Valeant Hit My $35 Price Target; Now What?

Tuesday the Valeant VRX released preliminary unaudited Q4 financial results and it did not go well. I perused the results, saw that the 2016 revenue forecast was shy of previous estimates and assumed the stock would rise 10% as usual. By mid-morning my brokerage account had gone haywire; VRX had free fallen 45% and my long-dated puts were deep in the money.

The Situation

Management's estimates for both revenue and "adjusted EBITDA" are lower than its previous guidance delivered in mid-December. The prior revenue guidance was $12.5 - $12.7 billion and the new guidance is $11.0 - $11.2 billion. That would make revenue flat versus an $11.2 billion run-rate through nine months ended September 30, 2015. This is key for two reasons; it probably means that recent price cuts have taken a toll and revenue contribution from the Sprout acquisition (consummated in Q4) is negligible. I previously warned that the value destruction from the $1 billion purchase of Sprout's Addyi would come back to haunt Valeant.

The adjusted EBITDA figure is less useful; it sounds like an internal metric only meaningful to Valeant. At the mid-point of the range ($5.7 billion), management expects it to be about 19% lower than previously estimated. Either way, its $31 billion debt load is over 5x EBITDA -- junk levels. The company's cost of capital will likely increase until Valeant can prove it can generate enough cash flow to support its debt load.

Debt Covenant Defaults

In November I advised investors to ignore Citigroup's C bullishness as Valeant's debt covenants would be a problem. As usual, I was viewed as an alarmist by bulls. Tuesday management divulged it was in compliance with most of its debt covenants -- interest maintenance, senior secured leverage, net leverage, etc. However, Valeant would be in default of its revolving credit facility and its bond debentures if its 10-K was not filed by March 30th and March 16th, respectively.

The company could cure the breach under the revolver by filing the 10-K within 30 days of the default event; it could cure its breach under the debentures by filing the 10-K within 60 days of receiving a default notice. That's a long-winded way of saying there is a risk that [i] Valeant's debt could accelerated and [ii] it would have to file for bankruptcy. That's what drove VRX down on Tuesday and why it was sub-$30 on Thursday --a 52 week low.

Time To Cover

Now that VRX has blown through my $35 price target the question remains, "Where from here?" The short answer is, "It's time to your short position." I closed out my short play and now hold some modest long-dated calls. Valeant could still implode but I believe there are more risks to the upside than otherwise. There would be no reason for lenders under the revolving credit facility to accelerate the company's debt. First of all, with $1.2 billion in cash Valeant could almost repay the $1.5 billion outstanding under the revolver outright. Secondly, at Q3 2015 the company had $2.7 billion of accounts receivable it could liquidate to repay the revolver. In my opinion, there is only a remote risk the revolver would not be repaid -- at least for the next few quarters.

The holders of the debentures have no incentive to push the company into bankruptcy either. As a last resort Valeant could sell assets to repay the debentures. Those underlying brands would likely garner a more robust purchase price if [i] the parent company was still a going concern and [ii] if potential buyers didn't think the company was desperate to sell. An orderly sale process would be in the best interest of all stakeholders involved.

Lastly, Valeant just might file a 10-K during the specified cure period. Any one of those scenarios -- a removal of the debt covenant(s) or delivery of the 10-K could send VRX higher and cause serious pain for shorts. It time for shorts to take their ball and go home.