In October we posted an article on Seeking Alpha detailing some apparently shady dealings between the Chronic Disease Fund (CDF) and Questcor Pharmaceuticals (QCOR). A week later, on its Q3 earnings call, QCOR announced that the, 'USAO [US Attorney's Office] for the Southern District of New York and the Los Angeles Office of the Securities and Exchange Commission are also participating in the ongoing investigation by the USAO in Philadelphia,' which has been investigating the promotional practices of QCOR since September 2012. This is no simple matter as another regulatory body, the SEC, has begun investigating QCOR and is working in conjunction with the US Attorney for the Southern District of New York, which, unlike the SEC pursues criminal proceedings. The timing may be a coincidence - or not.
Another event which occurred in the last few weeks and which we find very unlikely to be a coincidence is that the Founder, Chairman and President of the Chronic Disease Fund, Michael Banigan, has stepped down from his post at the CDF. Michael Banigan is no longer on the Leadership page nor is he the Chairman or a Trustee of the Board. Even the 'Our Founders' Story' discussing Michael Banigan's personal struggles with Crohn's Disease has been scrubbed from the website. The new Board Chairman is the Hon. Glen M. Ashworth, a retired judge and professional arbitrator/mediator. We find it curious that just as the CDF is receiving a large amount of scrutiny it hires a Chairman well versed in lawsuits of all kinds. Maybe they are getting ready to deflect future legal problems. Further, we highlight the fact that the entire CDF Board has turned over. In 2012 the Board consisted of seven people: Michael Banigan, Al Henry, Jay Arbetter, Kenneth Brown, Steven Block, Mike Scholten and Joel Fineberg. Not one of those people is currently on the Board. Banigan, Henry, Arbetter, Block and Scholten had been on the board for over five years. In our view, this is not a coincidence. The CDF has been exposed and they appear to be covering their backs. This may potentially produce large problems for one of the CDF's largest donors: Celgene (CELG).
Celgene and the Chronic Disease Fund
We know that CELG works with the CDF because its major drugs Revlimid, Abraxane, Thalomid and Pomalyst, which collectively account for ~86% of CELG sales, are covered by the CDF. According to the 2011 CDF Audited Financials we also know that two pharmaceutical companies account for 81% of the $215 million of donations received that year. Based on conversations we have had with experts in the industry and directly with CELG we believe one of these donors is CELG. Assuming CELG represents 40% of total donations then CELG donated $86 million to the CDF in 2011 and possibly much more in 2012. If the CDF were to shut down or curtail its operations significantly it would be a big problem for CELG because the CDF's copay assistance program drives a large proportion of CELG's revenues.
CELG reported in its most recent 10-Q that it increased its donations to independent non-profit organizations in the United States by $25.5 million Y/Y which accounted for 27% of the company's $94.1 million SG&A increase Y/Y. This is a huge number - CELG is on pace to increase its donations to US-based charities for copay assistance programs by $100 million annually (which is an acceleration from the $72 million increase in 2012). We also note that the $72m increase Y/Y in 2012 was a 6x acceleration from 2011 when donations increased by just $11.7 million Y/Y. These increases are extremely important because copays average about 10% of the cost of the purchased drug. In other words, $100 million in increased donations to copay assistance programs like those run by the CDF can ultimately generate $1 billion in incremental drug sales for CELG. Given that CELG is likely to increase revenue in 2013 by about $1 billion this year and according to Street estimates another $1 billion next year we think any meaningful change to their ability to drive revenue through copay assistance programs will impair earnings growth. Finally, we note that if CELG donated $86 million or more to the CDF in 2012 then such donations likely drove as much as $860m worth of CELG's total revenues (16% of the total and 27% of US revenues).
Companies like CELG and QCOR need these large scale copay assistance programs because very few people can afford their high-priced drugs. What we find remarkable is despite the fact that CELG's drugs sell for tens of thousands of dollars per year, they continue to raise prices. The CELG 2012 10-K indicates that 24% of the company's revenue growth that year was due to price increases ($162.2 million of increased revenue related to price increases vs. $685.9 million of total net product revenue increase). CELG highlighted its US price increases in the 10-K: 'the increase in price was primarily due to price increases on Revlimid, Vidaza and Thalomid in the US market.' CELG's pricing was actually down Y/Y in 2011 as the company had problems with Medicare: 'The decrease in prices was primarily due to increased Medicare Part D Coverage Gap [the donut hole] rebates resulting from the Health Care Reform Act.' We find it hard to believe that CELG increased donations to charities like the CDF in 2012 by $72 million without expecting some sort of revenue increase. They had a problem getting reimbursed due to changes in Medicare laws and utilized charities like the CDF to help sell their high-priced drugs.
Financial Implications and Price Target
Without the increased utilization of copay assistance programs like those provided by the CDF we estimate 2012 price increases for CELG would have been nil and total revenues would have been $720 million lower ($72.0 million in increased copay can generate 10x the sales) This compares with reported US sales growth for CELG in 2012 of $309.1 million. We believe that without the increased help of charities like the CDF, CELG's US sales could have declined meaningfully in 2012. Incremental margins for CELG are around 55% so lower sales of $720 million would lower EBIT by nearly $400 million (15% lower) and EPS by $0.80 (16% lower). In other words, without help from charities like the CDF 2012 non-GAAP EPS could have been $4.11 (up just 8% Y/Y vs. the reported $4.91 which was up 29% Y/Y). CELG is an expensive stock; it currently trades at 28x 2013E consensus EPS estimates. Any hiccup to its growth rate could result in meaningful multiple contraction. Assuming the CDF's activities are largely curtailed and CELG has difficulties ramping up spend elsewhere we see 2014 revenues 10% lower than expectations at $6.55B and EPS of $6.20 (representing growth of just 3% Y/Y) vs. consensus expectations of $7.05 - a 12% miss. Our price target is $112 (down 34%): 18x our $6.20 2014E EPS estimate.
Some critics of our analysis would say, 'Even if the CDF is shut down Celgene will simply move their copay assistance dollars elsewhere.' While this may be true we think it is instructive to highlight just how big the CDF is compared to the six other charities with copay assistance funds CELG operates with. The CDF took in and spent about $200 million in 2012 on copay assistance programs. Collectively, the six other copay assistance programs CELG works with spent about $224m, only slightly bigger than the CDF itself. And nearly half of these expenditures come from just one charity: Patient Access Network ($108m). The rest are relatively small: CancerCare ($6.8 million for financial assistance), The Leukemia & Lymphoma Society ($46 million for copay assistance), HealthWell Foundation ($42 million), National Organization for Rare Disorders (NORD - $11 million spent on patient services), and NeedyMeds ($10.5m in total 2012 donations). Looking at this analysis it would stand to reason that the CDF represents about half of all the copay assistance donation dollars CELG spends ever year.
The potential dismantling of the CDF, likely CELG's largest copay assistance partner, will produce revenue and earnings growth problems for CELG and we think investors should heed our warning. While the CDF is not the only copay assistance program out there it is by far the largest and may be a harbinger of changes to come in this charitable industry. Finally, given what we believe about Michael Banigan and his dealings with the CDF as well CELG's relationship with the CDF we think it is fair to wonder what else could be going on at CELG.
Disclaimer: This is not a recommendation to buy or sell any investment. Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author's estimates. Investors should contact the company directly and read CELG & QCOR public filings to form their own opinions and make their own investment decisions. The author may transact in the securities of CELG & QCOR without notice.