We’ve all heard the news. Valeant is going to devote its 2016 cash flows to paying down its debt. Urged on by its most prominent shareholders, Valeant has promised that 2016 will be all about showing its ability to reduce its debt.
But, perhaps Valeant’s newfound interest in paying down its debt is motivated even more by satisfying its creditors.
One key premise of the article is that Valeant “risks violating its credit agreements and triggering a technical default on its senior debt next year if its Ebitda — earnings before interest, taxes, depreciation and amortization — over a 12-month period aren’t enough to cover its interest expense at least three times.”
Now, not to alarm Valeant’s creditors, but in Q3 2015 (per Guru Focus), Valeant’s ebitda was $1.14 billion and its interest expense was $420 million. (Yahoo Finance has a trailing twelve months ebitda of 4.97 billion, which includes $400 million from Pershing Square’s Allergan investment. Take that out and divide by 4, and we have an almost exactly identical amount of $1.15 billion).
That’s a coverage ratio of 2.71. If we simply pro-rate that over the next 12 months, then Valeant is already in breach of its senior debt covenants. Speaking roughly, if Valeant does not increase its ebitda (and for the purposes of this analysis, I will make that assumption because of the headwinds that Valeant is facing), then it will really, really, really need to repay some debt to avoid breaching its covenants.
Valeant has roughly $30 billion of debt. Each billion of debt is roughly responsible for $14 million in interest payments per quarter. ($420 million in interest/30 = 14). If EBIDTA is flat, then Valeant needs to gets its quarterly interest payments below $380 million. (1.14 billion / 3 is $380 million). That means Valeant needs to repay roughly $3 billion in debt over the next 12 months to avoid triggering a breach of its covenants if it’s quarterly ebitda remains flat. That’s putting aside the fact that Valeant drew down $845 million of its revolver in October in order to pay for its acquisitions and, according to Pearson, that’s Valeant’s first priority – let’s say that balances out the fact that Valeant will presumably pay off higher interest rate debt first.
(My guess is that Valeant may have worked out a deal with its creditors that allows it to use some special form of ebitda, like the deal that allowed it to add back synergies when calculating ebidta for debt borrowing purposes. But, on the other hand, it would be like Wall Street to give Valeant the rope with which to hang itself. For the purpose of this analysis, we’ll assume it’s regular old Ebitda.)
So, Valeant appears to need around $3 billion in cash to pay off debt over the next twelve months to avoid defaulting on its covenants. And Valeant says its going to use all of its cash for that purpose. Can Valeant generate that much cash?
I think the first place to look is at Valeant’s historical record of cash generation.
The Record Reflects…
Interestingly, Valeant has said similar things before about using capital to pay down debt.
In December 2014, after its bruising battle with Allergan, Valeant leaked to Reuters its new strategy.
Valeant was going to show the world just how good its business was. It was “abandoning its growth-by-acquisitions strategy for the time being to try to reduce debt, boost its stock price and one day return to its traditional deal-making in a stronger position, people familiar with the matter told Reuters.” It would “focu[s] on its ability to pay down debt or buy back shares.”
Valeant wanted its balance sheet to stop being cluttered by all these darn acquisitions so that investors could see just how great Valeant was: “”The silver lining that has come out of the Allergan situation is that we have already reported one relatively clean quarter…By delivering several more clean quarters over the next several months, we will clearly show the strength of our base business.”
That sounds like a great idea. It would have been interesting if Valeant had actually done it. But instead, within two months of announcing its plans, Valeant spent 15.8 billion dollars to buy Salix.In order to finance the acquisition, Valeant borrowed 10.1 billion in junk bonds, issued 1.45 $billion worth of shares, and assumed about$4 billion in debt from Salix.
And, unfortunately, that pesky balance sheet became messy again. Valeant, to its great regret, will have to incur $300 million in integration costs over the next two years. (pg. 17)
Valeant has talked a good game about capital allocation. Indeed, in order to appear like an Outsider CEO, you are expected to say that you’re going to be flexible with your cash flows – buying back stock, paying down debt, or acquiring companies – depending on the business environment.
But, in order to be flexible with your cash flows, you must actually have cash flows. Since 2012, Valeant’s actions, rather than its talk, fail to indicate the presence of substantial cash flows. They certainly do not indicate that Valeant will be able to generate the $5 billion in cash it needs over the next year to avoid triggering its debt covenants.
Valeant shareholders in recent weeks have hopefully talked about how Valeant will use their cash flows to buy back shares – at least before Mike Pearson shot that down on the most recent conference call.
But Valeant’s most recent annual report provides a wonderful summary of their general approach to using cash flows for stock repurchases: talk a lot, do a little.
Every November, as the leaves turn, Valeant announces a stock buyback program of between 1.5 to 2 billion dollars.
“On November 3, 2011, the Company announced that its Board of Directors had approved a new securities repurchase program (the “2011 Securities Repurchase Program”). Under the 2011 Securities Repurchase Program, which commenced on November 8, 2011, the Company could make purchases of up to $1.5 billion of its convertible notes, senior notes, common shares and/or other future debt or shares. The 2011 Securities Repurchase Program terminated on November 7, 2012.
On November 19, 2012, the Company announced that its Board of Directors had approved a new securities repurchase program (the “2012 Securities Repurchase Program”). Under the 2012 Securities Repurchase Program, which commenced on November 15, 2012, the Company could make purchases of up to $1.5 billion of senior notes, common shares and/or other future debt or shares. The 2012 Securities Repurchase Program terminated on November 14, 2013.
On November 21, 2013, the Company’s Board of Directors approved a new securities repurchase program (the “2013 Securities Repurchase Program”). Under the 2013 Securities Repurchase Program, which commenced on November 22, 2013, the Company could make purchases of up to $1.5 billion of its convertible notes, senior notes, common shares and/or other future debt or shares. The 2013 Securities Repurchase Program terminated on November 21, 2014.
November 21, 2014, the Company may make purchases of up to $2.0 billion of its senior notes, common shares and/or other securities prior to the completion of the program, subject to any restrictions in the Company’s financing agreements and applicable law. The 2014 Securities Repurchase Program will terminate on November 20, 2015 or at such time as the Company completes its purchases.”
Wow, that’s a total of $6.5 billion in announced buybacks. So, how much did Valeant actually purchase with these announced purchased programs.
Let’s start with 2011.
Under the 2011 Securities Repurchase Program, the Company repurchased 5,257,454 of its common shares for an aggregate purchase price of $280.7 million.”
Okay, not bad, $280 million dollars worth.
“Under the 2012 Securities Repurchase Program, the Company repurchased 507,957 of its common shares for an aggregate purchase price of $35.7 million.”
Okay, a lot less, but still something .
“No common shares were repurchased under the 2013 Securities Repurchase Program”
Not great, but they were busy buying Bausch & Lomb.
“No common shares were repurchased under the … 2014 Securities Repurchase Program.”
Okay, couple of down years.
BUT, in 2015, shareholders will be pleased to learn that ” the Company repurchased 224,215 of its common shares for an aggregate price of $50 million .”
So, in total, Valeant has announced $6.5 billion in buyback programs, and actually purchased…$365 million in stock since 2012.Perhaps this is simply a prudent capital allocation because Valeant’s stock was overpriced the whole time, but that would raise other questions.
And, what happened to Valeant’s share count? It’s gone up about 10% despite that $365 million of repurchases because Valeant has issued about $3 billion of equity.
At the end of 2011, Valeant’s share count was 306 million. In 2013, Valeant issued about $1.5 billion in equity to help it close the Bausch and Lomb transition. The share count went up to 333 million. In 2015, Valeant issued another $1.5 billion in equity to close the Salix transaction after it got into a bidding war. The share count now stands at 343 million. (Valeant’s use of equity issues for its major acquisitions shows that it’s not using whatever cash it’s generating from its business for its big purchases – presumably they’re going to bolt-ons, because Valeant only had 1.5 billion in the bank at the end of last quarter .)
(Small tangent, the pride of Sequoia, Rory Priday, stated that Valeant’s reliance on debt rather than equity for acquisitions (if increasing share count 10% is limited) was a good thing. I think by the time this is done, Valeant’s shareholders will be very, very sad that Pearson did not rely even more on equity for his purchases…but perhaps he did not have a choice.)
I’ll reproduce the chart he used from Capital IQ.
|Balance Sheet as of:||Total Cash & ST Investments||Total Debt||Net Debt|
I think it speaks for itself. Whatever cash Valeant was making, was generally not going to paying down the debt prior to 2014. (I think but am not sure, that the weirdness in 2013 involved issuing equity for B&L).
2014: Valeant shows its hand
But, in 2014, Valeant did succeed in paying down some debt early! Per the 2014 annual,
“Long-term debt (including the current portion) decreased $2.1 billion , or 12% , to $15.3 billion as of December 31, 2014 , primarily due to (I) $1.3 billion in net repayments, in the aggregate, under our senior secured credit facilities in 2014, (ii) the redemption of $500.0 million aggregate principal amount of the 2017 Notes in October 2014, and (III) the redemption of $445.0 million aggregate principal amount of the December 2018 Notes in December 2014.”
So, it appears that when Valeant puts its mind to it, pre Salix, it could find $2 billion-ish in cash for debt repayment.
But, there were two presumably one-time sources of income that Valeant took advantage of in 2014.
First, Valeant received $397.5 million of net profits from Bill Ackman’s investment in Allergan. (Valeant had a right to 15% of the net profits – which indicates that total profits from Ackman’s trade were 2.6 billion post short-term capital gains tax, and he kept about $2.3 billion. If you want to know how Ackman achieved 44% returns last year, or why he tried to front run Valeant on Zoetis, then you probably have your answer.).
Second, Valeant received $1.5 billion from its sale of facial aesthetic fillers and toxins (aka – many of the assets from its Medicis acquisition).
So, that comes to a total of $1.9 billion. Very, very close to the amount of debt that Valeant was actually able to repay. For the sake of simplicity, let’s cancel that out and say Valeant basically reduced debt with these one-time inflows.
So how much cash did Valeant actually make from operating activities in 2014?
Valeant started the year with total cash of $600 million. By the end of the year, Valeant’s cash was $320 million, so it spent about $280 million.
During the year, Valeant spent $1.3 billion on acquisitions. (Solta & Precision Dermatology).
Humoring Valeant, it experienced “one-time integration costs” of 381.7 million.
Putting it together, this indicates that Valeant in 2014 had operating cash flows of about $1.4 billion ($1.3 billion + $381.7 million – the decrease in cash of $280 million).
(There were some other cash expenses – $291.6 million for Plants & Equipment, $55.2 million for debt financing, $106.1 million for contingent consideration. I’m not including them here because I think these are just the costs of doing business – every year, I would think, Valeant will have costs like this. I consider this a fair tradeoff for not questioning their classification of integration expenses).
At the end of 2014, Valeant had a total enterprise value of $63 billion dollars and it’s stock price was 94.26. It’s ratio of operating cash flow of 1.4 billion to total enterprise value of 63 billion was about 45 to 1. (I’m using this reverse engineered metric for cash flow because I think it gets across just how much cash Valeant is really, truly generating.)
How does it compare to some leading competitors at the end of 2014 (using GAAP operating cash flows to total enterprise value)
|Teva||10.5||(57 bil. EV / 5.4 bil. Fcf)|
|Gilead||11.2||(143 bil. EV / 12.8 bil FcF)|
|Pfeizer||12.9||(196 bil EV/ 15.1 bil FCF)|
|Johnson & Johnson||15.4||(291 bil EV / 18.8 bil FCF)|
So, pick your comparable. If Valeant is Teva (primarily a generics and branded generics manufacturer), then it’s enterprise value at the end of 2014 should have been 14 billion. That would have meant that the equity was worthless, because the debt (even after those repayments) was over $15 billion.
If Valeant is Johnson & Johnson (and I hope/pray for the investors in Pershing Square that even Bill Ackman doesn’t think Valeant is Johnson & Johnson), then it’s enterprise value at the end of 2014 should have been $21.5 billion. Taking out $15 billion of debt would leave $6.5 billion of equity.
Rather than a share price of $94 at an equity value of 47 billion; Valeant would instead have share price of $13 at an equity value of $6.5 billion. And, again, this is if Valeant is given the same multiple as Johnson & Johnson. (Currently, Valeant appears to have a trailing twelve months GAAP cash flow of about $2.5 billion – giving it the Johnson and Johnson multiple indicates that the enterprise value should be $37.5 billion, leaving us back at $6.5 billion of equity value again, and a share price of $18).
If Valeant had simply continued to pay down its debt, and show its operating cash flow to the world, I think the equity value would have started to sink down to $13.
For an ambitious executive team almost entirely incentivized by stock compensation, this is a very, very big problem (especially because I think they had been counting on being able to successfully merge with Allergan).
So, speculatively, I think at the end of 2014/beginning of 2015 they decided to make two major moves.
First, they ramped up Philidor to squeeze cash out of their dermatology business.
Second, they purchased Salix – a pharmaceutical company that many drug manufacturers had been circling and that was very, very, very much for sale.
The first decision has received tremendous attention, obviously. The second decision comparatively little and, with certain exceptions, has generally been considered positive. In a subsequent post, I will advance an entirely speculative argument that it is actually the second decision that will doom Valeant, and that the purchase of Salix will go up on the shortlist of horrible corporate acquisitions along with luminaries like HP/Autonomy. (My thumbnail case – Valeant was counting on tremendous growth from Xiafaxan’s entrance into the IBS-D market – growth that would be explosive largely because many people suffer from IBS-D and it is a chronic condition. I think this assumption was disastrously misguided because: 1) Salix’s gastrointestinal team had already been aggressively pushing Xiafaxan’s usage for IBS-D off label, so much of the growth was priced in, and 2) the FDA only approved Xifaxan, presumably because it is an antibiotic with the potential for resistance, for two 14 day treatment cycles total (perhaps over the course of a patient’s lifetime?). It is hard to make a pill for a chronic condition into a blockbuster when the FDA does not allow you to prescribe it chronically.)
Returning now to the repayment of debt.
Based on 2014, Valeant should have about $1.3 billion in cash for debt repayment.
That’s quite a ways from $3 billion.
A few expected responses.
Can’t Valeant just sell assets to pay down the debt?
Yes, Valeant could, but then it would have less income to pay down the remaining debt. It would have to get a good price. Nonetheless, there is some validity to this point. My biggest worry as a Valeant bear is that a buyer will come along and pay a very nice price for one of Valeant’s assets. In my subsequent posts, I will explain why, after a fair amount of thought (and a tiny bit of hope/faith in the rationality of CEOs) I decided that this was not a significant concern.
Isn’t Valeant going to have an EBITDA of $7.5 billion in 2016 and thus, loads of cash?
That would involve trusting Valeant’s management and I don’t trust Valeant’s management. Heuristically weighing Valeant’s obstacles (Philidor shutdown, PBM retaliation, continued currency headwinds, genericization of key products like Glumetza and Xenazine, backlash to exorbitant pricing, potential fines/clawbacks from government/insurers) vs. Valeant’s positives (errrm, Salix?), I think it’s reasonable, perhaps even generous, to project that EBITDA will be flat based on Q3.
And, in its most recent conference call, even Valeant was not willing to reiterate its $7.5 billion EBITDA guidance.
(One note on that magical $7.5 billion EBITDA figure. Much like my desire to lose that last 10, err 15 pounds, Valeant has long desired to get to a net debt to ebitda of below 4 (although it uses an adjusted metric to achieve that goal). In 2014, it bragged when it was able to bring it down to 3.5. Post Salix, it was back up to 5.6 even under their adjusted metric. One could argue (one = rhetorical straw man), that Valeant chose it’s $7.5 billion ebidta for 2016 because it is the amount that could allow them to achieve a ratio of 4 without actually paying down any of the $30 billion in debt). Alternatively, one could argue that Valeant thought it could grow its ebidta from $4.5 billion to $7.5 billion in one year. The miracle of adjustments!
So, what will happen?
I think the most likely scenario for Valeant is the slow bleed out – it tries to pay down debt over the next year, it makes too little progress, and equity holders slowly exit the sinking ship as bond holders prepare for the fight to recover their assets in the Chapter 11.
The worst case scenario is that Valeant did something else Philidor-esque and blows up very quickly
The best case scenario is that buyers emerge and Valeant equity holders get something back – but, in that case, I don’t think it would be over $30-40 a share at absolute most. I will discuss valuing Valeant’s businesses in my next several posts.
I am short Valeant through put options.
I do not trust the public statements of Valeant’s management. I rely on Valeant’s SEC filings and external sources of information. If you do trust Valeant’s management, then you should probably buy stock in the company. They say it’s a fabulous deal.
I am obviously biased but I try to be reasonable and avoid motivated reasoning and epistemic closure. If I have erred, please let me know.