Smoke Today, Fire Tomorrow?

One of the things that can ruin a company is financial risk. Valeant Pharmaceuticals is loaded with it and nobody seems to care.

| More on:
The Motley Fool
You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn more

Making a positive contribution to the S&P/TSX Composite on this fine March day is Valeant Pharmaceuticals (TSX:VRX,NYSE:VRX).  Valeant is no stranger to the list of positive contributors as the stock has increased by 19% thus far in 2013 and is up 31% over the past year.  Valeant shareholders are surely beaming over these solid returns.  However, all shareholders, current and prospective, should be aware of the financial risk embedded within this name.

Background

Valeant, in its present form, was born out of a merger between it and Biovail in 2010.  The combined entity is a specialty pharmaceutical company focused on skin care products, neurology medicines, and growing its presence in international markets.  Its product portfolio includes branded, generic, and over-the-counter items.

Since the merger, the new Valeant has been, to say the least, rather acquisitive.  During 2011 and 2012 the company spent close to $6 billion on numerous acquisitions.  To put this figure into context, this was a company that exited 2010 with a market cap of about $7 billion.  The Valeant shopping spree has included everything from individual products to entire companies.

Financing

The company generated a total of $1.1 billion in free cash over the two-year 2011/12 period.  Good, but not $6 billion of acquisitions good.  The shopping spree was largely financed with debt, as equity issuance has been negligible.  In fact, management was so enamoured with acquisitions, $850 million (net) of stock has been bought back.

Total debt has increased from $3.6 billion at the end of 2010 to $11 billion (!!!) at the end of 2012.  This has left Valeant’s balance sheet in a rather precarious state.  As the table below indicates, debt related ratios have clearly deteriorated.

LTM

2010

Total Debt

11,026.2

3,595.3

Total Debt/Equity

3.0

0.7

Interest Coverage

1.8

2.2

Debt/CFO

16.8

13.7

Z Score

0.91

0.51

Source:  Capital IQ

The Z-Score is the only metric on the table that shows an improvement.  This ratio has a reasonable track record of predicting insolvency before it occurs.  The problem with the improvement that Valeant has shown is that both Z-scores represent a firm in financial distress.  Anything below 1.81 qualifies as “distressed”.

Cause for concern

Along with all of this debt, the company has taken on a pile of intangible assets.  Goodwill and intangibles have gone from 1.9x book value to 3.9x.  A couple of years from now, if Valeant finds that it overpaid for some of its acquisitions and is forced to write-down these intangible assets, its net worth could be completely wiped out.

On the bright side, at least this debt has been added in a historically low rate environment.  If however they don’t begin chipping away at this massive pile, as they have to start rolling over the debt in a potentially higher rate environment, interest charges are going to spiral to potentially unaffordable levels.

The Foolish Bottom Line

Analysts love Valeant with 10 of the 17 that cover it giving it a coveted “strong buy”.  2 others have it ranked as a slightly less prestigious “buy”.  What sell side firm would be crazy enough not to embrace such an acquisitive, fee generating entity?

Given its short-term performance, investors clearly love it as well.  I’m sure you’d be hard pressed to find a growth oriented Canadian portfolio manager that doesn’t own this stock.

This debt situation is a clear red flag in my mind.  Valeant is loaded with financial risk, something that can bring a company to its knees.  Stacked on top is the execution risk that an extended series of acquisitions brings.  There is smoke associated with this story – time will tell if it’s attributed to a red-hot stock or an exploding business model.

Follow us on Twitter and Facebook for the latest in Foolish investing.

Fool contributor Iain Butler does not own shares in any of the companies mentioned in this report at this time.  The Motley Fool has no positions in the stocks mentioned above.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

More on Investing

Man holding magnifying glass over a document
Investing

3 Heavily Shorted TSX Stocks to Watch This Summer

Canadians should monitor heavily shorted TSX stocks like Canada Goose Holdings Inc. (TSX:GOOS)(NYSE:GOOS) in this bear market.

Read more »

Airport and plane
Investing

3 TSX Stocks Set to Take Off With Summer Travel

Canadians should direct their attention to the travel industry and snatch up TSX stocks like Air Canada (TSX:AC) and others…

Read more »

Investing

Young Investors: 3 Canadian Stocks You Can Trust as Inflation Rises

Inflation has soared to new heights, which should spur young investors to snatch up Canadian stocks like Empire Company Ltd.…

Read more »

analyze data
Cryptocurrency

2 Tech Stocks That Benefit From the Decline of Crypto

Crypto's bear market creates opportunities for traditional rivals like Lightspeed (TSX:LSPD)(NYSE:LSPD).

Read more »

Growing plant shoots on coins
Investing

Why This Canadian Growth Stock Could Double Next Thursday

This growth stock is set to soar if market recovery continues and what analysts expect from the company continues.

Read more »

Glass piggy bank
Investing

Market Correction: Boost Your Retirement Fund With These 2 Stocks

The correction in top TSX stocks presents a solid opportunity for investors with long-term financial goals to buy shares of…

Read more »

Happy family father of mother and child daughter launch a kite on nature at sunset
Dividend Stocks

Parents: Here’s Every Credit and Benefit You Can Claim From the CRA

Parents have it hard already, so make sure the CRA is doing everything for you by dishing out payments you're…

Read more »

edit Colleagues chat over ketchup chips
Dividend Stocks

3 Canadian Dividend Stocks to Buy and Hold for Life

These dividend-paying stocks have solid earnings base to support their payouts for decades.

Read more »