Given the latest scrutiny over Valeant Pharmaceuticals, I would like to point to some of the inferences that I had drawn over this issue based on the facts; and the facts does not add much confidence for investors in this company.

The bombshell: Citron Research’s report[1]

Much of the recent decline in prices can be attributed to the publication of a negative report by Citron Research on Tuesday, October 21^st, an online newsletter that has exposed many corporate frauds of recent years. Citron Research is fairly credible as a research group; based on a recent Wall Street Journal analysis[2], out of the 111 stocks that Citron has wrote about since the website was founded in 2001 (including its predecessor, StockLemon), 90 were lower one year later, and experienced an average stock price decline of 42%.

The main issue, as pointed out by the report, revolves around the issue of Philidor, which appears as a distributor of Valeant Pharmaceuticals that most sell-side analysts were unaware of until early last week. Citron reached out to the Philidor’s founders and key people that are associated with its operations; but they refused to talk about the company and its relationship with Valeant. However, as it turns out, Philidor is actually an exclusive distributor of Valeant’s products. Another issue came up when a company by the name of R&O Pharmacy filed a lawsuit claiming payment from Valeant in the amount of $69 million; however, based on Citron’s investigations, it appears that Philidor OWNS R&O pharmaceuticals. Moreover, it also appears that Valeant also have a network of other pharmacies, including westwilshirepharma, safexpharma, orbitpharmacy, that only does business with Valeant.

Before we delve into what these facts meant, we need to dispel several misconceptions regarding Citron Research. Many have made the argument that Mr. Left, the editor in charge of Citron Research, is a short-seller, and therefore have every incentive to beat the stock price down, and that this report is nothing more than a “bear raid”. However, before we start criticizing the short-sellers, investors should understand the enormous risks that Mr. Left had taken on by publishing this report. If it turns out that Mr. Left is wrong, the lawsuits that he will face will no doubt force him into serious financial distress. This report is not written without thoughts to its consequences. As Mr. Left himself have stated, he had been more right than wrong, and this is how he remain active.

The question that we have to ask ourselves is what exactly is the purpose of Philidor? It is simply very difficult to understand what is the purpose of these subsidiaries when a company like Valeant can distribute their products more directly. Philidor, as far as anyone can tell, is a secret distributor that Valeant tries not to publicize. Philidor ONLY distributes Valeant’s products and nothing else, and it appears that Valeant is selling to an off-balance sheet entity that buys only from Valeant.

Let’s assume that the intentions of Valeant are benign, and in this best case scenario, they have created a complicated financial structure and is simply making the accounting more opaque. If the intentions of the Company are more malicious, they have created a fairly convenient venue for them to conduct fraud and create fictitious transactions and sales (this is what Citron alleges). Next Monday, October 26^th, the company will discuss Philidor and respond to criticisms; how the management explains the purpose of Philidor will be an issue of great importance.

Before moving on, I would like to point out on October 19^th, the famed investigative reporter Roddy Boyd, had also discussed Valeant Pharmaceuticals in his article with the Southern Investigative Reporting Foundation[3] (SIRF) the extent to with Valeant Pharmaceuticals tried to obfuscate the relationships between the two companies.

Here are other issues of concern in addition to those that are brought up in Citron’s report:

Flawed business model:

Valeant operates by buying smaller drug companies and then raise the prices of those drugs to make a profit. The company does not really engage in original R&D and acts more as a marketer of pharmaceuticals. The company, therefore, was able to enormous margins on the drugs that they are selling. Hedge Funds, Bill Ackman’s Pershing Square Capital included, are absolutely in love with this model as shown by some of the largest holders of Valeant[4] as of Q2 2015,

1. Pershing Square (Bill Ackman): 19,472,993 shares, 5.71%
2. ValueAct Holdings (Jeff Ubben): 14,994,261 shares, 4.39% (sold 4.39 million shares in Q2)
3. Paulson and Co. (John Paulson): 9 million shares, 2.64% (added 6.95 million shares in Q2)
4. Lone Pine Capital (Steven Mandel): 5,310,143 shares, 1.56% (sold 259,317 shares in Q2)
5. Viking Global (Andreas Halvorsen): 4,616,738 shares, 1.35% (added 558,395 shares in Q2)

In fact, at the annual Sohn Investment conference, Bill Ackman even claimed that Valeant could be the next Berkshire Hathaway due to its strategy of acquiring diverse companies in the pharmaceutical space[5].

Last year, Valeant attempted to take over Allergan in a much publicized deal. Valeant offered a tremendous sum to purchase the company using shareholders and lenders money. In many ways, this deal resembled the AOL-Time Warner deal in which an overvalued company attempts to take over another company with a more well-developed network of product and services. The deal failed and called into question the model that the company had been operating under. The company aims to grow through acquisitions at all costs and it is highly doubtful that they will be able to grow through outside purchases alone. In fact, the Company’s CEO stated that soon the Company would start having to produce their own drugs, as the prospective markets for future acquisitions have lessened[6], Valeant is running out of smaller drug companies and drugs to acquire. The market was not expecting this, and the stock traded down a bit on the news. To put it quite simply, Valeant’s model of growth up until this point is unlikely to continue forever.

Here is partial list of acquisitions that the company has made in the last couple of years[7]:

2014

PreCision Dermatology, Inc. (“PreCision”). July 2014

Solta Medical, Inc. (“Solta Medical”). January 2014

2013

B&L August 2013

Obagi Medical Products, Inc. (“Obagi”). April 2013

Natur Produkt International, JSC (“Natur Produkt”). February 2013

2012

Medicis. December 2012

OraPharma Topco Holdings, Inc. (“OraPharma”). June 2012

Certain assets of Gerot Lannach. March 2012

Divestiture

2014

Facial aesthetic fillers and toxins. July 2014

Metronidazole 1.3%. July 2014

Tretin-X® (tretinoin) cream and generic tretinoin gel and cream products. July 2014

2013

Divestiture of certain skincare products sold in Australia. October 2013

2012

Divestitures of 1% clindamycin and 5% benzoyl peroxide gel (“IDP-111”) and 5% fluorouracil cream (“5-FU”). February 2012

In addition, the company’s way of raising the price of the drugs (sometimes by over 1000%) had also faced serious scrutiny. Currently the company is facing a Congressional investigation on the price increases of two medications[8]: Isuprel, which is used to treat cardiac arrest, was raised from $215 to $1,346; while Nitropress, a medication used to treat congestive heart failure and life-threatening high blood pressure (hypertension), was raised from $257.80 to $805.61 a vial. As the New York Times have put it, “Valeant’s Drug Price Strategy Enriches It, but Infuriates Patients and Lawmakers”[9]. On October 14^th of this year, the company issued a press release stating that the CEO, Michael Pearson, is now responding to these allegations and talked about Valeant’s reasoning “underlying Valeant’s pricing decisions, and Valeant’s programs designed to improve patient access, among other topics.”[10] As the regulators continue to scrutinize the company’s pricing decisions, we can expect certain regulatory actions that can impact the firm’s margins.

Aggressive and questionable sales techniques:

Valeant is aggressive when it comes to generating sales for its products, and they offer a number of incentives for the patients to purchase the company’s medications. For example, for several of the medications that the Company sells, Valeant’s venders offers to pay for the patient’s copay and to essentially give it off free of charge for the customer. Neither the doctors nor the patients have asked for it. The patients, of course, do not mind this as long as they need to pay nothing, and the patients end up having more medications than they possibly need. For Valeant, however, they are able to increase their sales volume and revenue tremendously. Moreover, the margins on those products are tremendous, and paying for the copays of the customers if it meant more sales made economic sense for Valeant.

However, the Company itself believes that their ability to generate sales is all due to organic growth. In the Q3 earning held by the company on Monday, October 19^th, the company’s CEO, in response to a question regarding how Valeant was able to recognize revenue of about $460 million after initial projections of around $300 million, stated, “… again, there’s no sales incentive, I think it’s all growth. The products continue to grow above what we had forecasted in our deal model…”[11] The company insists that sales incentives are not the cause of their product sales, and that the Company’s products are extremely popular among users. This argument appears shaky at best.

In addition, the company received subpoenas from the U.S. Attorney’s Office for the District of Massachusetts and a subpoena from the U.S. Attorney’s Office for the Southern District of New York. Both are now requesting “documents with respect to our [Valeant’s] patient assistance programs, and also include requests relating to financial support provided by the company for patients, distribution of the company’s products, information provided to the Centers for Medicare and Medicaid Services, and pricing decisions.”[12] These “patients assistance programs” are highly problematic, and is one of the key drivers of sales for the company and what enables it to have such high sales growths year-on-year.

As can be imagined, insurance companies are the ones that are cheated by this deal. While the strict legality of these actions are questionable; in the past, several insurance companies have filed lawsuits against surgeons who waived copays for patients and who instead charge enormous fees on the insurance companies. It remains to be seen in court whether or not it is legal for drug distributors paying the copays of the patients[13].

Other new developments since Tuesday, 10/20:

Earlier in the week (10/21), the company halted the trading of the company’s stocks and called Citron’s report “erroneous”[14]. At that time, the stock was down 40%. On Friday, October 23^rd, the stock rallied for a bit as many hedge funds, including Pershing, reiterated their commitment in going long on the stock, as well as Valeant’s announcement that they will address these issues at Monday’s conference call[15]. Other pharmaceutical companies – Akron, Allergan, Endo – all issued statements stating that they do not own other pharmacies for distribution and attempts to distance themselves from Valeant.

Finally, investors in this company should be aware of the fact that Valeant now have to face new lawsuits coming their way, such as Morganti Legal’s lawsuits[16] alleging that the company issued “materially misleading business information to the investing public including potentially inflating revenues by recording intercompany sales in its revenue figures” and many others; in addition, on Thursday October 22^nd, a class-action lawsuits was filed against the company accusing the company of creating phantom accounts aimed at defrauding investors[17].

It remains to be seen after Valeant responds to these allegations on Monday what the market will do. Until then, investors beware.

[1] The full report can be found here: http://www.valuewalk.com/2015/10/valeant-pharmaceuticals-vrx-citron/

[2] http://www.wsj.com/articles/the-short-who-sank-valeant-stock-1445557157

[3] http://sirf-online.org/2015/10/19/hidden-in-plain-sight-valeants-big-crazy-sort-of-secret-story/

[4] http://www.businessinsider.com/hedge-funds-that-own-valeant-2015-10

[5] http://fortune.com/2015/05/04/bill-ackman-valeant-could-be-next-berkshire-hathaway/

[6] http://www.fiercepharma.com/story/valeant-changes-its-spots-promises-limit-price-hikes-spend-more-rd/2015-10-20

[7] Company’s 2015 10-K

[8] http://www.mccaskill.senate.gov/imo/media/doc/20150923McCaskilllettertoValeant.pdf

[9] http://www.nytimes.com/2015/10/05/business/valeants-drug-price-strategy-enriches-it-but-infuriates-patients-and-lawmakers.html?_r=0

[10] http://ir.valeant.com/investor-relations/news-releases/news-release-details/2015/Valeant-Provides-Update-Regarding-Government-Inquiries/default.aspx

[11] Earnings Transcript,

[12] http://ir.valeant.com/investor-relations/news-releases/news-release-details/2015/Valeant-Provides-Update-Regarding-Government-Inquiries/default.aspx  Emphasis are mine.

[13] http://www.bloomberg.com/news/articles/2012-07-19/silicon-valley-surgeons-risk-moral-authority-for-200-returns

[14] http://www.zerohedge.com/news/2015-10-21/vrx-halted-down-40-news-pending

[15] http://www.thestreet.com/story/13336555/1/valeant-pharmaceuticals-vrx-stock-rebounds-ahead-of-call-to-address-allegations.html?puc=yahoo&cm_ven=YAHOO

[16] http://finance.yahoo.com/news/shareholder-alert-morganti-legal-announces-155700510.html

[17] http://www.usatoday.com/story/money/2015/10/23/valeant-class-action-lawsuits/74457788/