Valeant Pharmaceutical (VRX) shares were surging in premarket trading Wednesday, after analysts with Morgan Stanley upgraded their rating on the struggling Canadian drugmaker to Overweight from Neutral, reinstating the rating they last held in September, just as Valeant shares began falling into a near year-long tailspin.
After roughly 90% of Valeant's market cap has evaporated over the past 12 months, shareholders got a 10% boost before the opening bell Wednesday, lifting shares to about $29.32, after an analyst team led by David Risinger published an investment note entitled, "Leverage Works Both Ways," highlighting that Valeant's $31 billion debt obligations may not be as perilous as some market doomsayers are saying.
"Following the company's second-quarter earnings call, we see a clearer vision under new CEO Joe Papa to enhance financial prospects," they said. "We expect management to successfully renegotiate debt covenants for a small amount (estimating $60 million extra annual interest expense), improve operating income & cash flow, and pay down debt."
As Real Money reported, debt covenants have become a particular concern for Valeant, as the drugmaker has accumulated a precarious leverage position after a several years of debt-fueled acquisitions. The company stands at particular risk of violating a minimum of interest-coverage ratio on a 1.6 billion tranche of bonds coming due in 2018, on which Valeant risks technical default if it fails to cover an interest-coverage ratio of 2.75x. (The coverage ratio is measured by the ratio of interest expenses covered by trailing 12-month EBITDA, a standard valuation metric that stands for earnings before interest, taxes, depreciation and amortization.)
Morgan Stanley also increased its 12-month price target on Valeant to $42 from $33, basing the valuation on a potential 10% increase in Valeant's trading enterprise value to roughly $44 billion from $39 billion, which the analysts say could help drive shares by as much as 58%.
"Even if Valeant maintains the same enterprise value, we anticipate that deleveraging can drive higher equity value accretion," they added. "Simple math on stability: if we assume that Valeant's enterprise value were to remain constant, each $2 billion in organic (non-divestiture) free cash flow could effectively increase current equity value of $9.3 billion by more than 20%."
On the controversy surrounding Valeant's price hikes on acquired drugs, Morgan Stanley says it has already modeled the step-down in prices and the implications of generic competition facing Valeant's "most controversial drugs" Isuprel and Nitropress, and the analyst noted they have also considered about $500 million in annual cash outflows Valeant will likely need to pay throughout 2020 for related investigations and lawsuits.
Morgan Stanley also said that a primary impetus behind their ratings upgrade was Valeant's decision to reaffirm its 2016 earnings guidance on its August earnings call, in which the drugmaker said it continues to expect EBITDA to clock in within a range of $4.8 billion to $4.95 billion, which had prompted shares to spike as many concerns among creditors and shareholders were eased.
Valeant's roughly 90% share-price decline since last summer was largely prompted by controversy that the company hiked prices to exorbitant levels on some of its acquired drugs, SEC probes into the sales bookkeeping of Valeant's former partnership with mail-order pharmacy Philidor, the delay of Valeant's annual and first-quarter filings with the Securities and Exchange Commission, and a management reshuffle at the helm with the replacement of former CEO Michael Pearson with Joseph Papa.