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Edited by Adam Isaac

In my previous article, I tried to come up with a fair value for Arena Pharmaceuticals (NASDAQ:ARNA) based on sales in the domestic market. Carrying on the same theme, I decided to perform a fair value analysis for VIVUS (NASDAQ:VVUS) as well. Vivus, like Arena, has its drug approved for obesity. The company plans to market the drug in the second half of the current year. Vivus had been doing the ground work to launch the drug in the market before the decision on the approval came out. Most of the sales representatives are in place, and the firm will be starting with a team 150 sales representatives initially.

My valuation model involves certain assumptions about the revenues, costs, capital structure and the direction of the business. I will be explaining these assumptions as I reach the linked areas of the article.

Vivus will probably set a higher price for Qsymia. The reason for the high price is that the company will be combining two drugs already available in the market. Vivus does not own any manufacturing facility; Qsymia will be manufactured at outside facilities. ScinoPharm of Taiwan will supply one component (Topiramate) for the manufacturing process. ScinoPharm has also been providing Topiramate for the trial period.

In the model, I have assumed a price of $4.25 for daily dose. Vivus manufacturing costs will be high due to outsourcing; as a result, I have assumed manufacturing expenses a little higher at 55% of the sales price. The company clearly states in its recent report that it does not intend to engage more than one supplier. I believe engaging only one supplier can lead to problems in the future if a conflict arises or the supplier goes through some trouble of its own.

There was an increase of more than $10 million in operating expenses for the second quarter; the increase was mainly due to the efforts to market the drug in the second half of the year. I expect operating expenses to increase as the company tries to market the drug to a bigger market; as a result, the operating expenses have risen gradually in the model. Vivus cash and cash equivalents increased significantly in the second quarter thanks to the issuance of 9,000,000 stocks for a net amount of $192 million. Vivus mainly raises capital through equity issuance, but I expect the company to raise capital through both debt and equity markets in the future, once the product settles in the market.

As the company will raise capital through debt, interest expenses will increase. Currently the interest expense is very little for Vivus. The company keeps working capital in shape of cash and securities. Most of the securities are treasury securities, and the company intends to change the choice of securities as the debt market picks up. I have also assumed a mix of securities and cash for working capital, hence the interest income will also arise in the model. As the operations of the company expand, I expect the company to hold higher levels of working capital. Vivus has been accumulating tax losses, which make its effective tax rate low and may inflate the earnings. I have assumed a flat 35% tax rate which is the industry standard. Vivus has almost 10 million stock options outstanding, which I expect to be exercised as the stock price goes up. I have also assumed equity issue for financing purposes and stock option issue to management in the future, indicated by my estimates of dilutive shares.

Future earnings will be discounted at 12%; a slightly higher discount rate, which I believe was warranted for a firm with elevated levels of risk. So, here is the ProForma earnings model:

ProForma Earnings:

 

 

 

2012

2013

2014

2015

2016

2017

Patients prescribed full year dose

150,000

200,000

340,000

578,000

867,000

1,300,500

Patients prescribed three months dose

25,000

50,000

52,500

55,125

57,881

60,775

cost of one year prescription (based on $4.25 per day dose)

$1,551

$1,590

$1,630

$1,671

$1,712

$1,755

Revenue for full year Prescription

$116,343,750

$318,006,250

$554,125,891

$965,564,364

$1,484,555,210

$2,282,503,636

Revenue for three months subscription

$9,695,313

$79,501,563

$85,563,557

$92,087,778

$99,109,471

$106,666,568

Total Gross Revenue

$126,039,063

$397,507,813

$639,689,447

$1,057,652,142

$1,583,664,681

$2,389,170,204

Manufacturing costs

$69,321,484

$218,629,297

$351,829,196

$581,708,678

$871,015,575

$1,314,043,612

Gross Profit

$56,717,578

$178,878,516

$287,860,251

$475,943,464

$712,649,107

$1,075,126,592

Operating Expenses

$35,000,000

$65,000,000

$84,500,000

$109,850,000

$142,805,000

$185,646,500

Interest Income

$0.06

$0.12

$0.25

$0.52

$1.09

$2.29

Interest Expense

$0.05

$10.50

$15.60

$19.50

$24.38

$30.47

Net Income Before taxes

$21,717,578

$113,878,505

$203,360,236

$366,093,445

$569,844,083

$889,480,064

Tax rate

35.00%

35.00%

35.00%

35.00%

35.00%

35.00%

Tax expenses

$7,601,152.35

$39,857,476.83

$71,176,082.57

$128,132,705.76

$199,445,429.14

$311,318,022.25

       

Net Income

$14,116,425.79

$74,021,028.41

$132,184,153.35

$237,960,739.27

$370,398,654.11

$578,162,041.31

Net Profit Margin

11.20%

18.62%

20.66%

22.50%

23.39%

24.20%

Shares outstanding

100,360,000

111,399,600

123,653,556

137,255,447

152,353,546

169,112,436

Diluted Shares outstanding

110,569,830

127,155,305

137,327,729

148,313,947

160,179,063

172,993,388

       

EPS

$0.14

$0.66

$1.07

$1.73

$2.43

$3.42

Diluted EPS

$0.13

$0.58

$0.96

$1.60

$2.31

$3.34

As it is apparent from the model, I expect the company to generate healthy net profit margin and handsome earnings per share at its peak. I believe my estimates are conservative, as I have assumed significantly high costs and tax rates. Based on the earnings estimates, I derived the following fair value estimate for the stock.

Evaluation:

 

 

Evaluation

2012

2013

2014

2015

2016

2017

Earnings

$0.14

$0.66

$1.07

$1.73

$2.43

$3.42

Discount rate

12.00%

12.00%

12.00%

12.00%

12.00%

12.00%

Present Value Factors

0.94

0.89

0.80

0.71

0.64

0.57

Discounted Earnings

$0.13

$0.59

$0.85

$1.23

$1.55

$1.94

Terminal year Value @5% constant growth

     

$44.87

Discounted Terminal Value

     

$25.46

True Value

$31.76

     

Summary:

According to my valuation, the stock should trade at $31-$32. At the moment, the market is undervaluing the stock. The stock has about 50% upside potential to reach its fair valuation. I believe the investors are waiting to see the next step of the company to jump in again. Vivus will be entering a market which is full of potential. Qsymia is an effective drug which can be a massive hit in the market. I expect the stock price to move towards the calculated price once the drug hits the market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Vivus: 50% Upside Potential