Article Thesis

Valeant's (NYSE:VRX) huge net debt position and worsening operational performance mean that there is non-negligible credit risk for Valeant. It thus seems best to avoid the company's shares, especially since there is no catalyst in sight that could allow for an ongoing share price recovery.

Rationale

Valeant has been a high flyer for years, with its share price seemingly growing endlessly until, at one point, it didn't.

Valeant's fall, which decimated 95% of the company's share price, began in the second half of 2015, when the company's non-GAAP earnings story began to show some cracks. In the fourth quarter the company reported GAAP losses of $0.98 per share, whilst still claiming underlying earnings power (non-GAAP earnings) of $2.50 per share. The market since got wary of Valeant's adjusted earnings numbers, and rightfully so, the company has, however, reverted its use of big adjustments since, and GAAP number and non-GAAP numbers are now more in line with each other.

In the most recent quarter Valeant's GAAP results were actually better than the company's non-GAAP numbers:

As we can see, GAAP net income of $628 million is much higher than the non-GAAP bottom line number -- which Valeant does not include in its quarterly release. We can, however, calculate it by using the EBITA number of $766 million and adjusting it for interest expenses, taxes and amortization of intangible assets.

VRX Net Interest Income (Quarterly) data by YCharts

When we assume amortization costs to be zero, and calculate with interest expenses of $470 million, we get to pre-tax earnings of a little below $300 million, which, adjusted for taxes, means adjusted net earnings of $180 million.

VRX Effective Tax Rate (NYSE:TTM) data by YCharts

When we calculate with amortization expenses of $500 million, which is in line with the quarterly average over the last years, we don't get to any net earnings, however -- pre-tax losses would total $200 million quarterly.

Valeant is in too much debt

In order to determine the sustainability of Valeant's debt pile, we should look at its debt to EBITDA ratio:

Valeant points out that its debt position has shrunk from $32.3 billion at the end of the first quarter of 2016 to $28.9 billion one year later, but that is only part of the story.

Over the same twelve months, Valeant's adjusted EBITDA has declined by $1.1 billion, which means the debt to EBITDA ratio is now actually higher than it was one year ago: 6.95 versus 6.15, respectively.

Valeant's earnings power is shrinking at a much faster pace than its debt position, which means the debt pile is getting ever less sustainable.

When we annualize Q1's EBITDA of $860 million, we get to an estimate of $3.4 billion in EBITDA this year -- which could still be too high, as it does not account for further deterioration in Valeant's earnings power. In this case the debt to EBITDA multiple would stand at 8.4.

What happens when this is combined with rising interest rates, which makes Valeant's debt ever more expensive?

The Federal Funds rate is expected to grow to 3.0% over the next 18 months, an increase of 2.1 percentage points from the current level. If higher central interest rates are resulting in likewise higher interest rates for Valeant, the company could see its interest expenses rise by $610 million annually over the next one and a half years.

If, at the same time, Valeant's EBITDA continues to shrink at a 20% a year rate, the annual EBITDA run rate would total below $3 billion by the end of 2018.

VRX Net Interest Income (TTM) data by YCharts

As Valeant's interest expenses already total $1.9 billion, the total would stand at $2.5 billion -- barely covered by EBITDA. This does not include the impact of Valeant's ever-increasing debt to EBITDA ratio, which would likely push Valeant's interest expenses even higher -- this only calculates for sustained EBITDA declines and the increase in the Fed Funds rate.

It is difficult to forecast the additional impact of higher interest expenses due to investors shying away from Valeant's bonds if they are deemed too risky. But the fact that, even when we do not account for that, Valeant could be in a position where the company is just barely able to finance its interest expenses in one and a half years is a good reason for investors to think hard about whether it is a good idea to hold Valeant's shares.

The market cap has come down to a small level, and due to the huge volatility in Valeant's share price, it is very possible to make some short term gains. But in the long run, the outlook is not positive, and when we look a couple of years into the future, we see that Valeant could come into a position where it is no longer able to finance its debt.

I thus believe that it is best to stay away from this company's shares.

Takeaway

Valeant's non-GAAP shenanigans have ended, and for the most recent quarter it makes sense to look at the adjusted results. These spell trouble, however, as the company's earnings power is shrinking much faster than its debt levels.

Add in Federal Funds rate hikes that push interest rates higher, and the possibility of investors shying away from Valeant's bonds (which would increase interest rates further), and the risk for Valeant not being able to finance its debt any longer in a couple of years is not negligible any more.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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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Valeant: There Is Significant Bankruptcy Risk Here - Seeking Alpha