Healthcare: Is Valeant Pharmaceuticals the Turnaround Story of the Century?

This week, Valeant Pharmaceuticals (BHC -0.69%) reported its earnings, and the market rewarded it with a 17% stock price bump. While the company's shares are still down 95% from their 2016 highs, some investors are wondering if Valeant is actually starting to turn things around -- and if now might be a good time to buy in.

In this week's episode of Industry Focus: Healthcare, analysts Kristine Harjes and Todd Campbell go over the report to explain where the company is doing well, where it's still struggling, and what the long-term future could hold for it. They also discuss another company that just reported earnings -- Keryx Biopharmaceuticals (KERX), shares of which fell 17% even though it just won FDA approval to sell a drug into a huge new indication. Find out why the market shrank away from the company, and why today's huge drop may have been an overreaction.

A full transcript follows the video.

This video was recorded on Nov. 8, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Wednesday, Nov. 8. I'm your host, Kristine Harjes, and I'm joined via Skype by healthcare expert Todd Campbell, one of Fool.com's most prolific writers. Todd, how's it going?

Todd Campbell: Good! I've been prolifically writing all day.

Harjes: [laughs] I introduce you so much on the show that I'm kind of running out of new ways to do it.

Campbell: We have to mix it up, no question.

Harjes: Are you prolifically writing on anything interesting today?

Campbell: Oh, yeah. Listeners can go online to Fool.com, type in Todd Campbell and see everything I'm putting out.

Harjes: Perfect. So, for today, we have two topics to discuss. The first one is a company called Keryx Biopharmaceuticals, which I don't think we've ever covered on the show before. If we have, it's escaping my memory. It's certainly not something we've covered heavily. They have some interesting things going on. Then we're going to talk about Valeant, which we have certainly talked about on this show before. We'll give you the update on what's going on with this company that's somewhat of a turnaround story that's just starting to get their footing back. But first, Keryx Biopharmaceuticals. The ticker there is KERX.

Campbell: What a weird story on Keryx. That's probably why we're interested in talking about it.

Harjes: Yeah. The headline here is that they got a drug approved, and they reported earnings, and the stock slides 17%. So, on the surface there, you're like, wait, they got their drug approved, that's a good thing. But if you really dig into it, it's the details of the earnings report that actually seem to have mattered, at least for this daily instantaneous reaction that the market had.

Campbell: Yeah. It was really a strange situation all around. The FDA decision on their drug, which is Auryxia, was expected on Monday. And at the same time, the company was expecting to report their earnings on Monday night. Well, 5 p.m. rolls around, and Keryx puts out a press release saying, "Hey, we haven't heard from the FDA yet, so we're not going to report earnings until we hear from them, so we'll talk to you tomorrow." Of course, that set off the Twitter-sphere, and everyone was going back and forth trying to figure out what that meant. Sure enough, first thing in the morning, they announced, yes, the FDA has approved it, and here are our third quarter numbers.

The problem was, third quarter numbers were completely disappointing, and that won the day as far as news flow. People looked right beyond the fact that the addressable patient population for Auryxia is going to get bigger, and said, "Wait a minute, why didn't the numbers hit what we thought they would hit in the third quarter for its already-approved indication?" And that's something we didn't spell out. Auryxia is already in the market for one indication in chronic kidney disease, and this new approval is supplemental approval for the drug that essentially allows its use in non-dialysis patients, where before it was being used in dialysis patients.

Harjes: Exactly. So, this is a drug that's already on the market. We've been able to follow along with the sales from this drug for a while now, since it was approved in September 2014 originally. So, now there's a new extended indication that the drug is being used for, was just approved for use in. But people are still watching carefully the sales of the original indication for this drug. And what's been really interesting is, the volume of the patients that are taking this drug was up. They reported really good year-over-year growth in patient numbers that are taking this drug.

But, essentially, revenue was kind of flat if you look at it over prior quarters, and that was, as they put it, due to a change in the mix of business, meaning the types of payers that are covering the patients that are taking this drug are not giving them as much money. Specifically, Medicare patients are making up a larger and larger percentage of this pie, and they don't pay as much for the drug. Therefore, when you do your multiplication of how much you're getting per patient times the number of patients, even though that number of patients is going up, your revenue is not going up as quickly.

Campbell: Right. The per-patient cost is a big issue. Let's back up for a second and explain the patient population that Auryxia was previously approved in. It was approved for the ability to control phosphorus levels in patients with chronic kidney disease that were on dialysis. That's about a 450,000-patient population. Managing that patient population is complex, and there are a lot of metabolic things that they have to consider, especially the impacts on iron and phosphorus. When those get out of balance, they can cause all sorts of problems and contribute to mortality. So, this helped improve the control of phosphorus in dialysis patients. A lot of people thought this drug, when it hit the market, would be a blockbuster drug. It hasn't. Sales have been very small, and really didn't start picking up until last year, when some manufacturing concerns got resolved, and as it was able to negotiate more and more coverage with different commercial insurers.

That brought us into 2017, where those negotiations continued, and they were able to cut some deals with, specifically, Part D plans run by Humana and United Healthcare, two of the biggest insurers. So, they have a lot of pricing power. As a result, when those ramped up in the third quarter, you saw, as you just described, a pickup of patients, but a drop in the average amount of revenue generated per patient. Of course, that's a big problem. Now, I think what shouldn't get lost, necessarily, in that, Kristine, is that while the revenue missed expectations by $3 million -- it came in at $15 million in the quarter -- that's still up significantly from where it was last year.

Harjes: Yeah. The other thing is, I don't think you can say these new agreements that they have with United Health and Humana are bad deals. I actually think they're fantastic new contracts for them to have inked, because now, when you look at the expanded indication, you have a bunch of patients that are going to be eligible for this. And those new patients with this new extended indication, the extended label, they're often covered in a more profit-friendly commercial way than these patients that you're seeing have less revenue per patient. So, when you start to make the reach out to the new doctors or the existing doctors saying, "Hey, same drug that you're used to, you can prescribe it to more patients," that's going to be a good thing.

Campbell: I agree with you. You have 450,000 people who are on dialysis. That's the addressable market heading into this last week when they got the approval. They just added another 650,000 addressable patients. All these patients are being treated by the same doctors. So they already have the sales team in place, up to speed, out there visiting and calling on these doctors. It's much easier than it would be for, say, a brand-new company getting a brand-new approval, to then go and say, "Hey, guess what? You can use this in your non-dialysis patients as well as a way to boost iron," which is a big problem in the progression of the disease, is less iron and anemia. So, the ability to address that with an oral tablet, without having to go to IV infusions for iron, or having to take vitamin supplements that sometimes can cause problems for people's GI system, there are some advantages that may allow this drug to generate sales. Who knows what those sales would be?

We've got, like you said, a bigger proportion of non-dialysis patients covered by commercial insurers. Theoretically, they'll pay more than the Part D plans will for the drug. It's a larger patient population, but maybe they don't get as much penetration into it. It's hard to say, and I think that's why people are really concerned about what the future holds for Keryx, because Keryx, by its own admission, they removed their guidance for 2017, saying, "We don't fully understand how the Part D situation is going to play out with our existing patient base for the rest of the year, and we don't know what kind of an impact this new approval in the patient mix will have from that." So, they actually pulled their guidance from 2017, and I think that scared a lot of people. Now they're looking at it and saying, "We're growing year over year, but we don't really have any insight or clarity into what that growth might look like."

Harjes: Yeah, absolutely. And uncertainty is definitely another contributing factor to the loss that the stock suffered. Also, I want to point out that this is a stock that quite a few people are extremely bearish on. About a quarter of their float, of their shares outstanding, is sold short, meaning people are betting that this company is going to fail. I think a big reason for that, besides what we already covered with the uncertainty, is that they really need sales to pick up to avoid somewhat of a cash crunch.

Campbell: Yeah. They have $114 million in cash, which is not a ton of money when you have a commercial stage drug. It's expensive, marketing these drugs. As a result, you did $15 million in revenue in the third quarter, that was up from $5.8 million year over year, but it was relatively flat quarter over quarter. That's the problem, quarter over quarter was flat. A $24 million loss reported in the third quarter. So, $114 million in cash, $24 million loss, that's got to make you say, at one point are they going to have to tap investors for more money? They do have an at-the-market facility, they can go out and raise cash by selling stock at whatever price the market is trading at. Obviously, they don't want to do it at $5. They were probably hoping it was going to go up, and they could tap it that way. But, they can access $75 million from the at-the-market. So, I don't think the cash crunch is immediate. I think people could see dilution over the course of the next couple of quarters if the non-dialysis business doesn't ramp relatively quickly.

And then, of course, on the whole uncertainty issue, you do have competitors in the space that are also working on their own anemia drugs. One of them, the symbol there is AKBA, Akebia. Easy for me to say. They have trial results panning out in 2018-2019, and potential commercialization some time in 2019-2020. So, I think that's weighing on a little bit of investor enthusiasm, too. So, this is a high-risk stock. The investor takeaway is, sales are still growing year over year, a doubling of the addressable patient population. It could be that the stock is underpriced, but it's certainly not a stock to buy for the faint of heart.

Harjes: Yeah. It's not surprising that there are competitors researching into this industry, if you think about the fact that one in seven adults has chronic kidney disease. There's a lot of patients that we're talking about here, and there are a lot of complications with the disease. Of course you're going to have interested drugmakers trying to develop new and better cures for these people. 

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As promised, our second topic of the day is Valeant, another stock that just reported earnings. In contrast to Keryx, which sank about 17% earlier this week, Valeant soared 17%. They're still well below where they once were. Today's price is about 95% below their 2016 peak. They have a new CEO, new-ish, and he's trying to turn the stock around. And it seems like he might be starting to get some positive momentum.

Campbell: It's all a matter of traction with this company. We've talked about Valeant in the past. Maybe it would be helpful for some of our new listeners who aren't as familiar with the story to give a little bit of background on the company. I think, to sum it up, what we could say is this is a relatively problem stock, one of the most love-to-hate stocks on Wall Street over the course of the last couple of years. The former management team had a business strategy that was highly acquisitive: We're going to go out, we're going to acquire all sorts of other companies, we don't care how much it costs us, how much debt we have to take on, that's what we're going to get our growth from. As a result, we're not going to spend a lot of money on  research and development to develop our own drugs in house. We're just going to focus on acquisitions, acquisitions, acquisitions. And then we're going to drive growth from those acquisitions by using a specialty pharmacy that has since come under scrutiny and been shuttered for some, we'll call it improper marketing techniques. So, that was a big headwind for a company. You have the fallout from that, where management got shaken up, and you got a new CEO come into the company about 18 months ago. And you've also got a steep drop off in sales stemming from this whole problem that emerged in 2015 and 2016 as well.

I think the big issue for Valeant shareholders today is, we know it was $250-something a share back at the peak, but it was also less than $10 at the low. Where is it going to go from here? That I think really depends on how well this company orchestrates on its turnaround plan. How quickly can they get the debt levels under control, and then shore up sales to get to a point where they're actually delivering growth instead of contraction? 

Harjes: And that's a bit of a catch-22. They're really caught in between a rock and a hard place. On one hand, they need to make more money to generate more revenue to cover their interest expense. But on the other hand, they kind of need to sell off some assets just so that they can lower their debt levels pretty quickly and get rid of that interest expense again. But if you sell off your assets, you don't grow revenue. And that also makes analyzing their quarterly statements extremely interesting and kind of difficult, because you can't just compare year-over-year on a GAAP basis, which is that number that you see reported as the accounting number. You kind of have to take these necessary adjustments to it and look at the non-GAAP numbers to see what's really going on with the growth here. If they report one thing, but that's because they have, say, one big tax advantage, and they sold off this other huge unit, that doesn't really give you a clear picture of what's going on.

So, what you really want to look at here is what happened on constant currency and excluding divestitures and discontinuations. That's how you can really get a better sense of how they're doing. In particular, it's really important to look at this with their bread-and-butter segments, which is the Bausch & Lomb segment, and the Salix segment. These are two places where they generate 77% of their business. So, that's really where you need to look for organic growth. And thankfully, they have not sold off those entire units yet -- there was speculation that they might be considering a sale of those units. But, again, to do that would really hamper their growth going forward. 

So, you look at some of the constant numbers. The Bausch & Lomb unit grew their revenue by 2% constant currency. Or, if you take even more exclusions -- this is, again, the divestitures and the discontinuations -- their sales increased 6%. That's not gangbusters sales growth, but that's solid. Salix, meanwhile, had organic growth also of 6%.

Campbell: Yeah. So, you have those two parts of its business that are performing at least stable to slightly up. If you look at those businesses, I think Bausch & Lomb was up 1% if you include all of the junk. Salix was up 3%. That's not barn-burning by any stretch, but at the same time, it's pretty darn good when you look at the other parts of its business, which is the branded Rx business generally and the U.S. diversified products business, both of which saw sales drop off pretty dramatically both because of the divestitures and also because of some competitive threats of new drug launches and pricing renegotiations and like.

So, overall, Valeant reported $2.2 billion in revenue. That was down 10.5% on an all-included basis. Or, if you just want to look at organic, it was down 4%, which isn't horrible, if you look at it on the organic, the ex-currency and all that basis. Bausch & Lomb and Salix did really well. However, branded Rx fell overall, down 17% to $633 million, and U.S. diversified products fell 29% to $332 million. So, those two smaller pieces of the business really are a big drag, and they are going to have to find some footing for those two businesses if they hope to get to a point in late 2018 or 2019 to start putting up top line growth once all the junk gets anniversaried, and you have cleaner year-over-year comparisons to be looking at.

Harjes: Yeah. One other metric to really keep a close eye on is the EBITDA-to-interest-coverage ratio, which essentially just means, how safe are the loans? If you're somebody who had lent Valeant a bunch of money, you want to make sure that you're going to get paid back, so you can put in these stipulations saying, "You need to meet my demands, otherwise there are going to be repercussions." So, with this, Valeant needs to make a certain amount of money as compared to how much they're paying in interest in order to not violate these debt covenants and potentially trigger stuff like a quicker required repayment. They have made some progress on this, but not really a ton. Their interest expense is not dropping that quickly. Fortunately, I guess -- I do want to pull out some good news to try to highlight why the stock was up -- they don't have any long-term maturities until 2020. They have slightly less debt. They ended the quarter with $27.6 [billion], this is down from the end of Q2, they had $28.2 [billion]. They have pretty steady levels of cash from quarter to quarter. And right now, that interest coverage ratio that I talked about has gone up to 2.08, which is a good thing. You want that to be well above the required 1.5.

Campbell: Yeah. To back up slightly, one of the reasons that so many people hated this stock and were willing to short this stock is, they thought the creditors were going to put them into default for violating the covenants. I think originally, it was a 3-to-1 ratio, they renegotiated it down to a 2-to-1 ratio, they renegotiated that to 1.5-to-1 ratio. It was expensive to renegotiate that, and that's why you've seen debt fall by $6 billion, but the interest expense hasn't really moved that much, because, of course, the terms have changed for the debt. That being said, they are making headway.

And if you look at where we are on those EBITDA to interest coverage trends, we're well above the 1.5 on the adjusted basis and above 2, and as long as there's nothing that's materially crazy that happens for this company over the course of the next year, without having any long-term maturities, it's one of those situations where you look at it and say, OK, maybe we go from valuing this stock as a stock or company that's at risk of going into bankruptcy because of creditors. Instead, say, it's a troubled turnaround story that's in the early innings of getting itself back on the right path. If you're an investor, that changes your whole approach to the stock, because now you're not saying, "Am I hoping for a bankruptcy, or am I hoping for slow growth over time?" It may not be worth being short the stock anymore if that's the case. And I think that's really what we're seeing here. A lot of investors who held a significant number of shares short are saying, you know what, I think the story is changing a little bit here, and as a result, when the stock sells off a little bit, I'm going to cover some. So, every time that the stock has sold off in the last two quarters, buyers have come back in and driven it back up. And I think a lot of that is due to reduction in the short interest.

Harjes: Oh, yeah, I absolutely agree. As defaulting on their debt becomes less and less likely, the shorts are exiting their positions. Remember, with shorting a stock, your potential losses are infinite, so a lot of shorts can be kind of skittish. If it looks like the company might be about to break out, they want to get out of there. They don't want to be caught having to pay up to who knows how much.

Campbell: Yeah. We're an investing show, so every investor listening right now is thinking: Do I go out and buy Valeant? It's very hard to make the argument that Valeant is the best stock in healthcare, that you need to run out and add this to your portfolio. I think it's a changing story. I wouldn't be short it, and frankly, I wouldn't be long it. I think it still needs to prove itself. We need to get some of these junk quarters behind us so that we can actually get some clean numbers and see where this company is heading once we get late into 2018 and 2019. Now, the stock could go up significantly, it could bounce significantly in the interim. Who knows. We don't know. But, I just don't feel confident enough one way or the other to recommend that investors go out and either continue selling it short, or go out and add it to their portfolios at this price.

Harjes: Yeah, absolutely. And when I look at their new CEO, Joseph Papa, I think about him the same way that I think about Uber's new CEO. He came into this business when it was at such a low point that's there's really not a whole lot he can lose. Either this stock doesn't end up doing very well, it can't ever get back to its former days of glory, and people are like, "Eh, you know, he tried, but what are you going to do with that pile of garbage?" Or, you end up being able to turn it around -- and he said it himself, it's the turnaround opportunity of a lifetime -- at which point, the guy is a hero. So, it could be a very dramatic story to watch going forward, and we'll be sure to give you all of the updates on Industry Focus.

As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!