Valeant OD’s on Sketchy Drug Sales

This week drug company Valeant Pharmaceuticals International (VRX) saw its stock price plummet by nearly 50% after a story said it has been padding its revenue figures. A report from Citron Research accused the company of booking “phantom sales” to subsidiary pharmacies and other entities to create the impression of higher sales.

If true, then Citron’s comparison of Valeant to Enron is a fair one—to a point—since Enron also used subsidiaries to hide massive losses from its energy arbitrage business. However, while Enron had phantom sales, Valeant’s may turn out to be real if the inventory transferred to its subsidiaries ends being bought by customers.

At the very least Valeant’s accounting tactics were more than a little aggressive, if not illegal. In its defense, the company issued a statement justifying its actions, noting that its formal financial statements submitted to the SEC conform to GAAP. Regardless, the use of one set of financial statements for reporting requirements while using a different set for public relations purposes is deeply troubling.

Regardless of how this plays out, it illustrates the danger many momentum stocks, and their shareholders, are facing in the new stock market we have entered. While the Fed was pumping trillions of dollars into the economy via Quantitative Easing over the previous five years momentum stocks dominated the market, but now that it has become more of a zero-sum game there is little tolerance for companies trading at a premium that cannot sustain their aggressive growth objectives.

That’s why I sold Valeant out of the Personal Finance Growth Portfolio shortly after taking over as its Chief Investment Strategist a year ago. My proprietary model for evaluating stock prices – the IDEAL Stock Rating System – flagged Valeant as being grossly overvalued and ripe for a big fall. In an article (“We Answer Your IDEAL Questions”) in the January 14th issue of PF I wrote:

“I can’t justify hanging on to a stock that only earns a score of 1 on our scale of 0 to 10, so I am removing Valeant Pharmaceuticals from the portfolio. There was excitement over the promise of some of the drugs developed recently, but it pays no dividend, trades at almost 100 times earnings, and is a momentum stock swept up in the mergers euphoria currently enveloping the sector. It’s not a bad company, but it is overvalued. Sell Valeant Pharmaceuticals International.”

It can be argued by the market timers out there that I bailed too soon; on that date VRX closed at $156.80, considerably below its peak closing price of $262.52 on August 5th. But that’s the problem with momentum stocks. Since there is no rational reason to justify their price, there is also no good way to determine just how high they might go before crashing back down to earth.

For what it’s worth, back in January my model indicated a fair price for VRX would be $35.47 if the company were valued the same as the average S&P 500 stock. I doubt its share price will fall that far – it seems to have found a temporary bottom around $100 – but it does suggest how unsustainable Valeant’s recent price above $200 really was. For that matter, the entire healthcare sector had become inflated to the point that in the April 17th issue of PF we printed a list of 12 other medical companies – “The Dirty Dozen of Healthcare Stocks’ – that were overvalued and at risk of getting slammed. Since then all but one of them has lost value, and as a group they have lost more than 13%.

If you didn’t sell out of Valeant before this week then it may be too late to do much about it, but it’s not too late to get out of other stocks that are equally overvalued. If you are a subscriber to Personal Finance, you can visit our listing of every stock in the S&P 500 to see its current IDEAL score (if you click on the column header ‘Total Score’ it will rank every company from lowest to highest; clicking on it again will reverse the ranking from highest to lowest).

All stocks with a current IDEAL score of 0 or 1 are at high risk of suffering a major decline in the near future. That’s because they pay very little or no dividend, are not growing their net operating cash flow, yet are trading at a premium to their sector peer group. In short, they are priced as if they are performing well, when in fact, they are not.

These stocks are especially at risk during earnings season, which is going on right now as companies roll out their quarterly financial reports. You do not want to be left holding the bag when a grossly overvalued momentum stock finally reaches too far – as Valeant may have done – to live up to expectations of higher sales keep posting higher sales figures by fudging the numbers.

For that matter, even a mild disappointment in operating results will send most momentum stocks tumbling down the charts these days. There isn’t that much upside potential left in most of them, and the risk of hanging on to them just isn’t worth it. By now it should be apparent where most of the so-called “smart money” is heading; away from ticking time bombs like Valeant, and into solid value plays that will hold up in this very different economic environment.