Valeant Pharmaceuticals: A Look Behind The Latest Q2 Figures

| About: Valeant Pharmaceuticals (VRX)

Summary

Latest financials indicate Valeant would have to have all the luck in the world to meet their full year guidance as H1 2016 signaled weaknesses in their performance to date.

Non-core asset sales at suggested prices may lead to value destruction for common shareholders.

Refinancing remains viable but terms would depend on leverage levels, interest rate environment and market sentiment at that point of time.

Valeant Pharmaceuticals (NYSE:VRX) announced their Q2 results Tuesday.

A quick look at the published figures leaves little room for joy for investors as the company fell short of market expectations for EPS. More worrying, however, is the decline of 11.5% between Q2 2016 and the similar quarter last year.

Despite the upbeat language in their investor presentation about stabilizing the business and returning to growth, the financials reveal a much weaker company that may trip under the heavy debt load in the not-so-distant future.

Earlier this year, Valeant's management provided a new guidance for the investment community. Mid-point for expected revenues was US$ 10.0bn and EBITDA of US$ 4.9bn.

The guidance was initially thought to be conservative and easily achievable. Many investors, debt holders and ratings agencies bought into the story.

Yet, following today's results and Valeant's insistence to keep the guidance unchanged, it is becoming difficult to understand how the company would achieve an adj. EBITDA of US$ 2.8bn for the second half of 2016 when they only achieved less than US$ 2.1bn in the first six months.

The usual ratio of 47/53 between H1 and H2 results doesn't bode well for believing that they would hit their annual budget.

If we take the 11.5% drop in sales mentioned above as a proxy of how their market will develop in the near future and assume declines of 10-11% for Q3 and Q4 this year in comparison to 2015, then Valeant would hardly even achieve US$ 9.7bn in overall sales for 2016.

I have presented an EBITDA to adj. EBITDA reconciliation for H2 2016 in the table below. It's worth noting that I have conservatively taken VRX's adjustments for H1 and extrapolated them to H2, except for restructuring costs of US$ 150m that the company guided towards in Q1 this year.

All amounts in US$ million

Q1

Q2

H1 2016

Q3

Q4

FY 2016

Net loss

(373.7)

(302.3)

(676.0)

(281.9)

(288.8)

(1,246.7)

+ Interest expense, net

425.7

470.4

896.1

448.1

448.1

1,792.2

+ Provision for income taxes

7.2

(72.8)

(65.6)

-

-

(65.6)

+ D&A of intangible assets

746.8

935.1

1681.9

888

888

3,457.9

= EBITDA

806.0

1,030.4

1836.4

1,054.2

1,047.3

3,938

Adjustments

Restructuring & integration

39.8

19.5

59.3

90.0

R&D impairment

0.5

17.4

17.9

17.9

Share based compensation

63.5

33.7

97.2

97.2

Inventory step-up

28.9

7.5

36.4

36.4

Contingent considerations

2.4

6.9

9.3

9.3

Other gains/(charges)

66.5

(27.6)

38.9

38.9

= Adj. EBITDA

1,007.6

1,087.8

2,095.4

4,227.5

Revenues

2,371.6

2,420.2

4,791.8

2,480.4

2,435.5

9,707.7

EBITDA

806.0

1,030.4

1,836.4

1,054.2

1,047.3

3,937.8

margin (%)

34.0%

42.6%

38.3%

42.5%

43.0%

40.6%

Click to enlarge

My assumption is that the company would fall short of expectations in Q3 and Q4 and only achieve US$ 4.2bn of EBITDA (approx. US$ 625m below their budget).

More interesting would be when this decrease in EBITDA is translated into cash flow.

I have presented the reconciliation below using Valeant's projections for outflows and inflows but on the lower EBITDA basis.

Expected cash flow for 2016

EBITDA FY 2016

4,228

- Cash interest

(1,700)

- Taxes (net of NOL)

(180)

- Change in WC

-

- Cash restructuring

(150)

- Milestone payments

(400)

- Sprout payment (Jan 2016)

(500)

- CAPEX

(275)

+ Proceeds from asset sales

60

CFs available for debt repayment

1,083

Adj. CFs for Sprout and asset sales

1,523

Click to enlarge

I have also provided an adjustment for the Sprout payment and the $60m asset proceeds from earlier this year in order to calculate what would have been the adjusted cash flow available for debt repayment for the year in the absence of these two non-recurring items.

Adjusted cash flows for the year come up to only US$ 1.5bn! And that compared to gross debt at the end of Q2 of US$ 30.8bn (~20 yrs to repay this at this rate). Net debt is just under US$ 30bn as the company ended the quarter with US$ 850m of cash and securities.

On a more positive note, the milestone payments and restructuring would decrease as soon as next year. However, any potential growth in sales would also trigger some negative changes in WC. Moreover, CAPEX is now below 3% of sales and traditionally has been in the range of 3.4-3.6%.

Still, it could be prudent to assume that CFs available for debt repayment go up by another $250m in 2017, despite the need for more WC and CAPEX. But even then, the approx. $1.8bn of cash flows going forward is a small amount compared to the mountain of debt that needs to be repaid in the next few years.

Looking at the near-term payment schedule, Valeant has interest, principal and lease obligations of US$ 7.4bn in 2017/18 and another US$ 12.9bn in 2019/20. Overall, more than $20bn of repayments until 2020!

It's hard to see how they would be able to accumulate the cash flow needed to service these payments at this rate of CF generation, unless they sell some non-core assets very fast and at very good prices.

Below, I have also tried to do a quick analysis of the options available to management in the near term - sell non-core assets within the next 12 months and/or refinance debt in 2017.

Review of non-core asset sales & refinancing

In today's conference call with analysts, CEO Papa mentioned that the company has received unsolicited approaches from potential investors to acquire assets generating revenues "greater than US$ 2bn" for a price of "approximately US$ 8bn." This statement clearly shows that on average these indicative bids valued these businesses below 4x revenues. Depending on how conservatively you want to look at this, this could be anything from 3.5x to 3.9x sales.

This is quite important because at the current price of $28/share, Valeant trades at an EV of US$ 40bn or just above 4x expected revenues for the year.

So these asset sales would actually not lead to value creation, but would be value-destructive for the common stock! That is if anyone buys a US$ 2bn revenues stream for US$ 8bn.

I am personally not convinced that Valeant would be able to fetch good prices of "approximately US$ 8bn" for these assets.

Any investor looking to buy VRX assets is fully aware of the precarious situation of the company and the looming debt payments due in the medium term. Hence, Valeant does not have too much time on their hands to negotiate a good deal, but is rather a forced seller. Therefore, I discount the "11x EBITDA" multiple from their presentation today and assume that they only manage to achieve a more moderate 10x EBITDA upon a successful sale of the non-core business.

This would allow them to repay back, say US$ 7.8bn, of debt but at the same time take out US$ 780m of their EBITDA going forward.

So adjusting for such a transaction, the gross debt becomes US$ 23bn and EBITDA only US$ 3.5bn. The Debt/EBITDA ratio improves to 6.7x from the current above 7.0x, but this does not fundamentally change the picture, if and when Valeant decides to refinance the outstanding amount with some longer tenor bonds.

A ratio of 6.7x would definitely put them in the upper bracket of the high-yield segment and the coupon payments would be significantly higher than the average 5.5% interest they currently pay. It's also hard to assume what the base rate would be 12-18 months from now, but we are currently at the lowest point possible, so there can't be any positive surprises going forward with rates going even lower. Chances are there will be rate hikes in 2017 and the base rate would be higher than the current.

Earlier this year, investors demanded a yield in excess of 9% for the risk they were taking buying Valeant's bonds, so it is highly unlikely that hedge funds would buy new bonds for a lot less, even if Valeant were to only pro-forma de-risked the investment due to slightly lower leverage ratio.

As a summary, I don't think Valeant would go into a downward spiral as I do expect that management will try to keep the ship afloat by pleasing the banks with some small asset sales.

However, I do think that the current price of Valeant's equity is absurdly high and will be adjusted by the market to reflect the problems ahead of the company related to its debt burden and lackluster cash flows.

I do believe that the current budget is unachievable and stands to be revised following the Q3 results release.

I can only assume that the CEO did not want to embarrass himself by lowering guidance yet again this year in his first call with the investment community.

Following a re-budgeting exercise at some point in Q4, I think we will see prices significantly below $20/share towards the end of the year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.