Long QCOR: 95% probability of a 20% Return or Higher
Based on our Economic Value model and Monte Carlo simulation, our "fair valuation" of Questcor Pharmaceuticals, Inc. (QCOR) affirms the current share price of $42.68 as of July, 18th 2012 is undervalued, with significant upside (Figure 1.1).
Our Monte Carlo simulation provides a range of 1,000 scenarios to determine the probability associated with making a minimum return of 20%, as well as the probability of taking a loss through either a short or long position.
For each scenario, a random value is generated for the unknown inputs in our discounted Economic Value model. These random values are based on reasonable ranges derived from 10-year historical distributions of company and peer data. While point estimates are often "precisely wrong," range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value (also known as Economic Profit, Economic Value Added, or EVA) calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.
Our estimate calculates a probability distribution of fair value (Figure 1.2).
For QCOR, the probabilities of return based on the following positions are as follows (Table 1.1):
- Long: 95% chance of 20% Return or Higher. 2% chance of a loss.
- Short: approximately 0% chance of 20% Return or Higher. 98% chance of loss.
Summary statistics (Table 1.2) show an expected value of $91 to $94 based on the median and mean.
Value Creation and Economic Value Ranking
To further validate and provide context to the reasonableness of our analysis, we compare QCOR operating performance with other companies. Amazingly this small company dominates when it comes to delivering long-term value to shareholders (Table 1.3), as measured on a size adjusted basis through Market Value Added (MVA) divided by Capital. MVA is the Market Value (Debt plus Market Value of Equity) less the book Capital employed in the business. MVA represents the accumulated value created over the life of a business or NPV, as well as shareholders' expectations of the future stream of Economic Value. Impressively, QCOR ranks at the top of the list, generating $13.71 for every dollar of invested Capital.
As to be expected, the company's Economic Value/Capital, which is equal to the Return on Capital less their Cost of Capital (Spread) is ranked in 1st place amongst some major players (ABT, AGN, ALXN, AMGN, ASTX, BIIB, BMY, CBST, CELG, EBS, ENDP, EXEL, FRX, GHDX, GILD, IPXL, IRWD, JAZZ, LLY, MRK, MYL, NOVN, PFE, PRX, QCOR, SLXP, SPPI, TEVA, VPHM, VRTX, WPI). QCOR generates a 59.8% return in excess of its cost of capital, which is significantly higher the next best peer.
The key drivers (Table 1.4) of QCOR's Economic Value performance stem from its ability to grow revenue, while generating significant returns on capital.
Slowly but surely, QCOR is extracting more pharmaceutical dollars than others in the industry, resulting in a climbing share of the market (Table 1.5).
Reasonableness of our Valuation and Assumptions
When we compare our assumptions of revenue growth and spreads (Return on Capital minus the Cost of Capital) to historical company and peer performance, our estimates are at best, conservative, and at worst, reasonable. The ranges (Table 1.5) of revenue growth represent our 90% confidence interval. Forecast is substantially lower than the most recent performance.
Historically (Figure 1.4), QCOR's revenue growth (solid black line) has been trending above the interquartile range relative to the universe of companies listed in Table 1.3.
However, our revenue growth forecast (Figure 1.5) drifts towards the industry's interquartile range despite the company's upward trend.
The distribution of revenue growth in our Monte Carlo simulation (black solid line) overlaid against the distribution of the Universe's weighted average (dark blue dotted line), CBST (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall revenue growth estimates compare to different benchmarks (Figure 1.6).
Again our estimates of spreads exhibit the same reasonable characteristics as our revenue growth assumptions (Table 1.6)
In fact, QCOR has generated spreads above the 90% confidence interval for 4 out of the 5 years, since 2008 (Figure 1.7)
Yet our forecast for Spreads, conservatively assumes these returns will decay within the 90% confidence interval for the industry, as we assume that the company's competitive advantage will not be sustained (Figure 1.8).
The distribution of spreads in our Monte Carlo simulation (black solid line) overlaid against the distribution of the Universe's weighted average (dark blue dotted line), CBST (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall spread estimates compare to different benchmarks (Figure 1.9).
We attempted to use ranges in our inputs that assumed QCOR had no sustainable competitive advantage, however, despite our conservative outlook, the valuation still suggests the company has considerable upside.
Given the level of short interest of 29.63%, as of July 10, 2012, (Source: Capital IQ), this company was a prime candidate for a short squeeze, which seemed to occur on July 9th, 2012, when the stock shot up 15% after the company released preliminary June sales for its drug, Acthar.
Needless to say, this put pressure on short sellers, many of which often leverage their position, which means a 15% increase in a stock will equate to major losses. Coincidently, Citron Research, a short seller, published a scathing report on July 10th, 2012, which was followed by a decline in the stock by 25%. One of the key points made in the report was questioning the sustainability of QCOR's competitive advantage. Although a qualitative story can be told to either support or refute Citron's claims, it is of little consequence as the fair value of QCOR is still very attractive, even when no sustainable advantage is assumed.
However, the numbers suggest that QCOR in fact does have a significant competitive advantage that is sustainable. While the market economics for the industry (industry weighted spreads) has remained flat, QCOR's competitive position (company spread minus market economics, Figure 1.10) has exploded into a significant competitive advantage.
In fact, the company's competitive advantage seems to be increasing at a rapid rate as demonstrated through the company's Economic Value Acceleration. The acceleration of the company's Economic Value (Figure 1.11), driven by a simultaneous increase in the quality of growth and productivity gains, can only be accomplished through a very strong business model.
Needless to say, it is very difficult for QCOR to generate these types of returns at an accelerating rate for as long as they have without attracting competitors, unless of course, the company has developed a sustainable competitive advantage with unique resources that are difficult to replicate.
Yet, the question of time still remains. When will a 20% return be achieved and what is the probability of doing so within various time frames? For QCOR, the probability of making a 20% return within the next 12 months is approximately 85%.
By calculating QCOR's share price volatility and our estimates of fair value, we can approximate probabilities of making a 20% return in the next 3, 6, 12 and 18 months by using a statistical concept known as "first passage times" (Table 1.7).
However, as QCOR earnings announcement draws closer (July 24, 2012), the probability of a short squeeze becomes very real, where a 20% return on a long position may come much sooner than 12 months, delivering another stellar year of returns (Figure 1.12). Unfortunately, short interest has fallen from 29.63% as of July 10, 2012 to 26.15% as of July 18th, 2012, suggesting that short sellers may be attempting to cover their position. Given QCOR's fair value, this makes sense, as the slightest spark (earnings announcement, acquisition announcement, or major long position by a smart hedge fund) can light the fuse that sends short sellers scrambling to purchase shares in order to mitigate their losses and avoid a margin call.
Disclosure: I am long QCOR.