More Reasons That Valeant Stock May Be Worthless

| About: Valeant Pharmaceuticals (VRX)

Summary

Hits to Valeant just keep on coming.

This article re-analyzes salient features of the company in view of recent news and my own prior analysis.

I continue to be disheartened by the situation at the company.

Though I have no position against the stock, my analysis is that the stock could well prove worthless or nearly so.

Thoughts about how a Valeant bankruptcy, if it comes to that, might affect the equity and junk bond markets are also presented.

Background

After Citron and others launched a short-selling raid on Valeant (NYSE:VRX), I wrote an article published on Oct. 22 in which I said, with VRX around $97/share:

But, given no blockbuster, little in-house R&D, and poor finances, maybe 6-8X GAAP EPS is more appropriate, or a single-digit share price. Whereas, the stock is around $97 as I write this on Thursday.

That was done assuming the company was completely on the up-and-up, for sake of argument. My goals in writing the article on a company that was not an innovator in new drug development - my main focus as a writer for Seeking Alpha - involved not only weighing in on a high profile story in my core field of pharmaceuticals but also to expound on the importance of GAAP accounting.

This topic became far more prominent about a week later when powerhouse business writer Gretchen Morgenson of the NYT wrote an article titled Valeant Shows the Perils of Fantasy Numbers, also focusing on the value of GAAP.

GAAP is not perfect, and when the issue is something as debatable as the present value of options grants, I don't write about it, but in the case of VRX, it and its fans were basically trying to imply that the capital lent to it to make acquisitions never had to be paid back, therefore never should enter the P&L as the expenditure that it was.

Subsequently, the ongoing crash in this highly volatile stock caught my attention with two additional articles last month analyzing and chronicling the deteriorating situation.

My goal in this article is to lay out the results of my analysis of certain details of this evolving story that I think could be valuable both for VRX shareholders (or shorts), those considering taking a position in the stock, and investors in general.

Full disclosure: I have never traded VRX, either the shares or options in it, and am not associated to my knowledge with anyone or any entity that has any financial interest in movements in the stock in either direction. This article is written as an analyst and commentator, taking note of the continued high volume in VRX shares and its nearly $10B market cap.

As mentioned in the bullet points above, my view is that VRX shares are overvalued at Monday's closing price of $26.11. My base case is that VRX is more or less worthless. As discussed below, as always with a public stock, anything might happen to the share price, which is one reason I rarely short any stock. But we all make judgments on financial assets understanding the uncertainty.

Herewith is a bear case for VRX that incorporates recent statements and information, mostly directly from the company, that I believe make my bearish thesis a reasonable one.

VRX - why the reluctance to report Q1 results could be a "smoking gun"

A modest restatement of revenues for 2014 into 2015 is irrelevant to a large cap stock, which was the status of VRX until recently.

More concerning is the continued delay in filing a 10-K for 2015.

But even that is A) historical and B) might be spun by the board claiming it was blindsided by CFO malfeasance (see below); and it's a whole year and difficult to analyze rapidly and accurately. I'm not excusing this delay at all, but to keep things simple, I want to focus on the biggest issue of this type as I see it: the desire of VRX not to file its Q1 results timely. There is no Philidor at all in 2016.

Why can't VRX report Q1 by June 14?

The company has not tried to explain this, at least that I have seen.

The specific source for this situation was the lede from the VRX press release from March 30:

LAVAL, Quebec, March 30, 2016 /PRNewswire/ - Valeant Pharmaceuticals International, Inc. (NYSE: VRX and TSX: VRX) today announced that, as anticipated and consistent with its previously disclosed intention, it has launched the process to obtain an amendment and waiver to its credit facility.

Pursuant to the proposed waiver, the Company is seeking to extend the deadline for filing its Form 10-K to May 31, 2016 and to extend the deadline for filing its Form 10-Q for the quarter ending March 31, 2016 to July 31, 2016. While the Company is working diligently to file its Form 10-K and Form 10-Q, these extensions provide relief under the credit facility in the event the Form 10-K is not filed by April 29, 2016 and the Form 10-Q is not filed by June 14, 2016. In addition to the extensions, the proposed waiver would also waive the cross-default to Valeant's indentures that arose when the Form 10-K was not filed on March 15, 2016. The proposed waiver and amendment must be approved by lenders holding more than 50% of the Company's loans in principal amount.

Before discussing the prior and more comprehensive press release of March 21, which came out just an hour or two after my most recent VRX article was published, let's just think about what it means not to want to submit a 10-Q by June 14.

The relative simplicity of the accounting for the (legal) drug biz

The pharmaceutical field is not complex from a financial reporting standpoint; it's nothing like banking or insurance, where forward-looking projections are routinely made. If a bank or insurance company makes a reasonable projection for loan losses or future claims, respectively, and does so competently and in good faith, then investors do not panic and blame management if results turn bad due to a recession, natural disaster, etc. There are other types of business that involve material uncertainties related to depreciation schedules, when an account receivable should be classified as doubtful, etc.

In contrast, in pharma, accounting is really pretty easy. Losses from sales to customers, i.e. distributors or occasionally end users such as M.D.'s offices, are immaterial, at least in the US.

Chemicals needed to manufacture the drug flow into manufacturing plants, then drugs flow out. Labor costs, rent, contract manufacturers, interest payments are easy to track. Amortization schedules are predetermined. So are GAAP charges for stock-based compensation, which everyone knows are just a guess.

That's pretty much it. Easy as pie.

Inventory and sales are tracked hourly or so, though VRX operates in numerous countries. Some of those countries are frontier-type, but the aggregate dollar sales there is likely so small that by now, the company has experience with how to get some numbers out of them.

So why is the middle of June inadequate to allow reporting of results?

I have trouble accepting at face value that more time is needed for the Q1 10-Q beyond mid-June. As actual or potential investors, we all make decisions based on incomplete information, and I smell trouble with this issue.

That said, now I want to double back to the March 21 announcement (which came out just after my March 21 VRX article was published).

What might have been the lead to the press release, or almost the lead item, was buried near the end of it. This critical part read:

Assessment of Disclosure Controls and Procedures and Internal Controls Over Financial Reporting

As a result of the restatement, management is continuing to assess the company's disclosure controls and procedures and internal control over financial reporting. Management, in consultation with the committee, has concluded that one or more material weaknesses exist in the company's internal control over financial reporting and that, as a result, internal control over financial reporting and disclosure controls and procedures were not effective as of December 31, 2014 and disclosure controls and procedures were not effective as of March 31, 2015 and the subsequent interim periods in 2015 and that internal control over financial reporting and disclosure controls and procedures will not be effective at December 31, 2015.

The improper conduct of the company's former Chief Financial Officer and former Corporate Controller, which resulted in the provision of incorrect information to the Committee and the company's auditors, contributed to the misstatement of results. In addition, as part of this assessment of internal control over financial reporting, the company has determined that the tone at the top of the organization and the performance-based environment at the company, where challenging targets were set and achieving those targets was a key performance expectation, may have been contributing factors resulting in the company's improper revenue recognition.

Just to repeat this oh so important phrase:

"...internal control over financial reporting and disclosure controls and procedures will not be effective at December 31, 2015."

This is potentially devastating stuff. Not to ignore also emphasizing the "tone at the top" phrase and that which follows it.

Might revenues have been overstated, perhaps significantly? Is there a secret warehouse somewhere for product that was booked as sales but was never actually sold? Or something like that?

"Challenging targets were set" suggests all sorts of negative things, does it not, when doing so "may have" contributed to "improper revenue recognition."

Was there much of a "there" there at VRX? This is scary language if you're long this stock, I would think.

I combine this statement with the desire to file Q1 as late as possible and wonder if the results could be really, really bad. Could they be bad enough to sink the Valeant ship? Does the board fear, or believe, that it needs to reshape its debt structure before coming out with what it fears, thinks or believes could be quite bad news of Q1 results?

Who wants equity exposure to this name at a $9-10B market cap? Why?

Remember, as I discussed last month, the company turned unprofitable in Q4 with worse results in Q1 admitted to by the company. This is before at best any increased interest costs the company has offered creditors.

Could this fit with the AIG analogy?

AIG (NYSE:AIG) suffered through this sort of thing for years before imploding; from ProPublica:

It wasn't until March [2008]-three years after repeated and significant misstatements and serious weaknesses, and one month after the latest set of errors-that Lee [a Federal regulator] wrote to AIG saying it needed to better manage its risk from credit-default swaps and report back with a corrective plan.

By September, AIG was essentially bankrupt, surviving only with at least $150B in bailout support from the central authorities.

Thus when I read about internal controls on the financials inoperative as of Dec. 2015 and then a fervent wish to delay Q1 financials, I think that a debt-heavy company's stock may be simply uninvestable except at a verifiably bargain price. After all, a highly-indebted company has many similarities to a typically-leveraged financial products company.

What, then, is a verifiable bargain price for VRX?

Unfortunately, I can't name one. In fact, I think that, at least for an outsider...

Valuing VRX is almost impossible now

To begin with, while it receives little attention these days, the first thing I do when evaluating a stock is look at the balance sheet. In fact, as the years have gone by and discussion of balance sheets has received progressively less attention in the business press, I pay more attention to it than before. In the case of VRX, its 10-K for 2014 revealed a net worth of $5.3B but a negative tangible net worth of $15.3B. After the large deal for Salix, these numbers changed, but as restatements are coming, the point is the same: if the intangibles and goodwill on the balance sheet were overvalued by $5.3B, then the company would have been technically worthless at the end of December 2014. Given the years of deal-making, often when general stock market (NYSEARCA:SPY) prices were much lower than they are today, just to be able to think that is a bit worrisome for the VRX longs, I would think.

Furthermore, does anyone think that the large Salix deal was done merely at fair value rather than above fair value? Perhaps several billions of dollars above fair value?

In my March 21 article, I guesstimated Q1 results assuming reasonably decent results on finalizing the numbers, which may or may not be overly generous to VRX. Given weak sales in Q1, I projected larger losses (I only use GAAP for VRX; see below) in Q1 than for the preliminary loss reported for Q4.

As matters stand with VRX around $26, the stock trades at 15X TTM EPS (earnings subject to revision, likely downward).

That's close to the P/E of Amgen (NASDAQ:AMGN) and Biogen (NASDAQ:BIIB); almost as high as that of AbbVie (NYSE:ABBV), maybe 2/3 that which I expect from Celgene (NASDAQ:CELG) for CY 2016, and double that of Gilead (NASDAQ:GILD). It's much higher than the P/E of the most iconic company of our time, obviously Apple (NASDAQ:AAPL).

However, that's just the P/E based on preliminary reported 2015 EPS, which the company has warned us are unreliable.

If we replace Q1 2015 with a projected loss for Q1 2016, the P/E would be higher. Would it be infinite (i.e. a 12-month GAAP loss)?

We'll have to wait to find out. But it's essentially certain that VRX is in reality a high P/E or infinite P/E stock with, among other problems:

  • negative current sales and earnings growth
  • weak finances
  • management and board turmoil of an almost unprecedented nature, and
  • board dissension - among other problems.

In situations such as this, I like to look at related matters. One showed itself recently that could contravene the story that VRX was so competent that it could pay rich prices for its deals and make the numbers work. This is discussed next.

The Sprout-Addyi problem could be a straw in the wind

In addition, showing for me the apparent and surprising weakness of VRX as a marketer and/or deal-maker, we had this from a few days ago:

Former Sprout investors unhappy with Valeant over Addyi price

Former investors in Sprout Pharmaceuticals say Valeant Pharmaceuticals International failed in its attempts to commercialize the female libido pill Addyi, the drug developed by Sprout that was acquired by Valeant last year for $1 billion cash.

A representative of the investors sent a letter to Valeant alleging that the pharma giant has not held up its end of the deal and therefore not met the obligations in the acquisition agreement.

Specifically, the investors say Valeant has priced the pill too high, according to Bloomberg, which reported on the letter...

The former Sprout investors say, "Valeant predatorily priced Addyi at $800 a month even though Sprout had established a price point of approximately $400 a month for the drug based on market research," according to Bloomberg. The higher prices have kept insurance companies from covering the drug. Without insurance coverage, women who want to buy the pill must pay full price.

This complaint strikes me as credible, though I have no special knowledge of the situation beyond what I have read recently on it.

Seemingly worse, on Monday Bloomberg News reported this:

Valeant Pharmaceuticals International Inc. has terminated the sales force for the female libido pill that it acquired last year for $1 billion, people familiar with the situation said, after the drug, Addyi, failed to gain traction in its first six months on the market.

Valeant plans to relaunch its sales effort for Addyi with an internal team it will build in the coming months, according to the people, who asked not to be identified because the matter was private. The drug will still be available in the meantime.

Along with the 140 contract workers that make up the Addyi sales force, Valeant is firing about 140 employees across its dermatology, gastrointestinal and women's health divisions, with dermatology taking the biggest hit, according to one of the people...

Once again, VRX appears to have fallen short on a project.

This raises the following issue:

VRX as poor marketer

In addition to the Addyi/Sprout issues discussed above, the Bloomberg article also paints a downbeat picture of other aspects of its marketing. From the article:

In Pearson's [leaked internal] memo, he did not specify how many sales people would be used to market Addyi.

In the gastrointestinal division, Pearson said different parts of the sales force would be integrated given the company's increased focus on marketing Xifaxan for hepatic encephalopathy. The drug is also approved for irritable bowel syndrome with diarrhea.

I have previously commented that this important drug for VRX has a problem, namely that the IBS with diarrhea market is a difficult one to sell into, and that Xifaxan had limited efficacy in this syndrome above the high rate of response to placebo. The condition of recurrent hepatic encephalopathy can be pre-terminal, is not all very common, so shifting sales resources from the far larger IBS market to it does not strike me as a positive sign.

Thus, in the context of the very expensive Salix acquisition, I perceive more red flags suggesting that VRX may have seriously overpaid.

There's even more breaking news, and in some ways it could be the worst news of this part of VRX - namely problems in one of its core areas of alleged expertise - dermatology.

The article also says this:

Pearson said the dermatology division would be downsized because the company has "received increasing feedback from doctors that we have too many people calling on them to discuss closely related products."

Sorry to be a "one-note" here, but on seeing this, I really said "oh my gosh" to myself (maybe something a bit earthier if truth be told).

This company was supposed to be good at dermatology, with a broad product line in this high-margined sector. Now we learn that just as the "Citi swarm" did not save Citigroup (NYSE:C) from a brush with bankruptcy in 2008, VRX has been employing something like a "Valeant swarm" to push its derm products. Meaning, I presume, that they were not selling well enough to suit management, so the reps had to offer the staff a lot of take-in lunches and otherwise insinuate themselves into the doctor's office - where they got to be pests - or something like that; so it seems to me based on the above and my knowledge of the pharma marketing industry.

A strong product line such as Lipitor in its day and Harvoni/Sovaldi or Revlimid/Pomalyst does not need to bother doctors, just market to them in a normal fashion. The company knows the product is strong and that getting a rep to a doctor's office is costly. The quality, highly-profitable companies do not get themselves into this sort of situation. They do not, not, not annoy the doctor; they try not to annoy the receptionist who is the first gatekeeper in the office. Everybody knows the drill. A rep gets a minute or two with the doctor maybe once a month in return for some samples, which benefit the doctor because patients appreciate it. There is commonality of interest, and matters run smoothly. The above issue with VRX strikes me as unusual and problematic.

This looks more like a sinking ship than not to me

Everywhere I look at the news on VRX, from the company's own words as well as well-sourced reporting, I see a sea of troubles.

I see no reason to expect sales and earnings to pick up as sales people are laid off and Mr. Pearson's recent memo implies that the company has not experienced the success it had wished for in marketing of several key products.

That brings me to the two concluding points. Since VRX is asking for forbearance from creditors, but it lost money in Q4 and has strongly implied that lost a lot more money in Q1 (but cannot or wishes not to tell us how much), the question is why should creditors cut it any slack at all. This is what I said in my last VRX article, from March 21:

This implies that the lenders are not going to sit around passively and let VRX gradually, slowly amortize the money it spent ("lost") on those acquisitions - money it mostly or entirely never earned.

The dynamic I expect is that increasingly, and perhaps rapidly and stochastically, VRX is likely to find that lenders want to get out of their exposure. If this is the best of times for pharma pricing and market share, why hang around?

Apparently this is similar to what is going on now, as Bloomberg News also reports.

VRX runs up against reluctant creditors

This is hardly a case of a natural disaster or some other one-off identifiable situation, or a Great Recession, where lenders want to stick with a solid performer. Per Bloomberg also from Monday:

Valeant Creditors Resist Proposal to Relax Lending Pact

Valeant Pharmaceuticals International Inc. is facing push back from some of its lenders as it seeks to waive a default and loosen restrictions on its debt, according to people with knowledge of the matter.

The resistance may complicate Valeant's efforts to win the support it needs before the Wednesday deadline for lenders to respond...

Under the current proposal, the drug maker is also seeking to loosen restrictions on its credit pact that govern a measure of earnings the company needs to maintain relative to its annual interest expense, Valeant said in a statement on March 30.

The interest-coverage ratio was set to jump to three times from 2.25 times, with that level set to be tested before the end of June, according to its current agreement with lenders.

Again, the question I ask is what incentive does a lender have to go easy on this company, unless it or an affiliate is also a large stockholder?

So I see this as very reasonably a total or near-total loss for common shareholders soon. Can I predict that with any certainty? No. Anything can be, and I'm on the outside looking in. My investment point is that I cannot see, from my perspective as an outside investor with some experience in the pharmaceutical industry, why any new money would want to come into this name at any valuation remotely close to the current $9B or so.

My view is that this is an uninvestable, uninterpretable, highly unfortunate situation. Who did what, knew what, intended what, accomplished what - all those questions cannot be answered by anyone except perhaps insiders. And even there, those of you who have functioned at high levels of corporations or other institutions may agree with me that even (or especially, perhaps) there, a single truth may well not exist. People can legitimately see things differently.

So given the risk that the company has no profitable core operations sufficient to meet interest and principal repayments, I think it's very possible that one way or another, at one time frame or another, the lenders will end up taking control of the company and maximizing their returns. If that occurs, whatever would be left for shareholders is anyone's guess.

Of course, a better outcome is possible. That would be nice. But I would not bet anything on it unless the stock were at true distress levels.

I want to end by speculating on what effect a VRX bankruptcy this spring or summer might have on the stock and junk bond markets.

Concluding remarks - could VRX going under also hurt the markets much?

There would be direct and indirect effects in a bankruptcy situation. In our very large stock market, the loss of VRX's market cap is not large enough to cause a real shock to the system in and of itself. So the stock's implosion to date, and if it continues, will be of limited systemic importance per se. Psychologically, it might be a different story. Investors might start looking skeptically at non-GAAP "earnings," for example. Pro forma earnings for IPOs that have been stripped and loaded down with debt may not fly very high in the future.

I therefore think there would be some more toward a more traditional set of valuation metrics if VRX goes down for the count.

The effect on the junk (high-yield) bond market could be more profound. It might turn out per the extreme scenario laid out above that unfortunately, lenders were misled, either deliberately or by their own carelessness. Maybe they trusted Mr. Market that there was a significant equity cushion to protect their capital, and that may have led them to underestimate the risk they were taking. Also, it appears increasingly likely, if not certain by now, that operationally VRX was not what they thought it was. The complaints by the company about the CFO and "tone at the top" (presumably meaning the CEO and not the board), plus all the points made in this article and previously by me, plus all the other problems with VRX I have not even discussed, speak to that.

My guess therefore is that junk bonds have risk here from a continued VRX implosion if it comes to that.

If that occurs, there is an important secondary effect on stocks that could occur. If we look at the yield to maturity available from a decent quality high-yield ETF (NYSEARCA:HYG), I believe it's attractive compared with a 24X TTM P/E on the SPY. If yields increase much more on HYG or its lower-credit quality ETF sibling (NYSEARCA:JNK), this might put severe pressure on stock market valuations. This is, after all, a market where the S&P 500 trades near 24X EPS but the other 1000 stocks that with the '500' comprise the S&P 1500 trade at substantially higher P/E's despite much lower operating profit margins. I think there is potential for very significant price-cutting of share prices, especially among the smaller stocks but also among the '500,' to realign with the values available from high-yield bond funds if those yields rise further.

Summary

I have no financial interest in VRX stock, options, etc. I am rather horrified to see the current situation. Using the best analytic tools I have, which admittedly are those of a small private investor and not those of a sophisticated analyst, I find it difficult to put a valuation on VRX common shares much above zero. They may of course trade much higher than that, but I think the risk is real that they are or will prove to be worthless or nearly so.

If that situation does come to pass, I also think that junk bonds may see their prices cut and yields rise. If that in turn occurs, I see the possibility that equity valuations could decline, perhaps significantly, to "catch down" to a renewed fall in the junk bond market.

All in all, the VRX situation may show that while it is not possible in all cases to take the advice of Polonius and be neither a borrower nor a lender, it's wise for a company to have real equity and real earnings when it takes on debt, and it's also wise for lenders to be prudent stewards of the capital they lend out.

As Charles Dickens wrote in David Copperfield in 1850:

"'My other piece of advice, Copperfield,' said Mr. Micawber, 'you know. Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery."

I fear that VRX might be in a "misery" situation in an increasing way, and perhaps sooner rather than later.

Disclosure: I am/we are long AAPL, GILD, AMGN.

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.