Valeant Is Likely to Go Bankrupt…Here’s Why

Valeant Pharmaceuticals International Ltd. (NYSE:VRX) has been on a tear and is up 26.8% in April. Last week one prominent analyst even called for it to double.

But the more I look at VRX, the more convinced I become that the company is a likely bankruptcy candidate.

We are still awaiting the filing of the company’s year-end financials, but the most recent information available shows a balance sheet with enormous amounts of debt, goodwill and intangible assets. The value of the company’s businesses as well as its cash flows are likely insufficient to overcome a balance sheet that is nothing short of a horror story.

This company is functionally insolvent from a balance sheet perspective. It has cash flow but not nearly enough to repay its $30 billion debt. I think we are looking at a bankruptcy….very soon.

Here’s why. And here’s how to profit.

Great Expectations – But No Real Value

A careful reading of VRX’s financial disclosures reveals that the company’s financial statements are more fiction than fact and rely to a troubling extent on management assumptions and projections that are highly uncertain.  Management’s track record of incomplete disclosures gives little reason for investors to have one whit of confidence in their numbers.

The company’s balance sheet shows that most of its assets are either intangible assets or goodwill whose value is based on what management says they are worth. While the company’s auditor is required to test management assumptions, the irregularities already discovered regarding the company’s financial reporting raises questions about the auditor’s judgment as well. A careful look at how the company accounts for these intangible assets raises serious doubts about their real value.

The company carries over $17 billion of goodwill on its balance sheet.  The goodwill was incurred in a series of M&A deals that were cheered on by investors but loaded the company with over $30 billion of debt (as of 9/30/15). In VRX’s own words, goodwill represents “the difference between the acquisition date fair value of the consideration transferred and the values assigned to the assets acquired and liabilities assumed” or the excess of what VRX paid over the book value of the assets it acquired. But it is not as simple as that.  The goodwill figures are really just estimates made by management of what the future may hold.  For example, with respect to VRX’s acquisition of Salix Pharmaceuticals for $173/share or $14.5 billion in 2015, goodwill represents “the Company’s expectation to develop and market new product brands, product lines and technology; cost savings and operating synergies expected to result from combining the operations of Salix with those of the Company; the value of the continuing operations of Salix’s existing business (that is, the higher rate of return on the assembled assets versus if the Company had acquired all of the net assets separately); and intangible assets that do not quality for separate recognition (for instance, Salix’s assembled workforce.”  In other words, these goodwill figures aren’t actual, verifiable numbers – they are made-up numbers based on the assumptions of a management team that was given unprecedented incentives to inflate the company’s financial condition. Soon-to-be former CEO J. Michael Pearson’s compensation as well as the pay of the rest of his management team was primarily based on pumping up the company’s stock price regardless of the underlying condition of the business.  As investors have learned at huge expense – and as the company has admitted publicly – these incentives led to questionable behavior at the top.  Much of the value of the company on which management was paid is illusory because it consists of goodwill and intangible assets values derived from management assumptions.  No doubt we will soon hear how the company needs to lower the strike price on managements’ stock options now that the stock has fallen by nearly 90%. But rather than rewards, management deserves to be fitted with pinstripes for fudging the numbers.

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The company also carries $22.4 billion of “intangible assets” on its balance sheet (as of 9/30/15).  Again in VRX’s own words, “intangible assets” represent the value of “Finite-lived intangible assets” including “product brands ($21.6 billion),” “corporate brands ($1.0 billion),” “product rights ($3.2 billion),” “partner relationships ($221 million),” “technology and other ($526 million),” and “Indefinite-lived intangible assets” including “acquired in-process research and development ($722 million),” and “corporate brand ($1.7 billion)” – in other words, hard-to-value non-physical assets. What are the odds that product brands and corporate brands will maintain the value management placed on them in view of the company’s soiled reputation?

If you read the footnotes in the company’s financial statements, you see that these balance sheet figures are not only little more than estimates based on management’s judgment but are also subject to further adjustment. The company states that it will “finalize these amounts as it obtains the information necessary to complete the measurement process. Any changes resulting from facts and circumstances that existed as of the acquisition dates may result in retrospective adjustments to the provisional amounts recognized at the acquisition dates. These changes could be significant. The Company will finalize these amounts no later than one year from the respective acquisition dates.” Are they **** kidding?

In summary, the company’s financial statements are highly unreliable and subject to change. For example, the company’s 3Q15 Form 10Q states: “the allocations of the goodwill balances associated with the Salix Acquisition and certain other acquisitions are provisional and subject to the completion of the valuation of the assets acquired and liabilities assumed.” What are they waiting for? And does anybody reasonably believe that these valuations have increased since last year in view of the company’s difficulties? No way!

VRX’s Balance Sheet Tells The Real Story

The company itself reports the huge amount of amortization expense that the company will be eating over the next few years (while also stating that “[e]stimated amortization expense…does not include potential future impairments of finite-lived intangible assets” (which means that these figures are understated): $2.5 billion in 2016, $2.5 billion in 2017, $2.35 billion in 2018, and $2.2 billion in 2019. These amounts reduce earnings and are not tax deductible. I would wager a large sum of money that these figures will increase significantly because the company is likely to be compelled to accelerate write-offs as it becomes increasingly clear that it overpaid for the companies it acquired.  Remember – they were making acquisitions in an extremely expensive stock market.

If you adjust the company’s balance sheet for goodwill and intangible assets, you can see the problem. Leaving aside intangible assets for a moment, just subtracting goodwill from VRX’s 9/30/15 book value of $6.5 billion leaves you a company with negative tangible net worth of -$10.9 billion. If we haircut intangible assets by 50%, the company’s negative tangible net worth drops to -$22.0 billion. A 50% haircut is a reasonable assumption if you consider that prospective purchasers of the company’s assets are well aware that the company is a forced seller and are going to drive a very hard bargain. Coupled with $30.2 billion of debt at 9/30/15 (it is slightly higher today), this is the balance sheet of a financially troubled company.

Equity analysts rarely pay attention to balance sheets, which is one reason why almost two dozen Wall Street analysts missed what was happening at VRX. Even now, these analysts are pulling their punches and ignoring the company’s poor financial condition because their employers want to get the business of selling off VRX’s pieces. The balance sheet alone should have been enough to squelch the enthusiasm that drove the company’s stock price to a ridiculous $263 per share last year. Instead, Wall Street whored itself to a company that paid hundreds of millions of dollars in fees and ended up missing the story.
Last week, VRX reportedly called in investment banks to start figuring out how to sell off pieces and try to save itself. These are the same investment banks who helped it overpay to buy other companies with tens of billions of debt. Perhaps it is only fitting to allow the foxes to rip apart the henhouse one last time.

The only chance Valeant has now is if it can sell its businesses and assets at a high valuation. In other words, this is a company that is totally dependent on markets not falling apart but continuing to rally in the face of serious headwinds – and you know what I think of that possibility.

Long investors should avoid this mess at all costs. For short investors, I believe there’s another round of big profits here for the taking. You want to look for a low-risk way to play it because VRX may not collapse right away; after all, it has enough cash flow to keep paying interest (or so it says).

I recommend buying long-dated puts on VRX at a single-digit strike price. I’m looking at the following options. On both of these, volume is very low, so be careful to put a limit order on your bid as opposed to a market order.

  • Buy VRX January 2017 $7.50 puts (VRX170120P00007500), currently trading around $0.60.
  • Buy VRX January 2018 $5.00 puts (VRX180119P00005000). These are changing hands around $0.79.



17 Responses to “Valeant Is Likely to Go Bankrupt…Here’s Why”

  1. Why would I want to buy a $7.50 put? VRX is now at #34-35. If VRX does not go below $7.50 by Jan 2017, I lose my put premium. If VRX does go below $7.50, that is such a low amount, I would not make much profit. So what is so great about your advice?

  2. At list now it is obvious that you was paid to publish that stuff all the way down. Based on your other investments suggestions, it is quite obvious that you are just the weapon in the game against Ackman’s position. All comes from his short on Herbalife. He got a lot of powerful enemies. The only way to damage the company is by regulation authorities that I guess also did not wake up some morning and decided to investigate Valient without any one’s push…. there is some cloud over the company till 10K will be filled, but to claim based on known information that the company is going BK – it is not only not professional but does point on some hidden interest to make damage to the stock price, because it is not so easy to cause damage to the company. I am sure that Ackman understands the situation and not wasting time to smash his opponents in that fight where we all small investors are just pawns.

    • Alex, I have no position and am 100% independent. My analysis is based entirely on my own research, and my only objective in publishing this (or any other!) column in Sure Money is to help investors make the best possible decisions. (I understand that that may ruffle a few feathers at times, since my opinion will not always be in lock step with the status quo.)

  3. It’s a speculation based on the information provided on the balance sheet and the figures it shows regarding good will. You’re free to follow it or not. The recent past tends to confirm that what VRX shows is much too optimistic at best and likely bogus. Furthermore, don’t forget that they also are the target of a political campaign from the left. People may have accepted to be ripped off by the banks but they will not accept to be ripped off on their health.

  4. Unlike most long put recommendations where you’d expect the stock price to just go down, in this case you’re expecting it to go to zero. For 10 puts at .60 … $600 … you get to make a low risk binary bet … Does the company survive beyond Jan 2017 or not survive? If it doesn’t survive, you make $6.90 … over 10 times your money.

    Yeah, it would be a stupid move if you were betting on a 70% or even 90%, but you’re not. You’re betting on a BK. Not a bet I’d take, but not irrational either.

  5. Options are probabilistic instruments. What you pay for now, $ 60, is the probability that 100 shares of VRX will drop below $ 7.50 on or before January 2017. This probability is low, hence the price of the option is low. Say VRX drops by $ 10 in the near future, the probability that VRX drops to $ 7.50 will dramatically increase even if the stock’s price is still way above $ 7,50. Your options will increase in value many folds.
    It’s a bet with a small risk on your capital.

  6. Whith such attitude you can make a long list of companies that are candidates to BK. If you reduce the goodwill and intangible assets, shareholders equity will be deep.. deep negative. The only question in evalustion of such company is how much cash flow it can produce. in case of Valiebt if it can produce about 7$ per share cash in 2016 and 9$ in 2017 (based on assumtion of Bill Miller)…. who cares about the goodwill and how the balance sheet looks like. The stock will not be traded less then 80$… There are many options to bring to fare and normal valuation of Valient. I guess after 10K filling we can expect for normalisation of that story.

  7. I think the big money in valeants decline has been made. I never like to bet on bankruptcies. Is VRX overpriced? Yes. Lets move on already, i think there are other better shorts that don’t require bankruptcy to make money…

  8. The balance sheet with all goodwill started to worry only because the company value went down it was not and issue when the company was 90B worth. 10% equity placement could resolve all the problems. So the main goal not to bring back the reasonable Market Cap. Based on assumptions of Bill Miller, the company can make cash 7$ per share in 2016 and 9$ in 2017. So the company share price can be justedied around 90-120$ price per share. At that stage the option to issue some portion of new stocks to some strategical investors will resolve the problem of balance sheet.
    The quastion that should be asked is “how much milk gives that cow”… Filling 10K on time till 29th will change the centiment….

  9. Thomas Corpening

    Valeant is a crappy company, it does nothing for research and finding new drugs.
    I made my financial advisor (Who uses no stops) sell it on Aug 17th 2015, as it was
    vastly overpriced, and the next week it dropped $100 per share in price. The analyst
    who keep saying to rebuy it are foolish. Your analysis, on the other hand, has a ring of
    reasonable analysis, thoughtful evaluation. Keep me on your list of followers

  10. Wow, I’ve never seen an analysis that is so poorly argued. The rationale for bankruptcy, given by the author, is that goodwill is overstated. Well no company has ever gone bankrupt because of goodwill. The only way VRX can go bankrupt is if its debt holders are allowed to call in their loans. This is EXTREMELY unlikely, (can only happen if they don’t file their 10K). The earliest these loans can be called is in 2019. Buying put options for 2017 & 2018 is throwing away money. THE MOST IMPORTANT THING FOR ANY COMPANY IS CASHFLOW . VRX is forecasted to make $7 free cashflow this year, and $9 per share next year. This will allow them to bank $5 Billion over the next two years to pay down debt. As long as VRX can make their debt payments (which does not appear to be an issue) they will not/can not go bankrupt. Analysts need to look at cashflows in order to properly assess the value of a company. Valuing a company based on the goodwill is simply absurd. The author really needs to take an accounting course prior to publishing such nonsense.

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