A short squeeze is a tailwind for VRX stock. However, high leverage will keep a check on Valeant Pharmaceuticals stock.

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2017 has turned out to be a good year for Valeant Pharmaceuticals Intl Inc (NYSE: VRX) so far. Shares of the specialty pharma company have been on a tear of late. Valeant stock has gained more than 25% since the end of January compared to over 3% gain in Nasdaq Composite (INDX: COMP). The stock has gained more than 10% in the last two days. Valeant stock is up another 5% in the pre-market trade today on the news that FDA has approved "Siliq" (or brodalumab as it was previously known), a drug marketed by Valeant to treat adults with moderate-to-severe plaque psoriasis.

The factors driving Valeant's stock price

The impending approval of "Siliq" along with the recent asset sales were the main tailwinds behind VRX stock's recent bullish run. "Siliq" was developed by AstraZeneca (NYSE: AZN), who later sold it to Valeant. In spite of the black box warnings "Siliq" is required to carry and onerous milestone payments which Valeant has to make to AstraZeneca, "Siliq" is likely to be a strong cash flow generating drug for Valeant. The recent asset sales have been another tailwind. Valeant has announced more than $2.5 billion in assets sales which will help it pay a portion of its huge debt pile. Moreover, Valeant has managed to get a much better price than what was feared.

The recent rally in the stock might have also been helped by a short squeeze. In the latest round of reporting for the period ending January 31st, short interest in Valeant Pharmaceuticals Intl had jumped by more than 17%. Around 35.6 million shares making up 13% of the company's total float are currently shorted. It is possible that the massive rally in the stock price since January 31st would have forced many shorts to cover their position, driving the stock further up.

Technicals too have a bullish setup. In a bullish move, Valeant stock made a crossover over the 50-day simple moving average (SMA) a few days back. A crossover of 50-day SMA is a strong bullish indicator for many stocks. Another technical indicator which is flashing bullish sign is MACD. For the first time in more than 4 months, MACD has crossed above the zero center line, indicating a strong momentum in the stock. On a more cautionary note, the recent run in the stock has propelled RSI in the overbought territory.

High leverage will keep a check on Valeant Pharmaceuticals stock

While technicals and short squeeze may provide tailwinds for VRX stock in the short run, high debt levels and moderate growth potential continue to keep a check on its price in the medium term. With more than $30 billion in debt and just $4 billion in equity, Valeant's debt to equity ratio of more than 7 indicates that the company is over-leveraged and thus highly risky. Valeant's Altman Z-score, a measure of the likelihood of bankruptcy is still deeply in the red zone. Also, the debt agreements carry several restrictive covenants, including a covenant stipulating that Valeant's interest coverage ratio should not slip below 2. The recently announced plans for asset sales worth around $2.5 billion will ease the pressure on the company and provide it with some breathing space. However, the company still has a long way to go.

High leverage wouldn't have been such a huge problem for Valeant if it was a fast growing profitable company. However, that's not the case. The company has reported a loss in previous four quarters. In fact, the company reported around $1.2 billion loss in the previous quarter. And the planned asset sales will put further pressure on Valeant's future profits and cash flows. Valeant has been already forced to reduce its guidance for several times. JPMorgan analyst Chris Schott recently raised similar concerns:

We are again lowering our estimates to reflect 1) the company’s recently announced asset sales, 2) a more conservative view of Valeant’s diversified products division and 3) FX headwinds. Our new 2017 EPS and EBITDA estimates are $4.30 and ~$3.7bn. While Valeant’s recent divestitures are a step in the right direction (helping to meet near-term debt reduction goals), we still see a challenging setup for the story with significant leverage and modest growth potential.

Valeant stock is still a gamble

In spite of the bullish sentiment, Valeant stock still remains a very risky bet as reflected in its valuations. Valent stock is currently trading at a PS (ttm) ratio of 0.57. The valuations are unlikely to improve till Valeant is able to demonstrate that the risk of a debt default has reduced. The planned asset sales are steps in the right direction. However, Valeant Pharma has still a long way to go. The company will face its first hurdle when it announces its Q4 and FY 2016 results on February 28th. The company needs to report EBITDA around $3.8 billion to maintain its interest coverage ratio of 2 or it would be in the breach of the debt covenants which could trigger a technical default. However, a beat on earnings and strong EBITDA guidance for 2017 could trigger a strong rally in the stock.