Valeant Pharmaceuticals Intl Inc (NYSE:VRX) will be reporting earnings next month, and if Valeant’s earnings come in short, the guidance management provided for the full year of 2017 will be called into question. This guidance was already shockingly low because of patent LOEs, generic competition, and divestitures.
Without organic growth, divestitures are Valeant’s best option to meet mandatory debt obligations. Divestitures, while good in the short-term, will further reduce Valeant’s revenue, EBITDA, and the quality of its portfolio. The first quarter of 2017 is an inflection point for this struggling company. Either Valeant shows signs of stabilizing, or it is doomed. Don’t tell VRX shareholders, though.
Investor Ignorance & the Danger of Bias.
When investors come across information that conflicts with their beliefs, they have three ways to look at the new information:
- They can assume the new information incorrect. Implicitly, they know more than the author, or the author is a short seller attempting to manipulate the market.
- They can assume the author is correct and change their previously-held beliefs.
- They can ask questions or do further research to better understand the reasoning and data behind the conflicting information.
Unfortunately, investors usually choose the option that fits their previously established bias about either their investment or the source of the conflicting information, the analyst. This tendency is one of the biggest reasons why investors lose money in the stock market. It is also the reason why most Wall Street analysts try to avoid rocking the boat by telling the public only what they want to hear.
Several days ago, a reader corrected my claim that Valeant is unable to cover its debt obligations with free cash flow. And while he had a point, a quick look at Valeant’s 2016 cash flow statement shows free cash flow of $1.796b, while interest expense alone is $1.828b. FCF already accounts for interest expense, but it doesn’t account for the mandatory debt paydown that Valeant will be required to pay on top of its interest expense.
According to the reader, Valeant’s “near-term debt obligations are zero because a refinance done in March has pushed back obligations to 2020.” But here is a table of Valeant’s mandatory debt payments to 2021. These payments include both interest expense on the debt and the required pay down of the debt principal. While the interest expense can be covered, the debt principal (especially due in 2019) will be next to impossible to cover without selling assets or issuing more equity.
The reader assumed that Valeant’s recent debt refinance covered the company’s debt obligations until 2020 when it only covered a small portion of the debt that was due in 2017. The refinance kicked the can down the road. And as Valeant’s financial condition continues to deteriorate, the company will find it impossible to convince creditors to lend it more money. A clearer picture of Valeant’s debt situation will emerge in the first quarter result.
Valeant will be unable to meet its mandatory debt obligations with cash flow. And as the business continues to deteriorate, the likelihood of default looms larger and larger. Right now, the future looks grim for this struggling pharmaceutical. Unfortunately, bias prevents bullish investors from accepting information that conflicts with what they believe or want to believe about their investment. Most of Valeant’s bag holders will learn this lesson the hard way. Look forward to disappointing news on May 2, 2017.
I have no position in any stock mentioned in this article, but I may initiate a bearish position in VRX through puts before earnings. I am receiving no compensation for this article except through Smarter Analyst.