Valeant: Much More Upside Remains (Part II)

Summary

• Valeant can comfortably meet debt repayments through to 2020.
• At 2020, refinancing debt should be below 5x EBITDA, allowing Valeant to refinance on better terms than recent refinancing that was at 7x EBITDA.
• FCF-Equity will be $1.1bn in 2017, growing to $2.5bn by 2021.
• Valeant's share price should rise to $60+ by mid-2020 (3y from now).

In part I of this article, I showed how I expect Valeant (VRX) will deliver EBITDA within its 2017 guidance range and that its EBITDA will recover to ~$4.0bn by 2020 even after the Dendreon and iNova divestitures. In this part II, I explore the implications of this EBITDA growth for debt repayment and Valeant's share price trajectory. I also discuss potential events, such as a rumored debt-for-equity swap and a potential bid for the company.

Valeant much better placed after the refinancing

I believe that Valeant has conclusively shown its ability to service its debts during the past six months and that any projections of the company's impending bankruptcy have been proven to be false. First, there were the asset sales of CeraVe skincare, Dendreon, and other smaller assets that were announced in January. Second, the debt refinancing that was completed in March was very important, as it extended debt maturities and bought Valeant enough time to sell some assets and improve the profitability of its core business. Third, Valeant repaid $1.3bn of debt in Q1 17, and a further $1.0bn since then. Fourth, the core divisions for Valeant's future, Bausch & Lomb and Branded Rx, have begun to improve their performance as I discussed in the first article.

Of course, some of these developments have been reflected in the share price, which has doubled from the lows of $8.50. But I believe the share price still lags Valeant's underlying performance, and it still in part reflects the views of some parties that the company is not yet on the road to recovery. One of the stronger arguments that support this bearish view is that even though Valeant has paid off some of its debt, EBITDA has also dropped (in part from selling EBITDA-producing assets, and in part from the divisions VRX still owns) so that debt/EBITDA ratios remain close to 7x. Valeant remains highly levered. However, these views do not recognize that the quality of Valeant's EBITDA has risen with most of these asset sales (except CeraVe), and that from 2018 onward 80% of EBITDA will be from higher quality businesses that are growing their EBITDA. These businesses are also very cash generative so Valeant can easily meet interest payments and then also pay down debt by at least $2.0bn per year from 2018 onward.

Valeant well-placed to service debts through to 2020

To fully understand Valeant's improved ability to service and pay back its debts, we need to understand its debt maturity profile. The table below shows this profile, starting from the $28.5bn long-term debt as of the end of Q1 2017, after the refinancing transaction was completed. Net debt at that time was $27.3bn (cash was $1.2bn), and I expect net debt at the end of Q2 to fall to $26.2bn. This includes a large net cash figure of $2.1bn as of the end of the quarter, but Valeant has since used $1.3bn to repay the $811mn of senior debt and $498mn of bonds that were due in 2018. Following further cash inflows from operations in Q3 and Q4, and the proceeds of the iNova sale that are expected in Q4, I expect net debt will be at $24.6bn by the end of 2017. This will be 6.7x 2018e EBITDA, a vast improvement from the 8.0x 12m fwd. EBITDA from the end of 2016 (leverage figures are in the next table).

Having recently repaid the 2018 bonds, Valeant has no debt due until 2020. The next table shows that Valeant can likely meet its 2020 debt repayments ($5.7bn worth of bonds) from internal cash flows, but can probably not meet the repayments of a further $3.5bn in 2021 and $4.8bn in 2022.

This isn't a problem, however, as Joe Papa & Paul Herendeen have made it clear that they do not expect to pay off all debts, but just to get back to a more manageable level of $15-20bn rather than $25bn+. Valeant should have net debt of $18.6bn by the end of 2020, which will be 4.5x EBITDA at that point. This places the company in a much stronger position to refinance its remaining debts, which I expect it will do in H2 2019 or H1 2020 than it was during the March refinancing when its leverage was at ~7x EBITDA. I expect Valeant will be able to negotiate better terms in this refinancing, but I have not modeled these below as interest rates may have risen by then, offsetting the lower risk spreads that it is likely to receive.

Growth of Free Cash Flows for Equity

This table also shows my expectation for Valeant's cash flows through 2025. "Free Cash Flow to the Firm" shows the cash flows that Valeant is generating before paying interest payments, and "Free Cash Flow to Equity" is after interest payments, and representative of what stock holders earn each year, even if this cash flow is used to pay down debt. Note that FCF-Equity is growing rapidly even in 2021/22 when I introduce tax payments on the (conservative) assumption that by then Valeant may have worked through its prior tax losses. A final point is that in my model above I assume all cash flows are used to pay down debt, whereas it is likely that from 2020 or 2021, Valeant may then choose to pay down less debt and divert some cash flow to equity holders either through dividends or buybacks.

Likely returns for equity holders

Equity holders should earn substantial rewards if my expected scenario plays out. Valeant is currently on a 24% FCF-Equity yield compared to the market average of 5%. While some of that discount is warranted given Valeant's high financial leverage, over time the discount should narrow as it pays down its debts. I believe this re-rating will happen by 2020 at the latest when Valeant should be able to refinance its debts with net debt of 4.5x EBITDA rather than the recent refinancing at 7x EBITDA.

The table below shows my expected shareholder returns: I expect Valeant to double again to $33 by the middle of next year, reach mid 40s by mid-2019 and then $60+ by 2020. This $60 by 2020 is in line with incentive thresholds in Joe Papa's incentive plan, so I expect it will be one of his targets too.

I have also included a check on this valuation using comparable multiples. Valeant is currently priced at 8.3x fwd. EBITDA, which is a 35% discount to peers on a sum-of-the-parts basis. If Valeant reaches $63 per share by mid-2020 under my forecasts above, then this discount will have narrowed to 25%.

This shows there is room for much more upside that in my current projections: if the discount to peers falls to 10% by mid-2020, Valeant's share price would rise to $86/share. While this would be a great result for all those who own Valeant (including me), I would rather leave this as a potential upside scenario than have it as my base case.

Additional comments

(1) Technical analysis

I am not a technical analysis trader. Far from it. But as a fundamental investor, I have come to respect the fact that other market participants do use technical analysis, and that these traders do influence prices in the short term, especially in the absence of contradictory news on fundamental performance. I have learned to respect the value that technical analysis can bring for these reasons and to be wary of taking large positions when the technical indicators are contrary to my fundamental view.

As I pay attention to technical analysis purely because others follow certain rules, I pay attention to the most well-known indicators. During Valeant's rise from 2012 onward, its share price was above the 200 dma (200 day moving average) from 2012 until October 2015, except for the period of June to November 2014 when the stock traded sideways. In October 2015, Valeant's share price crossed below its 200 dma at a price of $209. This would have been a great selling point for most longs (admittedly with perfect hindsight). The stock plummeted, and it reached $30 by the end of March 2016.

Since March 2016, when I started following the stock and took a small position, Valeant's stock has traded well below its 200 dma, and below its 50 dma most of the time. The share price only rose above the 50 dma in August 2016 and February 2017, and both instances were false dawns for Valeant longs. The recent share price rise is more positive from a technical standpoint, however. After crossing the 50 dma in early May, Valeant soon crossed the 100 dma (and held it), before then crossing the 200 dma in late June. Valeant is now above the 200 dma for the first time since October 2015, and if current prices hold, the 50 dma should cross the 200 dma by the end of this month (a so-called "Golden Cross").

VRX data by YCharts

As I said, I do not base my investment decisions on technical indicators. But I am aware that others do, so I prefer to invest when the technicals support my fundamental view rather than when they are contrary to it. These long-dated technical indicators are now positive for Valeant's shares for the first time since October 2015, which brings me comfort for my long position.

(2) Debt for equity swap

There have been discussions in the market in recent weeks about the potential for Valeant to do a debt-for-equity swap to reduce its debt. I think such a transaction is highly unlikely, as it has no need to do it. After selling iNova, Valeant can meet its debt obligations organically, as I have shown above. Swapping debt for equity would reduce equity upside for shareholders and compensation for the senior management team, so I think it is highly unlikely. I view CFO Paul Herendeen's comment at the recent Goldman Sachs Leveraged Finance conference as indicating that it has considered all options on the table, but not that it is likely to pursue such a transaction. At the conference, he said:

"We generate a fair amount of cash. We convert a lot of our earnings to cash because of that tax rate I just spoke about. And we will continue to generate cash because I can tell you that not just from standard 'let's grow earnings' [strategies], we also have a lot of cash locked up on our balance sheet that we have the opportunity to improve upon, and things like that. We're going to be maniacally focused on generating cash and using that cash to reduce debt. The second and easy part is the sale of non-core or potentially core assets, and we'll do that to the extent we can reduce the quantum [of the debt] and improve the credit quality. The next is, and I've been seeing some flack about this in the investment community, it's like we've said, equity and equity-linked type securities are on the table. Of course, they're on the table, there's always on the table. When you have a debt stack that looks like our debt stack, it's not…to say it wasn't on the table would not be credible. It's something we certainly need to think about. I think that that's when we…and then the last, which is the best way to reduce your leverage is to grow your earnings".

In my view, Joe Papa & Paul Herendeen are focused on growing earnings, releasing cash from the business from working capital, and selling some non-core assets in order to pay back debt. I think if they were planning on a debt for equity swap or some other refinancing transaction, then they would have done it with the other refinancing transactions in March of this year, and that the only reason Paul Herendeen says these options are "on the table" is to placate the debt holders in the audience that he was presenting to.

(3) The scope for a buyout

Another pharmaceutical firm or a buyout firm could bid for Valeant, but I think such a bid is unlikely at this stage. My view is not for financial reasons, as the numbers clearly stack up, but for the difficulty of agreeing on a transaction price that makes sense for all parties.

I believe that Valeant's leadership team views the current share price as grossly undervalued, and that its view of true value is near to or above my estimates. I expect it would only accept a buyout offer if it was better than the alternative course of action of waiting, so assume $45-50 per share or higher. I expect it would also be anchored to this amount as (a) there were market rumors of a joint bid between Takeda Pharmaceutical and private equity firm TPG at $40-50/share in April 2016, but this offer was rejected by Valeant's board, before Joe Papa became CEO; and (b) Joe Papa's incentive structure has a stepped structure, and it pays much more at $50/share and again at $60/share by 2020.

While I agree that $50-60/share is probably fair value, I doubt a bidder would be comfortable offering 3-4x the current share price to get a friendly deal done. Even though such a price would only be a 35-40% increase in Enterprise Value, which is more in line with a typical bid premium, the 3-4x current share price number would capture the headlines. It would just be too hard for the acquirer to justify such a price to their investors, whether it is the pharmaceutical firm's shareholders or the buyout firm's LP investors.

A deal may happen of course, but I would be (very pleasantly) surprised if it did. Paradoxically, I believe a buyout deal may be more likely once the share price has risen to $25-30, as then the perceived premium is lower.

(4) Governance challenges and a name change

One challenge for Valeant is that its stock has become "uninvestable" for many potential owners. Some of these are legal constraints, as many funds are restricted from owning companies that have re-stated earnings or had similar governance issues within the last few years, and some of these constraints are just practical as fund managers that own Valeant would face a lot of pressure from their own internal compliance department and from their investors. The downside from owning Valeant and getting it wrong can be career-threatening, and it easily outweighs the potential upside from getting it right.

These issues are also compounded by the pressure on active managers from their asset owner investors, who are looking to shift funds from active to passive, and may use ownership of a toxic firm like Valeant as an excuse to withdraw their capital. Of course, this is somewhat irrational, as an active manager should be taking active bets, but the same pressures from internal compliance apply to the asset owners, and for them, the trade-off is even clearer: they have little upside if the manager gets it right with Valeant, so the much easier and lower risk option is to cut the manager unless they sell the position.

I believe some of these issues came to bear on Bill Ackman in March 2017 when he sold his stake in Valeant. Although Pershing Square stated that "the investment required a disproportionately large amount of time and resources" at the time, I believe that investor pressure on Pershing Square also played a major part in its decision, especially given the recent performance of Pershing Square funds.

Mercifully for shareholders, these pressures fade over time. Valeant is in the news less often these days, and often for nicer reasons of drug launches at good prices (Siliq) or share price appreciation. This is a good development. I expect Valeant will continue to create news for the right reasons over the rest of this year. I also expect it will be cleared of most of its legal troubles, although that timing is less certain. I expect Valeant will change the firm's name, as suggested by Joe Papa at its annual meeting after several more months of positive news in order to draw a line on the troubles of 2015/16 and become a more palatable investment option for institutional investors.

Risks to my thesis

There are risks to my investment thesis, of course. But these mainly revolve around Valeant's ability to meet my earnings forecasts. I discussed these at length in the first article in the series, which is available here.

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Analyst’s Disclosure: I am/we are long VRX. 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.