.6 billion had been wiped off Valeant's debt pile, and the company had yet to recognize the closing of the Dendreon sale for $819.9 million to China's Sanpower Group.
Additionally, Valeant was able to find a buyer for Australia's iNova Pharmaceuticals for $930 million, after the business had been on the market for about nine months. Finally, in July, another noncore asset was shown the door, with Obagi Medical Products being divested for $190 million to Shonghua Finance Acquisition Fund. Presumably, if Valeant uses the bulk of the proceeds from these sales, in combination with a little cash on hand and positive operating cash flow to reduce its debt, it could see in the neighborhood of $5.5 billion in aggregate debt reduction since Papa took office (in other words, there would be perhaps $26.5 billion in total debt remaining) by the end of the third quarter, in this Fool's best guess.
Wall Street sees a falling debt number, coupled with maturity dates that have been pushed further out, as a sign of strength.
Let's squash this Valeant Pharmaceuticals misconception once and for all
Unfortunately, this is the most common misconception about Valeant, and it's time investors looked beyond the company's debt pile and recent reduction efforts.
Even though we've witnessed Valeant reduce the total amount of debt owed, arguably the most important metric -- the one that determines whether or not it'll violate its debt covenant with secured lenders -- has gotten progressively worse with each passing quarter. If Valeant were to violate its debt covenant with lenders, it could be forced into a quick repayment of its debt, regardless of the fact that it's pushed its maturities out and made its interest payments on time.
The debt covenant is determined by comparing the company's EBITDA (earnings before interest, taxes, depreciation, and amortization) with the expenses it pays to service its debt, such as interest and fees. This comparison is expressed as a ratio: EBITDA to interest coverage. While there's no concrete definition of what a healthy ratio is, most companies are going to have annual EBITDA that's 3 to 3.5 times, or more, their debt-servicing costs. Valeant, as of the end of the first quarter, saw its ratio dip to a new low at 1.83-to-1. In other words, even though Valeant managed to reduce its debt by $3.6 billion, its renegotiated debt terms, which pushed out its maturities, also boosted the interest rate it's paying on its remaining debt, and even added fees. In fact, its first-quarter interest expenses of $471 million tied a previous quarterly high, from a time when Valeant's debt load was much higher.
Furthermore, with each asset Valeant sells (in many cases at a price well below what it wants), it also reduces its EBITDA.
Long story short, Valeant could arguably be in worse shape now than it's ever been, even after reducing its debt by $3.6 billion. The company's debt levels and debt-reduction efforts are irrelevant if it can't find a way to make its lenders feel more secure and reinvigorate its core businesses. Investors really need to stop focusing on the wrong metric before it's too late.