06 Jul Opinion: Time to short Valeant bonds, go long its stock
APPEARED IN MARKETWATCH JULY, 2016. BY STREET DILIGENCE.
With its stock dropping below $20 from a peak of $263.81, the bleak outlook for Valeant Pharmaceuticals International Inc. is largely priced into its stock, but its bonds have yet to catch up.
Valeant VRX, +1.10% bonds are currently trading around 80 to 89 cents on the dollar, suggesting that the negative headlines that have battered the stock in the past year have not been fully baked in. The Canadian-based drug company has been at the center of a scandal involving drug pricing and its accounting practices, and has slashed guidance, overhauled its management team and outlined a plan to stabilize the business.
But with “hidden holes” in its bond covenants, Valeant has much more room to manoeuver its capital structure than it appears, and is able to shift more pain to the holders of its $19.3 billion of bonds.
See also: Can troubled Valeant return to normalcy?
Covenants are provisions built into high-yield, or “junk” bonds, that are agreed on by the borrower and lender at the time of a new bond issue. For the lender, they are the means to protect the credit quality of an issuer over time, as a way to safeguard his investment. For the issuer, they are the strings attached to a deal that regulate its behavior and prevent it from further increasing its risk profile.
Valeant’s covenants are not entirely bondholder friendly.
For starters, the restricted payments covenant contains an unusually large $3.7 billion “starter value”. That means that regardless of its net income, Valeant can pay out $3.7 billion, or about half of its current market capitalization, as dividends to its stockholders, effectively circumventing the covenant that is designed to prevent such leakage of cash.
Another option for Valeant is to “prime” its unsecured bondholders with secured debt by exploring weaknesses in the liens covenant and the definition of cash flow.
The “carve-outs,” or written exceptions, of the lien covenant contain an uncommon ratio-base lien “grower”, allowing Valeant to create more liens if the ratio of its secured debt to cash flow is under 3.5 to 1. This “grower” is much more potent with Valeant’s own definition of “consolidated cash flow” that adds back an uncommon and alarming item: restructuring charges.
For each dollar categorized as restructuring charges, Valeant can secure $3.5 of new debt with liens, gaining plenty of room to leverage up and push current bondholders down the queue.
“The red flags in Valeant’s covenants are just screaming at you,” said Duo Ai, a partner at Street Diligence, a leading provider of covenant analysis. “If you spend a few minutes comparing Valeant’s covenants side-by-side to others in this industry, the weaknesses are so clear.”
With equity interests in the company, Valeant’s management will doubtlessly find innovative ways to shift more downside from stockholders to bondholders, especially with the new CEO’s hyper-charged incentives to lift the stock price, and so many hidden holes in the bond covenants.
Street Diligence, Inc., an analytics company, operates a software-as-a-service platform that provides deep covenant analysis on high yield bonds, bank loans, and private deals, enabling buyside and sellside investment professionals to conduct extensive due diligence. The company was founded in 2012 and is led by technology innovator Duo Ai and former hedge fund manager Stephen Hazelton.