Perhaps we are in Wonderland. What can explain a stock surging 8% (intra-day) on news that generates this headline from MarketWatch, a mainstream e-publication?:
UPDATED: Valeant stock surges 7.9% after Q2 loss, 2017 revenue guidance cut.
While there is usually a range of possible outcomes to a company, and in theory the upside is usually infinite, thus every stock can be viewed as undervalued, in practice things usually go… normally. In this case, the latest information out of Valeant [VRX] supports my long-held view that the stock is mostly worthless or nearly so.
Before getting to the details, an analogy is in order.
Valeant – controlled by and run for the benefit of the lenders
Over a year ago, the lenders could have forced Valeant (NYSE:VRX) into liquidation or reorganization, but allowed debt restructuring. It was later reported that the lenders gained significant influence over the board. And – no surprise – the actions of the company have been the bond investor’s (lender’s) equivalent of the shareholder-friendly reduction of shares outstanding. Meaning, VRX now boasts of its reduction of debt. When one has debt due in 2022, 2023, 2024, etc., what one wants is to own a greater share of the remaining debt, just as shareholders like to similarly be able to sit passively with their shares and own a greater percentage of the company.
Bloomberg News reported on this in March, titling the article Valeant’s New Bonus Math Puts Debt Holders in Driver’s Seat. This is the lede, which is straightforward:
Valeant Pharmaceuticals International Inc. shareholders, slide over: Debt holders are driving the bus.
The drugmaker has changed how it calculates executive cash bonuses. Their incentives are no longer tied to adjusted earnings per share, which were used as an executive incentive when the company was a market darling. The bonuses will now be pegged to Ebitda — earnings before interest, taxes, depreciation and amortization — which, as it happens, is also a metric watched by its creditors.
“Investors are laser focused on Valeant’s debt covenants — and covenants are tied to Ebitda,” said Umer Raffat, an analyst with Evercore ISI. “Executives are being paid on being able to service debts. It’s just about the debt servicing.”
That last sentence might just have well as been phrased: “It all about the debt servicing.”
Here is the key point in my point when thinking about VRX, the stock, in view of the above, assuming you accept Bloomberg’s reporting, as I do. The key point is that the lenders have a good thing going, as far as lenders rather than equity investors think. They have, say, something like 6% bonds now (that’s approximate). The largest single year maturity is 2022. Whereas they will get well under 3% from investment grade bonds with a 5-year maturity. Going forward, if they get, say, 6% a year for 5 years and begin with $10 million face value, they will end with $13 MM ignoring taxes, interest earned on interest paid, etc. If the company does really well and pays off the debt with a high degree of coverage, or does mediocre and pays off the debt with little margin to spare, it matters not to the lender. That’s not a great situation to incentivize executives to travel the world, pull all-nighters, etc. to create real value for shareholders. Worse, it matters only a little to the lenders if they get 99 cents on the dollar back, or even 98 cents, just so they get their interest payments in full.
Worse, while now the creditors will not be thrilled if a 5-year 6% loan effectively turns into a 5% loan because the debt is repaid at only 95 cents on the dollar, that’s still at least 2 full points better than a safe investment grade loan would have paid. So the lenders, in that case, can still be happy considering what a mess VRX was in by late 2015 and much of last year.
I see VRX acting in creditor-friendly fashion rather than going aggressively for growth, which would be a more shareholder-friendly strategy.
Thus, why should anyone want to be a shareholder of VRX who does not have to be?
Now to the latest information that I interpret as consistent with VRX shares being worthless. The range of possibilities does include them being worth something, and even possibly more than they are trading for, but here’s the evidence that the weights of what may happen tend toward a fair value near zero.
Before the earnings report, there was some material bad news Monday:
FDA does not approve a key glaucoma drug
VRX has had problems with a manufacturing facility in Tampa, Florida. Unfortunately, the company was forced to announce this on Monday:
Valeant Pharmaceuticals Receives Complete Response Letter from the FDA for Latanoprostene Bunod Ophthalmic Solution, 0.024% NDA
Valeant Pharmaceuticals International, Inc. today announced it has received a Complete Response Letter from the U.S. Food and Drug Administration (FDA) regarding the New Drug Application (NDA) for latanoprostene bunod ophthalmic solution, 0.024%, an investigative intraocular pressure lowering single-agent eye drop for patients with open angle glaucoma or ocular hypertension.
The CRL from the FDA only refers to a Current Good Manufacturing Practice (CGMP) inspection at Bausch + Lomb’s manufacturing facility in Tampa, Fla. The FDA did not identify any efficacy or safety concerns with respect to the NDA or additional clinical trials needed for the approval of the NDA for latanoprostene bunod ophthalmic solution, 0.024%.
Valeant will work closely with the FDA to determine the appropriate next steps for the NDA.
I believe this drug was the subject of a prior NDA, and this was a resubmission. One would certainly hope that an approval can be granted by the first half of next year.
But the longer it takes to get what could be a nice seller, with allegedly greater effects than the (heavily genericized and/or entrenched) drugs for glaucoma that work by a similar mechanism, to the market, the more entrenched the other brands and generics become. This includes drugs and possibly drug-device combos that work by other mechanisms. In addition, VRX’s debt repayments start up again in only 2+ years (2020), thus the longer it takes this drug to begin generating positive cash flow, the worse it is for shareholders and the more nervous the lenders may get.
Next, some takeaways from the Q2 earnings report.
Q2 does not change much
The reported loss of “only” $38 million, or -$0.11 EPS, may have assuaged some traders or scared some shorts into covering. However, in thinking forward, there were two items I focus on. One was that “operating income” of $175 MM needs to include net interest expense of -$456 MM. In other words, real operating income was $456 – 175 = -$281 MM or -$0.80 EPS.
This annualizes to about a loss of $3.20 per share, which is no way to escape a huge debt load that needs to be paid down beginning as soon as 2020.
The special situation that occurred in Q2 was a negative tax cost, i.e. tax benefit, which was worth $205 MM. There was also a small foreign exchange line in the calculations that “cost” $39 MM and was omitted from VRX’s main list of costs.
Basically, I’m doubtful that VRX can ever be profitable, except for one-time quarters that may involve such factors as negative tax rates, gains on sale of a division, etc. However, significant inflation that could push up the nominal value of the major Bausch & Lomb division, or a major surprise success (surprise to me; see below) for Siliq, could change matters. There is always some uncertainty, but I still see no investment merit to putting new money into VRX, and once again think that for those who do short selling, unlike me, VRX is an interesting and perhaps timely candidate; and timing is at least half the battle in short selling.
Moving on beyond GAAP EPS, for those who think that amortization, which is included as a cost in the calculation of profit or loss, is somehow a “fake” cost, VRX provided information regarding that.
On slide 17 of the presentation that accompanied the webcast, VRX states that normalized cash flow from operations was $458 MM. Annualize that and you get $1.84 B. Now make the possibly heroic assumption that despite selling off Provenge and a number of other products in Q2 and in H2; with losses of exclusivity proceeding apace this year and through 2019 (I believe); with VRX’s generics business imploding; with the new glaucoma drug delayed and possibly never coming to market; and other asset sales likely coming, that operating cash flow will not drop. Again, anything is possible until it happens, but I doubt that cash flow will even do so well as to stay even.
If it does, where does that get the VRX shareholder, and for that matter, the bondholder?
Not far. Take $1.84 B, multiply by 6, and you only get $11 B or so in cash flow in total or the next 5 years.
What does that get you with regard to debt repayments?
VRX’s challenging debt load and repayment schedule
This is presented by tranche near the bottom of the press release. It is also presented in more relevant form for my purposes in slide 16 (p. 15) of the presentation. Remember, VRX had $26.8 B of net debt as of 6/30/17. This is the repayment schedule by year, with none until 2020. We begin there with maturities of debt plus mandatory amortization (sinking fund equivalent as far as I can tell), in billions of USD:
- 2020: $5.7
- 2021: $3.5
- 2022: $7.0
- 2023: 6.0
- 2024 and beyond: 5.3.
See the slide for details, as the above numbers are not designed to add precisely to aggregate or net debt levels. But these numbers taken from the slide show the point I’m making well enough.
How is a company that is losing lots of money using generally accepted accounting principles apart from the negative tax rate, and that is only on schedule to generate what the company itself implies is $11 B (perhaps) in normalized cash flows from operations by mid-2022, going to A) meet its obligations to debt holders and B) have anything at all left over for shareholders? These numbers exceed $11 B by 2022 and then rise in 2023.
This looks really, really challenging to yours truly. So it may be all over under normal scenarios, and even under bullish scenarios.
In that regard, it may be telling that in a generally unrevealing conference call, the first question dealt with debt repayments.
What about Siliq?
The company did not tout its (very early) days on the market very heavily. This is a difficult product for VRX to turn into a gold mine. It has marketing rights in the Americas and certain other territories, but not in Europe, Japan or some other Asian countries. A profit share with the Big Pharma developer of the drug, AstraZeneca (AZN) has been agreed, and sales milestones of up to $175 MM are due to AZN from VRX. The big handicaps for Siliq are two-fold, as I described in an article on VRX and Siliq in April. One is competitive; the other is the suicide warning in a black box in the P.I. Both of these are important, but the latter one may be near-fatal to the drug’s prospects. This is from the P.I. (emphasis added by me):
WARNING: SUICIDAL IDEATION AND BEHAVIOR
• Suicidal ideation and behavior, including completed suicides, have occurred in patients treated with SILIQ.
That’s bad enough.
What adds to the potential pain for prescribers are two requirements, not mere recommendations. The first is the worse one in my opinion:
- Advise patients and caregivers to seek medical attention for manifestations of suicidal ideation or behavior, new onset or worsening depression, anxiety, or other mood changes.
Just to make sure you got the message, what this FDA-mandated language says is that the prescriber, typically a busy rheumatologist or allergist, must give that advice. It does not look optional.
This is not the same as advising the doctor to be alert for mood changes. The doctor must warn the patient, who is already not feeling too hot about having moderate to severe psoriasis and going on a first, second or even third biologic, that this drug may drive him/her to think of killing him/herself; and if so, get immediately to a doctor.
How many doctors want to tell patients that and then deal with the follow-up questions? And how many patients will not look for an alternative treatment plan? Or, will just look for an alternative doctor? Worse, you have to understand that if a patient gets very depressed, he/she is not necessarily either fully rational and/or able to competently accomplish something that can be difficult, namely actually getting to see a doctor.
So the whole story is a deal-killer for Siliq for me as far as anything much other than last-ditch use. We will just have to see, but that’s my basic bias. I would not touch VRX stock on the hope that Siliq turns out to be a home run. And, as shown in the prior section, the debt clock is ticking. If it turns out that Siliq does not deserve that block box, it will take time to get it removed; and time is not on the side of VRX shares.
The second requirement in the P.I. is to get certified in the Siliq REMS Program to allow the prescriber to prescribe Siliq. That’s not much of a hindrance – if the doctor wants to prescribe Siliq at all.
VRX has leaned on the idea that Siliq is the least expensive biologic for psoriasis.
If that’s the selling point, it has generally not worked when there are “issues” around a drug. When there are no serious issues, such as AbbVie’s (ABBV) and Merck’s (MRK) drugs for hepatitis C, then, yes, insurers and PBMs love price competition.
So I do not give Siliq much of a chance to make the difference for VRX.
What about all the other drugs?
Also unlikely as I see it. As an example, take Xifaxan, for several different GI conditions. Despite an increased sales and marketing effort, yoy revenues in Q2 rose from $200 MM to $233 MM, or 16.5% (slide 35). That’s nice, but this level and some future growth won’t fill the holes in VRX’s balance sheet that much larger revenues and profits must fill. Plus, the indications for Xifaxan are not growth indications.
The rest of the products are mostly blah, or, in today’s parlance, meh.
As far as the non-glaucoma pipeline goes, VRX mentions IDP-118, a pending topical treatment for moderate-to-severe plaque psoriasis. It will be nice if it comes to market, but this product is simply a co-formulation of two topicals, one a steroid, that are each already approved for that very indication. I predict that IDP-118 will, if approved for marketing by the FDA, not rescue VRX.
And so on.
Risks of not owning VRX
Risks of short-selling VRX
Large and theoretically infinite, but perhaps a good idea nonetheless.
Full disclosure: I am not a short seller, put buyer, etc.; and work alone, thus I am not “in league” (etc.) with any such person or organization. This article simply reflects facts that I have gathered and tried to interpret reasonably.
Now for some concluding comments and opinion.
Conclusions: VRX as dead meat
I’m going to leave the first part of the article alone, as when it was written Tuesday VRX was indeed up 8%. It closed Tuesday at $15.64, up 1.76%, and is being submitted to Seeking Alpha Tuesday night.
My guess is that the short-covering, hope-filled rally in VRX is over or just about over. The numbers are what they are. VRX seems to tell us via its normalized cash flow numbers that it simply appears not to have the firepower to meet its debt repayment and mandatory amortization requirements. Exactly how it calculates this metric is a bit obscure, though.
Being conventional, I prefer to think in terms of earnings rather than normalized cash flow, an undefined term, and I prefer to use generally accepted accounting principles, the oft-neglected GAAP. Here, the future of VRX looks bleak for shareholders and very possibly for bond holders. Even with a negative tax rate, Q2 saw a loss. But, that was with the benefit of what looks like a full quarter of Provenge sales.
Now that Provenge (Dendreon) was sold in Q2, there goes over $300 MM in annualized revenue. These were presumably profitable revenues or the deal would not have been done for $800 MM cash coming into VRX. Other products, product lines or divisions such as iNova have either disappeared recently or will do so in H2 this year; and losses of exclusivity are continuing apace.
I’m perfectly ready to be proven wrong, and as mentioned above, certain things might come together in an upside “perfect storm” to save the day for shareholders. But, more likely, it appears to me as though VRX did its roll-up thing not wisely and not too well. My analysis suggests that the result could easily be a complete wipe-out for shareholders and that creditors may be in trouble as well. This is not an outcome I’m hoping for, but hope is not a great investment strategy.
Good luck to all.
Thanks for reading and sharing any comments you wish to contribute.
Disclosure: I am/we are long ABBV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.