Questcor Pharmaceuticals Has Significant Upside Potential

Sep. 1.12 | About: Mallinckrodt PLC (MNK)

Edited By Adam Isaac

Questcor Pharmaceuticals, Inc. (QCOR), a biopharmaceutical company, offers drugs for the cure of multiple sclerosis, infantile spasms and nephrotic syndrome indicators. It primarily produces H.P. Acthar Gel, an injectable drug for the treatment of acute exacerbations of multiple sclerosis in adults. H.P. Acthar Gel is also commonly used to induce a diuresis or a remission of proteinuria in those with nephrotic syndrome, without uremia of the idiopathic type, or due to lupus erythematosus, as well as a monotherapy for the treatment of spasms in infants and children under two years of age. In addition, this product also focuses on rheumatology-related conditions, including collagen diseases and rheumatic disorders. Questcor also offers Doral for the treatment of insomnia. The company sells its Acthar primarily to specialty pharmacies and Doral to pharmaceutical wholesalers.

Questcor stock closed the last week at $43.44. I believe the market is undervaluing Questcor stock. Through the following valuation model, I have explained why I believe the stock is undervalued and what amount I believe the stock ought to be worth. As with any other ProForma model, certain assumptions are involved. These assumptions are explained in the following paragraphs.

Revenues and Cost of Sales

Questcor derives almost all of its revenues from Acthar Gel, through which it has managed to show phenomenal revenue growth in recent quarters. In fact, revenues have more than doubled in the second quarter of 2012, when compared to revenues in the same quarter of 2011. The industry experts expect the company to maintain its growth at 40 percent for the foreseeable future but, as always, I have taken a cautious approach and assumed a declining revenue growth. Instead, my revenue growth assumptions will start from 25 percent for 2013 and taper off to 4 percent constant growth in 2017. Moreover, I have also assumed a less-than-expected revenue growth rate of 70 percent for 2012, although Questcor has already registered more than 100 percent revenue growth for the same quarter last year. I have also assumed a less-than-expected industry growth rate because Acthar Gel has no patent protection at present; the patents for the drug have expired, so the firm will likely face competition from generic producers.

In addition, the company is also likely to face competition from other BioPharma companies with better resources. Competition from such competitors will eat into Questcor revenues. Acthar gel currently has 19 indications on the label; this wide range of indications ensures somewhat better than average revenue growth. Questcor is also trying to add more indications to the label; if the company is successful in its attempt then revenue growth could certainly exceed my expectations. This will only be aided by the fact that Questcor has been able to produce the drug at exceptionally low costs. Currently, manufacturing costs amount to just 5.7 percent of the revenues, giving the company a gross profit margin of over 94 percent.

However, manufacturing Acthar Gel is a complicated process. Questcor has an agreement with Bio Vectra Inc., to manufacture the API. In addition, it also has a supply agreement with Cangene BioPharma Inc., to produce commercial amounts of Acthar finished product. At present, Bio Vectra and Cangene are the sole source suppliers for Questcor. Both of these supply agreements need 12 months prior notice for termination. Furthermore, if Bio Vectra were to terminate its contract, it would have to provide commercial quantities of API for four years after the termination.

Similarly, if Cangene decides to terminate its contract, the firm would need to provide services for three years from the termination. This would, therefore, give Questcor ample time to find new suppliers before they ran out of product. I believe that Questcor is therefore well covered in the supply department, even if its existing contracts are terminated in the future. Even so, I have assumed higher manufacturing costs to compensate for any minor hitch in the supply. Barring any major events, however, I expect the manufacturing and supply process to remain smooth.

Operating Expenses and Interest Income

The firm will need to spend a significant amount on marketing once the generic drug manufacturers enter the market. Heavy competition will make it necessary to increase marketing and selling expenses in order to maintain or grow company revenues. Administrative expenses will also need to rise as the company broadens its market reach and expands its personnel.

I have, therefore, assumed a 10 percent increase in marketing and sales expenses, and a five percent and seven percent increase in administrative and R&D expenses, respectively. Questcor invests in securities and keeps a mix of cash and securities as working capital. Escalating operations will demand a higher working capital and a higher number of securities, hence the increasing interest income accounted for in the following model. Interest expenses will also increase as the firm takes on debt to fund its expanding operations.

According to my assumptions, QCOR will fund the expansion with a combination of debt and equity financing. At present, the firm has no third party agreements for the sale of the product, so it may in the future make an outside deal for the marketing rights to the drug. Gains on the sale of product rights here indicates a future partnership with a third party. Questcor has a tax rate of 31 percent; the same tax rate is used throughout the model.

ProForma Earnings

2011

2012

2013

2014

2015

2016

2,017

Revenue

Net Sales

$218,169,000

$370,887,300

$463,609,125

$579,511,406

$724,389,258

$905,486,572

941,706,035

Cost of Sales

$12,459

$25,962,111

$37,088,730

$52,156,027

$79,682,818

$99,603,523

$103,587,664

Gross Profit

$218,156,541

$344,925,189

$426,520,395

$527,355,380

$644,706,439

$805,883,049

$838,118,371

Operating Expenses:

Selling and Marketing

$56,728,000

$65,650,000

$72,215,000

$79,436,500

$87,380,150

$96,118,165

$105,729,982

General and Administrative

$17,743,000

$19,250,000

$20,212,500

$21,223,125

$22,284,281

$23,398,495

$24,568,420

Research and development

$16,778,000

$17,500,000

$18,725,000

$20,035,750

$21,438,253

$22,938,930

$24,544,655

Depreciation and amortization

$1,044,000

$980,000

$960,400

$941,192

$922,368

$903,921

$885,842

Interest Expense

$0

$0

$8,400,000

$12,180,000

$17,661,000

$25,608,450

$37,132,253

Impairment of Goodwill

$299,000

$285,000

$276,450

$268,157

$260,112

$252,308

$244,739

Total Operating Expenses

$92,592,000

$103,665,000

$120,789,350

$134,084,724

$149,946,164

$169,220,270

$193,105,891

Income from operations

$125,564,541

$241,260,189

$305,731,045

$393,270,656

$494,760,276

$636,662,780

$645,012,480

Operating Margin

57.55%

65.05%

65.95%

67.86%

68.30%

70.31%

68.49%

Interest and other income

$627,000

$846,450

$1,142,708

$1,542,655

$2,082,584

$2,811,489

$3,795,510

Gain on sale of product rights

$0

$0

$1,500,000

$2,025,000

$2,733,750

$3,690,563

$4,982,259

Income before taxes

$126,191,541

$242,106,640

$308,373,753

$396,838,312

$499,576,611

$643,164,832

$653,790,251

Tax Expenses

$34,154,000

$75,053,058

$95,595,863

$123,019,877

$154,868,749

$199,381,098

$202,674,978

Net Income

$92,037,541

$167,053,581

$212,777,890

$273,818,435

$344,707,861

$443,783,734

$451,115,273

Net Profit Margin

42.19%

45.04%

45.90%

47.25%

47.59%

49.01%

47.90%

Shares Outstanding

61,120,000

61,250,000

64,312,500

67,528,125

70,904,531

74,449,758

78,172,246

Diluted shares outstanding

64,113,000

63,115,000

65,639,600

68,265,184

71,678,443

75,262,365

79,778,107

EPS Basic

$1.27

$2.73

$3.31

$4.05

$4.86

$5.96

$5.77

EPS Diluted

$1.21

$2.65

$3.24

$4.01

$4.81

$5.90

$5.65

Click to enlarge

The model shows that Questcor will be able to generate healthy earnings throughout the next five years. I expect this company to demonstrate healthy earnings growth accompanied by a strong net profit margin.

Discount Rate

We will use a discount rate of 10 percent for our valuation purposes. In my previous valuation articles, I used a 12 percent discount rate for Arena Pharmaceuticals (NASDAQ:ARNA) and 11 percent for Vivus Inc (NASDAQ:VVUS). In comparison to these other two pharma stocks, QCOR has an established product and a successful revenue history. QCOR's financial position is therefore fairly strong. I believe the strong position of the company in the market, and an established revenue stream, warranted a lower discount rate than my previous valuation candidates.

Valuation

2012

2013

2014

2015

2016

2017

Earnings

$2.73

$3.31

$4.05

$4.86

$5.96

$5.77

Discount rate

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Present Value Factors

0.95

0.91

0.83

0.75

0.68

0.62

Discounted Earnings

$2.60

$3.01

$3.35

$3.65

$4.07

$3.58

Terminal year Value @4% constant growth

62.11

Discounted Terminal Value

38.56

True Value

$58.83

Click to enlarge

According to my valuation model, the stock should trade at $58.83. The market is currently undervaluing the stock, and I expect it to eventually move toward the calculated price.

Summary

Questcor has beaten the market earnings estimates for the six straight quarters and has a demonstrated record for long-term earnings growth and healthy revenues. The company has also expanded two sales forces, with plans to build a third force in rheumatology. In addition, Acthar should be able to generate solid revenues for the company.

As I mentioned, the drug has 19 indications on the label. However, the company believes that only nephrotic and multiple sclerosis can individually generate revenues of over $200 million. The drug has a wonderful clinical profile, helping to treat patients who do not respond to other medications. Moreover, there is little penetration into this market so there is significant space available for Questcor. The company has certainly recognized this opportunity, hence the increases in sales force.

As my valuation clearly shows, the stock is significantly undervalued at present and represents a great opportunity to enter and reap benefits.

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.