Update On Valeant’s Debt Pathway After Asset Sales

In an earlier article I showed that Valeant (NYSE:VRX) has a clear path for managing its debt without asset sales, confirming a claim by CFO Paul Herendeen on the latest earnings call. Since then, Valeant has announced the sale of Dendreon for $820M and CeraVe and several other skin care assets for $1.3B. In this article, I update the debt pathway analysis to take account of these sales and assess their impact (A few other minor asset sales have also been announced, but I do not include these here due to current lack of information about them and since they are unlikely to change the results of the analysis in a material way).

The impact of the asset sales on the debt pathway turns out to be very positive. The loss of revenue from the sales is more than compensated by the interest saved on debt repayment. The main factor behind this is that Valeant can now cover its Aug. 2018 bond when it matures and no longer needs to roll it over. The earlier analysis assumed the bond would be rolled over with a new coupon interest rate of 10%. This is no longer necessary, and instead Valeant can save the 6.75% coupon interest it currently pays for this bond after covering it.

This means that Valeant achieves an extra debt reduction of $2.1B without loss of cash flow after the asset sales; in fact, the cash flow increases slightly compared to the earlier analysis. The main findings of the analysis are summarized below.

Summary of the findings of the analysis

(1) Valeant can now cover its maturing debts through to 2020; refinancing will not be needed before then. This is a big improvement over the previous situation without asset sales, where refinancing was needed already in 2018. Being able to avoid the need to refinance until 2020 gives Valeant more time to turn around the problematic parts of its business and return them to industry growth rates. This will make future refinancing easier and less of a concern for the market.

(2) Debt deleveraging is accelerated: The debt is reduced to 4.4x EBITDA by the end of 2021, using the conservative EBITDA model in my earlier article. This is an acceptable leverage in the pharma industry; future refinancing will be unproblematic and Valeant’s debt crisis will be over at this point. In the earlier analysis, this level of deleveraging was not reached until the end of 2022.

The updated debt analysis requires details of the asse t sales summarized in the following. This is also an unmissable opportunity to stick it to the bears/shorts by pointing out how these sales undermine a number of their claims.

Details of the asset sales, and how they prove the bears/shorts wrong

One of the main claims of the bears/shorts had been that Valeant would not be able to get reasonable prices for its assets, that it would be a forced seller and probably have to accept lower prices than what it originally paid. For example, Endorama Global, a prominent VRX bear on SA, had this to say:

Whether they manage to get good prices for the businesses they are willing to sell is rather unlikely, considering that Valeant is a forced seller and potential investors know it.

Max Nisen, Bloomberg Gadfly writer and gleefully relentless VRX basher, wrote an article titled “Valeant’s Toxic Fire Sale”. It discusses at length the supposedly unattractive/toxic nature of assets Valeant might hope to sell, inclu ding Dendreon, and includes this nugget:

Possible buyers may expect something of a distressed seller discount. Valeant likely didn’t invest much in improving any of these assets — it’s notorious for its exceptionally low R&D spending and aggressive cost-cutting. All of that probably translates into lost value and lower multiples on any sales.

As it turns out, Valeant’s sale of Dendreon to Sanpower Group for $820M is almost double the $415M Valeant paid for it at the end of 2014 – so much for “lost value”! The sales price is ~7x EBITDA, a very reasonable multiple considering the low profit margin of Dendreon.

Valeant’s other sale of CeraVe and several other skin care assets to L’Oreal (OTCPK:LRLCY) for $1.3B is even more spectacular. It is almost eight times the $150M Valeant spent to buy these assets between 2008 and 2012 according to this source. “Lost value” indeed. The sales price is ~20x EBITDA, showing that Valeant has received a very good price for these assets. For comparison, the beauty company Estee Lauder (NYSE:EL) trades at EV of 15x EBITDA according to Yahoo Finance.

Admittedly, CeraVe was one of Valeant’s best assets, the crown jewel in its Consumer Products division and thus a “core asset” according to CEO Papa. However, the high price amply justifies the sale in this case. And let us also note that it was Valeant that developed CeraVe into the valuable asset that it is, as shown by the huge increase in the price it has sold for compared to the price VRX originally paid. So much for the claim of Nisen and other bears that “Valeant likely didn’t invest much in improving any of these assets”.

In light of these asset sales, bears/shorts might want to reconsider their thesis about Valeant and ask themselves what else they might be wrong about.

Setting up the updated debt pathway analysis

The initial cash flow generated from operations and available for debt repayment is assumed to be the same as in my earlier article, i.e. $300M per quarter. I adjust this below to take account of the lost revenue after the asset sales. In the previous analysis, I noted that Valeant is currently converting ~48% of its EBITDA into operational cash flow. However, for the asset sales, I conservatively assume that the bulk of the lost EBITDA converts into l ost cash flow. The savings on interest payments from using the money from the asset sales to pay down debt will be dealt with separately. All other assumptions in the earlier analysis remain the same here.

The 7x multiple for the $820M Dendreon sale implies its EBITDA is ~$117M. I assume that $100M of this converts into lost annual cash flow for debt repayment. Dendreon has elaborate manufacturing facilities, and there are likely to be lease payments and other savings for Valeant after the sale such that not all of the lost EBITDA converts to lost cash flow.

The ~20x multiple for the $1.3B skin care assets sale (CeraVe etc.) implies its EBITDA is ~$65M. I assume that $60M of this converts into lost annual cash flow for debt repayment.

According to a recent Valeant presentation, the skin care assets sale and the Dendreon sale are expected to close in Q1 and Q2, respectively. In the analysis below, I assume that the sales close at the end of each of those quarters.

As before, we will need the list of Valeant’s bank and bond debts from the latest 10-Q…

vrx debts

…and the effective interest rates paid on the various bank debts.

effective interest rates

Details of the analysis

2016 Q4-2017 Q1 (two quarters):

The money from cash flow (CF) available for debt repayment in this period is $300M x 2 = $0.60B. The skin care assets sale provides a further $1.3B, so the total amount for debt repayment is $1.90B. Use this to pay off the entire revolver loan ($1.10B) and pay down the A-3 loan by $0.80B. The remainder of the A-3 loan is $0.33B.

Annual savings on interest payments going forward: $1.10B x 3.60% + $0.80B x 3.41% = $67M. Balancing this against the loss of $60M annual cash after the skin care assets are sold at the end of Q1 2017, the CF for future debt repayment increases by $67M – $60M = $7M per year, i.e. $2M per quarter. The CF for debt repayment going forward is then $302M per quarter.

2017 Q2 (one quarter):

CF for debt repayment is $302M x 1 = $0.30B. The Dendreon sale provides a further $0.82B, so the total amount for debt repayment is $1.12B. Use this to pay off the remaining A-3 loan ($0.33B). The remaining cash $0.79B is saved for paying the Aug. 2018 bond later.

Annual savings on interest payments going forward: $0.33B x 3.41% = $11M. Balancing this against the loss of $100M annual cash from Dendreon after it is sold at the end of 2017 Q2, the CF for future debt repayment decreases by $100M – $11M = $89M per year, i.e. $22M per quarter. The CF for debt repayment going forward is then $302M – $22M = $280M per quarter.

2017 Q3-2018 Q2 (four quarters):

CF for debt repayment is $280M x 4 = $1.12B. Adding this to the earlier remaining cash $0.79B, the total available for debt repayment is $1.91B. Use this to pay off the maturing Aug. 2018 bond ($1.59B). The cash remaining after that is $0.32B. Use this to pay down the D-2 lo an ($1.05B). The D-2 loan is then reduced to $0.73B.

Annual savings on interest payments going forward: $1.59B x 6.75% + $0.32B x 4.28% = $121M. This is $30M per quarter, so CF for debt repayment going forward is now $280M + 30M = $310M per quarter.

Let’s compare this to the previous situation without asset sales. In the earlier analysis, after rolling over the Aug. 2018 bond at an assumed coupon interest rate of 10%, the CF for debt repayment going forward was $306M. This is less than the $310M we have in the present analysis. Thus the asset sales are cash flow positive at this point – the cash available for debt repayment has slightly increased compared to the earlier analysis while the debt repayment is boosted by an extra $2.1B from the asset sales. This is a very positive outcome.

The rest of the debt pathway analysis goes along the same lines as my earlier one, so I will skip most of the details, except for the next period below since there is a ni ce outcome to show: Valeant is now able to cover its maturing debts through to 2020.

2018 Q3-2019 Q3 (five quarters):

CF available for debt repayment is $310M x 5 = 1.55B. This is enough to pay off all the maturing debt in 2019, namely, the D-2 loan ($0.73B remaining from earlier) and the C-2 loan ($0.81B), which together amount to $1.54B.

The D-2 loan matures in Feb. 2019, and there will be a small shortfall of ~$100M at that time for paying it off in full. This can easily be covered by cash on Valeant’s balance sheet, which is currently over $600M. The CF for debt repayment after Feb. 2019 replaces this cash and pays off the C-2 loan maturing in Dec. 2019.

Skipping the remaining details, the final result of the analysis is as follows: After paying down the bank debt from cash flow and rolling over maturing bonds as described in the earlier analysis, by the end of 2021, the total remaining debt is $21.9B. The debt leverage can be computed using the conservative EBITDA model in my earlier analysis, where 2018 EBITDA is assumed to be $ 4.3B and assumed to grow by 5% per year thereafter. This gives 2021 EBITDA ~$5B, hence the debt leverage at the end of 2021 is 21.9/5 = 4.4x as claimed in the “summary” section above.

Market reactions to the asset sales

The reaction of the bond market and major credit rating agencies was positive but muted. Moody’s described the asset sales as “credit positive,” but left the credit ratings and outlook unchanged, as did S&P. Asset sales such as these were apparently already anticipated in their evaluation of Valeant. The bond market similarly seems to have already anticipated such sales. The bonds are up a bit from where they were before the sales were announced, but have not made a big move.

The stock market reaction, after an initial bounce that quickly reversed, has also been muted but to the downside. The market appears to have decided that the asset sales don’t change Valeant’s long-term outlook much, a view that also appears in various analyst r eports such as this one. The general attitude seems to be “Asset sales of $2B don’t put much of a dent in the $30B debt.”

This is a very mistaken view though, since, as the analysis above shows, the asset sales, although small compared to the size of the debt, make a major positive impact on Valeant’s debt pathway. It pushes out the need for refinancing by two years to 2020 and accelerates the deleveraging, reducing the time it will take Valeant to reach an unproblematic leverage multiple by one year (from 2022 to 2021). I expect the market will recognize this eventually, but how long it will take is anyone’s guess.

In the meantime, the stock market’s determination to fixate on negatives (real or imagined) with VRX, and discount positives and future potential, continues unabated. Now that the worry that Valeant is not able to sell assets at reasonable prices has been disproved, the market has moved on and found new things to fixate on, such as the upcoming loss of exclusivity for various drugs, drugs that have already paid for themselves several times over since Valeant acquired them. So it goes with VRX, but investors should remember that the market always gets it right eventually.

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.

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