One of the benefits of a highly indebted stock like Valeant Pharmaceuticals Intl Inc (NYSE:VRX) is that the rewards, mathematically, outweigh the risks. The VRX stock price, in theory at least, can rise 200% or even 400%. (I don’t think that’s going to happen — but it’s possible.) But an investor can’t lose 200% or 400% by buying VRX stock. An investor can “only” lose 100% of his or her money.
The other benefit of Valeant Pharmaceuticals’ high debt level is that it doesn’t take much in the way of valuation improvement for the company as a whole to move the VRX stock price. This is a benefit investors are seeing at the moment, as VRX now has rallied ~150% from a 52-week low reached back in April. Over that period, however, Valeant’s enterprise value — the value of its equity and debt combined — has risen just 15-20%, to just over $33 billion at the moment.
That leverage is a double-edged sword, however, and it’s something investors need to keep in mind when considering VRX stock above $20. That huge leverage makes VRX look cheap, at 6 times forward earnings-per-share estimates. But considering the company’s debt, Valeant isn’t anywhere close to cheap. And the rewards created by the debt as sentiment has turned in favor of VRX stock, can quickly become risks if that sentiment turns in the opposite direction.
Steps in the Right Direction
I’ve been a long-time bear on VRX, but, as I wrote last month, I’ll give credit where credit is due. CEO Joe Papa has done a fine job so far, selling assets to raise cash, pushing debt maturities out to 2020 and changing the tenor around Valeant stock. After the wild ride under former CEO Michael Pearson, Valeant feels much more “boring” from an operational standpoint.
That’s a good thing. The $26 billion-plus debt load needs to be repaid. Costs need to be controlled and execution on new rollouts like Xifaxan and Vyzulta, the company’s new glaucoma drug, needs to be perfect, or close.
Clearly, Papa and Valeant are establishing some level of trust on that front. That’s reflected in the rising VRX stock price, but also in the bond market. Valeant bonds have recovered, and now trade close to par value. This, in turn, suggests a relative low risk of bankruptcy — or at least a sense by bondholders that they would get most, if not all, of their money back in such an event.
That’s real progress for a company that seemed almost certain to file bankruptcy at some point when Papa took over. But the question for Valeant stock buyers now is how much progress already is priced in.
More Good News?
Over the past month, as VRX stock has risen sharply, more work has been done. The company commenced distribution of Vyzulta this week, and sees a multi-billion-dollar market for that drug. It’s refinanced more debt, raising $1.5 billion in debt due in 2025 to repurchase issues due in 2020. The sale of Obagi Medical Products closed, raising another $180 million to pay down existing borrowings.
But is that really good news? Valeant’s new debt, for instance, has a large 9% coupon and is priced below 99 cents on the dollar. Interest on the existing debt ranged from 5.375% to 7%. So, the refinancing extends maturities, but it also adds $35-$40 million in annual interest expense, a headwind to free cash flow going forward.
The Obagi sale removed $180 million of debt — that’s less than 1% of the total debt load Valeant has. In its third-quarter recap, Valeant boasted that it had repaid over $6 billion in debt since Q1 of last year, just before Papa was hired. Again, the company has done good work to do so — but it still owes another $26 billion-plus, with most of the non-core assets gone.
Valeant has had a lot of success, on which investors are focusing at the moment. But it’s important to remember just how much the company has left to do.
The VRX Stock Price Isn’t Cheap
And the problem is that VRX stock simply isn’t cheap. Yes, the forward P/E ratio of 6 looks cheap, but Teva Pharmaceutical Industries Ltd (ADR) (NYSE:TEVA) has a similar valuation — and debt concerns of its own. Mallinckrodt PLC (NYSE:MNK) trades at a 7 ratio.
Considering the impact of Valeant’s debt, meanwhile, the stock looks nowhere close to cheap. VRX’s enterprise-value-to-revenue multiple, based on 2017 guidance, is a 4. It’s EV/EBITDA multiple is over 9.
Those aren’t cheap multiples by any stretch. But Valeant is going to need those numbers to grow to keep the rally in VRX stock going. And that’s where the double-edged sword comes in.
Move the EV/EBITDA figure to 10, for instance (hardly a major move), and the VRX stock price surges to near $30. Move it back to 8, however (also not a big move), and VRX falls back into the high single digits.
An EV/EBITD figure to 10 isn’t ridiculous. Teva trades below that level. Gilead Sciences, Inc. (NASDAQ:GILD) is under 7. Much safer majors like Pfizer Inc. (NYSE:PFE) and Merck & Co., Inc. (NYSE:MRK) are in the 11 range.
Maybe Valeant’s multiple can expand. Maybe strength in Bausch and Lomb can drive overall revenue and profits higher next year (though, at the moment, that seems unlikely). But it’s a huge risk. And with VRX back above $20, it’s a risk amplified by the leverage on the balance sheet.
It hasn’t taken much from a fundamental standpoint for the VRX stock price to double. Investors need to remember, however, that it won’t take much for the stock to be halved, either.
As of this writing, Vince Martin has no positions in any securities mentioned.