Why I’m Going Long One of the Most Controversial Stocks on the Market

Bill Ackman spent four hours last week defending his position in Valeant Pharmaceuticals (NYSE: VRX) after accusations of fraud more than halved the stock’s price in less than three months.

The activist investor, whose Pershing Square Capital owns a roughly 6% stake in Valeant, made a strong argument in favor of the Canadian pharmaceuticals giant. Evidently, investors weren’t quite convinced, though, as shares sold off another 16% on the day of the presentation.

But while the market can be fickle, especially when it comes to legal uncertainty in the pharmaceutical industry, there is a lot of value in VRX. In fact, traders have a chance to book a quick double-digit return while hedging their risk.

Valeant Hit With a Media Firestorm

Under the leadership of CEO Michael Pearson and his aggressive acquisition strategy, shares of Valeant surged nearly 25-fold in seven years. By acquiring what he considered to be mispriced drugs and folding them into Valeant’s distribution channel, he kept research and development (R&D) expenses low compared to other drug manufacturers.

The trouble for Valeant began in August. First, presidential hopeful Sen. Bernie Sanders publicly requested the company answer for its practice of raising prices on drugs after acquisitions.

The following month, The New York Times ran a piece on the company’s pricing. Shortly thereafter, presidential hopeful Hillary Clinton jumped on board with a tweet about “price gouging” in biotech drugs, and the entire sector took a hit.

VRX’s sell-off accelerated in October when short seller Andrew Left accused Valeant of accounting fraud centered around specialty pharmacy company Philidor Rx Services.

Specialty pharmacies are a growing part of the health care industry. They typically offer services beyond retail pharmacies such as 24-hour access to pharmacists, financial assistance and access to specialty drugs that treat chronic or rare conditions.

Philidor began as a pilot program under Medicis Pharmaceutical Corp. After Valeant acquired Medicis in 2012, it made some of its drugs available for distribution through Philidor. Valeant consolidated Philidor’s results on its own financial statements, acknowledging the profits and losses from ownership, but said it did not control the specialty pharmacy.

All of this is legal, but Left accused Valeant of using Philidor to book fake sales, even dubbing it a potential “pharmaceutical Enron.”

Valeant denied the allegations, and on Friday, it said it was ending its relationship with the specialty pharmacy. Considering Philidor only accounted for 7% of Valeant’s sales in the most recent quarter, the 45% haircut since mid-October seems like an overreaction.

Why the Selling Is Overdone

When Ackman defended the company last week, he made several strong points.

Valeant is the leader in the dermatological segment. It commands nearly 20% of the U.S. market, according to Morningstar. It’s also a leader in ophthalmology, branded generics and gastroenterology drugs.

Plus, the company is taking steps to keep itself out of political hot water. In the most recent earnings call, management announced they no longer plan to seek out “price increase” acquisition deals. They also said they will increase R&D spending to better position the company for late-stage development opportunities.

Overall growth has been strong thanks to both volume and price increases, with the company showing 15% organic revenue growth for the year at the end of Q3. And even after cutting ties with Philidor, Valeant has a robust distribution channel. Management said it expects double-digit organic growth in 2016.
Yet possibly the strongest argument Ackman makes for Valeant came from looking at previous settlements against drugmakers. Legal judgements against the industry are somewhat common, but they don’t tend to amount to much in terms of penalties. The largest settlement — which came against GlaxoSmithKline (NYSE: GSK) in 2012 for unlawful promotion, kickbacks, concealing study findings and overcharging government programs — was only for $3 billion.

And from an investment perspective, these things tend to blow over quickly. Ackman uses a Novartis (NYSE: NVS) case as an example. When the Department of Justice filed an action against Novartis in April 2013 from a whistleblower complaint in 2011, shares sold off, as seen in the chart below.

NVS

But after Novartis disclosed a civil investigative demand and other details during its quarterly filing in July 2013, shares resumed their climb.

Valeant’s story will likely be similar.

Book a 19% Gain as the Storm Blows Over

Even if Valeant isn’t able to replace sales from the Philidor channel, Ackman estimates 2016 EBITDA of $7 billion, or about $14 per share. Competitors like AstraZeneca (NYSE: AZN) and Merck (NYSE: MRK) trade for around an average 12 times trailing EBITDA, which would put VRX around $168.

While the upside potential in shares is substantial, there is also a good deal of risk. For that reason, I want to employ a strategy with built-in downside protection.

It’s known as a covered call. If you’re not familiar with how it works or need a refresher, watch this short training video now.

With VRX trading at $97.86 at the time of this writing, we can buy 100 shares and simultaneously sell one VRX Jan 100 Call, which is trading around $13.90 ($1,390 per contract), for a net cost of $83.96 per share. This means the stock could fall more than 14% before we would experience a loss, which is a significant amount of downside protection.

If VRX closes above the $100 strike price at expiration on Jan. 15, our shares will be sold for that price. In this case, we will make $16.04 per share for a profit of 19.1% over our cost basis. Since we’d earn that in 73 days, it works out to an annualized gain of more than 95%.

If shares do close below the $100 strike price on expiration, I have no problem holding them and selling another call option to lower my cost basis even further. The extreme volatility in VRX means I can take advantage of high option premiums ahead of the eventual rebound.

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Originally Posted at Profitable Trading

— ProfitableTrading

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