Valeant Is ‘Desert Thirsty’ For Equity

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Valeant is "desert thirsty" for equity

Valeant (VRX) spooked investors last week when it filed an application to raise additional capital with the securities regulator in Quebec:

Valeant sparked expectations that it is about to raise new capital after filing what it described as a “routine” application with the securities regulator in Quebec. The highly-indebted drugmaker, which is headquartered in Quebec, said it had filed a “private placement exemption application” with the Canadian province’s regulator, the Autorité des marchés financiers. Such a filing must be made before a Quebec-based company can raise debt, or public or private equity. In a statement, the company said it “routinely evaluates refinancing opportunities including capital markets transactions, to continue to enhance its capital structure”.

In addition, Valeant reserves the right not to provide updates on its financing plans until such financing has been made. My interpretation of this is that the company could engage in a dilutive event as soon as next week and explain why after the capital has already been raised. VRX sold off 4.4% Thursday after the filing. It rebounded 4.1% Friday after the company completed the sale of iNova for $930 million and management indicated it was considering a new round of borrowing.

Asset Sales Were A Ruse All Along

After taking a beating to its brand and reputation the company vowed to stop raising drug prices and pare debt via asset sales. The problem with asset sales to pare debt is that a company has to forgo future earnings in order to accomplish the task. The question remains, “Why not simply raise equity?” I always assumed an equity raise would have [i] signaled the company’s financials were not as strong as management had indicated and [ii] loss of confidence could have shattered the stock and made an equity raise highly-dilutive.

Asset sales and monthly press releases of new product launches have helped propel VRX over 70% from its 52-week low just prior to its Q1 earnings release. In my opinion, asset sales have been nothing more than window dressing:

The company’s Q2 revenue and EBITDA fell Y/Y by 8% and 21%, respectively. Over that same period debt was only reduced by about 11%. In my opinion, asset sales to reduce debt have been nothing more than window dressing. Management has intimated it will halt asset sales. The company might have been better off simply raising equity. However, that could have sank the stock price.

Asset sales have sounded nice but over the past year Valeant’s EBITDA has declined more than its debt load. In fact, the iNova sale might have created a negative arbitrage. Valeant’s enterprise value of $31.4 equates to 8.9x run-rate EBITDA (Q2 EBITDA annualized). According to the company’s press release adjusted Q4 EBITDA from iNova was expected to be $35 million, which equates to a $140 million annual run-rate. At $930 million the sale was about 6.6x run-rate EBITDA, less than Valeant’s current trading value.

I have always been of the opinion that asset sales were designed to spike the share price from “optionality” in the stock or potential short-covering. Once the stock got into the $25 – 30 range I expected management to issue an equity raise to shore up its capital base. I said as much on my previous article:

Management says other than the assets currently on the block that there will be no new asset sales. Who didn’t see that coming? VRX thought they could [i] spike the shares up to $25 – $30 on asset sales and 85 press releases per month and [ii] then issue an equity raise at an inflated price. Now that the ruse didn’t worth they are stuck.

Via Shocking The Street, a premium service I run in conjunction with Seeking Alpha, I previously warned Valeant was insolvent by $8 billion. I fully expect the company to enter into a dilutive event to shore up its capital base at some point.

Major Hits Could Come Due

Valeant’s goodwill impairment charges and legal exposures could materialize over the next year. The company only has equity of $4.0 billion. Below are some of the hits that could deplete its equity base:

Sprout Impairment Charge – About $1 Billion

Valeant’s Q2 goodwill and intangibles of $34.1 billion (includes intangibles related to assets held for sale) exceed its current enterprise value of $31.4 billion. The value of intangibles for prior deals exceeds the value of the entire company. Let that sink in. The value of goodwill and intangibles are highly-subjective, but it could be difficult for even management to argue that intangibles for Sprout should not be written off. Sprout was acquired in Q4 2015. Addyi – its women’s libido-boosting drug – was marketed as “female Viagra.” However, sales were abysmal from the start.

The low number of prescriptions sold could call into question whether the billion acquisition of Sprout was worth it. Goodwill and intangibles associated with the Sprout acquisition were over $1.7 billion. I would expect a sizeable write off associated with Sprout in Q3 or Q4.

Allergan Insider Trading Case – Estimated $389 Million

In November 2015 U.S. District Judge David Carter in Santa Ana, California, said Valeant and Pershing Square’s (OTCPK:PSHZF) Bill Ackman must face a lawsuit accusing them of insider trading in botox maker Allergan (NYSE:AGN) prior to Valeant’s unsuccessful takeover bid:

The lawsuit was filed on behalf of investors who sold Allergan shares in the two months before the defendants on April 22, 2014 announced an unsolicited $51 billion bid for Allergan.

Pershing had by then quietly amassed a 9.7 percent stake in Allergan, which soared in value after the bid was announced. Investors said Pershing bought those shares knowing that Valeant was preparing a bid that could, and later did, become hostile … the judge, without ruling on the merits, found “serious questions” as to whether “substantial steps” had been taken toward a possible hostile bid, which would have required Valeant to disclose more or Ackman to stop his buying.

A key question is whether Valeant’s tender offer for Allergan had not been planned before Ackman purchased shares of AGN. A ruling against Ackman could force him to disgorge his profits from the trade. According to Forbes Ackman promised to share 15% of his profits from the trade with Valeant, which could have been as much as $389 million. A negative ruling could force Valeant to disgorge its profits as well.

According to Bloomberg Ackman might be tempted to settle the case as early as November:

Ackman might be tempted to settle before November, when a deal with Valeant that would restrict his potential losses is set to expire. The drugmaker said in a February filing that it had agreed to pay 60 percent of any settlement so long as both the company and the activist investor agree to the terms.

VRX shares could experience volatility leading up to a potential ruling.

Conclusion

Large asset impairment charges and legal exposures could erode Valeant’s $4 billion capital base. It might behoove the company to raise capital now while financial markets remain in record territory. A dilutive event could punish the stock. VRX remains a sell.

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