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Valeant: Lenders Should Demand An Equity Stake PDF Print E-mail
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VRX CEO Joe Papa
Monday Valeant Pharmaceuticals announced it had completed the sale of skincare assets to L'oreal and pared $1.1 billion of debt. However, it is now seeking another $3 billion as part of a debt restructuring:

Valeant Pharmaceuticals International Inc plans to line up a US$3.06bn incremental term loan as part of a debt restructuring ... In addition to the new debt offering, the company paid down about US$1.1bn of senior secured term loans with proceeds from the sale of its skincare products assets on March 3, according to a Monday regulatory filing. Valeant is also repaying a portion of its 6.75% senior notes due in 2018 and extending the maturity date of its revolving credit facility.

As part of the transaction the company also wants to remove covenants from its term B loans and modify covenants for its revolving credit agreement. In late Monday trading VRX was down over 5% on the news. Below is my takeaway on the proposed restructuring.

Valeant Will Likely Breach Its Debt Covenants

The fact that Valeant is seeking additional funding is no surprise to me. I did not expect it to happen so soon. The company's has total contractual obligations (including principal and interest) of $9.4 billion from 2018 to 2019. There is no way Valeant could meet these obligations via cash flow. It could potentially meet them through asset sales, but the market for large scale divestitures does not appear as robust as the company would prefer. That's why Valeant is balked at selling Salix.

Valeant is also likely to breach its debt covenants some time this year. The company has a minimum interest maintenance covenant of 2-to-1. Its 2017E adjusted EBITDA is $3.55 billion on the low-end of the range. Its annual interest expense is trending around $1.8 billion. If the company undershoots the low-end of its adjusted EBITDA estimate -- a real possibility -- it could breach its interest maintenance coverage. It would also likely incur fees and higher interest costs to cure the breach.

Under Valeant's current proposal it would [i] push back near term principal payments and [ii] remove or modify certain of its covenants. The restructuring would likely remove the threat of a covenant breach and buy more time to turn the company around. Q4 revenue and EBITDA fell by double digits, and I expect them to continue to fall. Furthermore, I believe the new structure of adding more debt is simply "kicking the can down the road."

Lenders Should Require Equity

I currently value VRX at around $1; that valuation is likely to go lower once I update it. Valeant's debt/EBITDA already exceeds 7x and the metric will likely deteriorate. The company has $29.8 billion in debt at year-end 2016. If it [i] repaid $2.1 billion from projected asset sales and [ii] raised another $3.0 billion then debt would increase to $30.7 billion. At the low-end of 2017E EBITDA of $3.55 billion, debt/EBITDA would increase to 8.6x.

I am on record that Valeant needs equity capital to help shore up its liquidity and meet debt obligations. That said, its current arrangement is effectively asking lenders to take on equity type risk, but receive debt-like returns. This is mullet money or "dumb money," in my opinion. Lenders should be properly compensated for the equity-like risk they are taking on. They should [i] keep an interest maintenance covenant in place and [ii] ask for warrants to sweeten the transaction.

As each quarter passes, Valeant loses money and destroys its equity base. The interest maintenance coverage would allow lenders to call their loan before the company's value erodes too much. The warrants would allow lenders to benefit from any upside from asset sales or new product launches. If the company doesn't like the deal it could always seek a massive equity raise -- something I recommended months ago.

Conclusion

Valeant's proposed capital raise is a de facto admission it will likely breach debt covenants. I believe VRX is worth closer to $1 than its current price of just below $12.50. VRX remains a sell.

 

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