Is the Valeant Pharmaceuticals Intl Inc (VRX) Debt Situation Overblown?

Valeant Pharmaceuticals Intl Inc (NYSE:VRX) isn’t quite in the same category as Enron for all-time collapses, but it’s having a pretty miserable run, cratering 95% since mid-2015. Still, investors have been growing more optimistic about VRX stock of late, in large part because the pharmaceutical company’s worrisome debt situation has been improving.

Is the Valeant Pharmaceuticals Intl Inc (VRX) Debt Situation Overblown?

Yes, shares are still only breakeven for 2017, but that’s a huge victory from a comparable standpoint. And shares have actually put together a massive 70% rally out of the April lows. But that includes a pullback over the past month that has taken some of the wind out of Valeant’s sails.

Should you or shouldn’t you go anywhere near VRX stock right now? That’s the question we’ll explore today.

The Debt

For the first seven months of 2015, investors obviously didn’t see a problem with Valeant. In the beginning of the year, VRX stock sported a $50 billion market cap. By July of that year, that figure climbed above $80 billion.

This came despite Valeant nearly doubling its debt from about $16 billion to more than $30 billion during the same time frame. A $50 billion company can manage $16 billion in debt, much like an $80 billion company can manage $30 billion in debt. A debt-to-market cap ratio of 35% to 40% isn’t great, but it’s definitely not bad. Worst-case — investors thought — is VRX performs a secondary offering, suffering a short-term hit to the stock to pay down some of its debt.

Rather than spending on research and development (like most big pharma companies), however, Valeant’s game plan was using constant acquisitions to fuel its growth. Thus, the debt continued to pile up, but growth was OK (because of the new assets), so investors looked the other way.

Accounting issues and debt concerns eventually became big issues, though. Also, Valeant was too aggressive with raising drug prices, drawing U.S. government scrutiny. And a Citron Research report alleging fraudulent activities with distributor Philidor RX — which included, by the way, comparisons with Enron — eventually led to criminal investigations.

These catalysts drove VRX stock from more than $250 to just $75 in the course of several months. And the once-wide-open secondary window slammed shut.

Joe Papa and the Turnaround

In May 2016, the company brought in Joe Papa to serve as chairman and CEO. Papa, who was previously with Perrigo Company (NYSE:PRGO), recently spoke in a CNBC interview. He said the company was ahead of schedule in reducing its debt and plans to divest 12 assets to help pay down said debt. Papa made the case that these divestitures won’t hurt the bottom line, as other drug lines are picking up the slack.

At one point in April of this year, VRX had a $3 billion market cap and about $28.5 billion in debt — yikes! Its market cap has since improved to about $5.2 billion today. While total debt still stands near $28.6 billion, it is down from $31.1 billion a year ago.

In other words, Valeant’s debt still is more than five times the size of its market cap, but it’s trending in the right direction.

When combining asset sales with Valeant’s free cash flow, management expects it will reduce debt by about $5 billion by February 2018, Papa said. But will it work? Even if VRX stock doubles, (pushing its market cap to ~$10.5 billion) and its debt reduction works, we’re still looking to at an intimidating debt scenario.

Also, the fact that Valeant had accounting issues is also a turnoff, but the issue appears to be in the past, so let’s scrub that worry.

I’ll admit, even getting to this point is surprising to me.

Bottom Line on VRX Stock

Valeant does produce a good amount of cash from its operations ($1.22 billion so far through six months of fiscal 2017). This will aid in paying down debt, especially if its creditors remain flexible.

Many will argue that despite Valeant’s turnaround efforts, investors should avoid the stock. And while VRX stock could double or triple from here on the successful execution of reducing its debt, I tend to agree. I don’t want to buy a company that has a debt pile five times the size of its market cap. It’s too risky for me, personally.

Imagine if Tesla Inc (NASDAQ:TSLA), which has $8 billion in debt, saw its stock fall 95% overnight, from $350 to about $17. Tesla’s nearly $60 billion market cap would be worth just $2.7 billion. Even then, its $8 billion debt load would “only” be about three times larger than its equity value. Balloon that debt up to about $15 billion, and only then would Tesla be in the same position Valeant is right now.

So I commend Valeant management on getting this far and wish them luck going forward. Management’s show of faith helps, with an insider recently scooping up 10,000 shares. That gave VRX stock a 4% boost Thursday, but still isn’t enough for me.

Bret Kenwell is the manager and author of Future Blue Chips and is on Twitter at @BretKenwell. As of this writing, Bret Kenwell held a position in NKE, SBUX and BX. 

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