PSB Monthly Issue September 2008

| September 2, 2008

September 2008


It happens every day, thousands and thousands of times.  A new life is brought into the world by a loving mother.  It’s estimated by US Census data that every 7 seconds a new baby is born.

The great joy of a new born is sometimes replaced with gripping fear.  Nothing’s more heartbreaking than a newborn with a serious medical problem.

Some medical conditions can be treated… others set the child up for a debilitating future.  That’s what happens to the children with infantile spasms (IS).

All of the data about this medical problem is heartbreaking:

• 40% of the cases the cause is unknown,
• 20% of the children die before age 5,
• 50% have persistent epilepsy, and
• 75% are mentally retarded.

According to the Epilepsy Foundation, “Infantile spasms are clusters of brief seizures involving various combinations of flexion and extension of the trunk and limbs, most common in the early morning or upon wakening from naps… The condition is often mistaken for colic, at least initially, because the babies double up during the spasm and cry afterwards.

Infantile Spasms occur most often before a child reaches a year old.  Sadly around 2,000 children every year are afflicted.

Untreated it quickly becomes a debilitating disease.

Amazingly, there’s no approved treatment in the US.

Many doctors however refuse to give up.

They’ll often prescribe other drugs for “off-label” use.

Off-label use is a fancy way of saying the drugs were originally developed to treat some other disease.  Doctors often find solutions in unexpected places.  A drug known to treat one disease may successfully combat another.  But there’s risks.

Clearly the pharmaceutical business can be a complex one.


I’ve discovered a quickly growing company called Questcor Pharmaceuticals (QCOR). The company focuses on providing prescription drugs for central nervous system (CNS) disorders.

The company has two commercial products: Acthar and Doral.  They’re also working on developing several others.

They have a great growth strategy in place… but more on that in a moment.

Acthar is Questcor’s primary product.

They acquired it from a major pharmaceutical company several years ago.  The drug was originally used in the 1950s and the list of approved uses is numerous – exceeding 50. (This is a hidden benefit I’ll tell you about later).

The drug was used to treat of multiple sclerosis.  However, it’s developed an amazing niche.  It’s very successful at treating infantile spasms.  This childhood form of epilepsy can be devastating if left untreated.

Believe it or not, the American Academy of Neurology and the Child Neurology Society published guidelines on Acthar’s off-label use for infantile spasms.  Acthar is now viewed as the “Gold Standard” treatment.

Amazingly, the drug isn’t patented in any way.  However, the company notes the drug is biological in nature.  That means it’s very difficult to manufacture consistently.

Lucky for us, Questcor has significant experience in that area.  It protects the drug from generic competition and knock-offs.

Trouble Sleeping?

Doral is Questcor’s other major drug.  It’s used for sleeping problems, including insomnia.  Patients typically have severe problems falling asleep or they wake up frequently at night.

That’s not all.

Questcor’s also in the process of developing other drugs.  One of the more promising is QSC-001. (You’d think they’d have better names for this stuff).

It’s a simple idea.  Many patents have trouble swallowing.  It makes taking pills difficult.

Questcor’s pain medicine is unique in that it dissolves in a patient’s mouth.  They’re starting the next round of trials in the second quarter of 2009.


I like this company because of their common sense growth strategy.  First and foremost, they’re taking a drug they know works and using it in unique ways.

Remember when I said Acthar has more than 50 approved uses?  I discovered this list buried in their public filings:

Acthar has over fifty other labeled indications and uses in certain endocrine disorders, rheumatic disorders, collagen diseases, allergic states, ophthalmic diseases, respiratory diseases, hematologic disorders, neoplastic diseases, edematous states, and gastrointestinal diseases.

This gives the company an instant list of other ways they can market the drug.  By opening up the sales channel to even one or two new uses, company sales might explode.

A perfect example is Nephrotic Syndrome.  It’s a kidney disease.  Right now there’s no “Gold Standard” for treatment.  Acthar works well treating this disease and by emphasizing its use, the company is working to drive sales higher.

QCOR is right now working on clinical studies for the treatment of Nephrotic Syndrome. The studies will give the company needed data to further publicize the drug’s use.

Another way the company is looking to grow – targeting MS (multiple sclerosis).

Acthar helps treat problems in MS patients.  The company’s growing its sales force to 15 reps focusing on using the drug exclusively for MS treatments.

They’re not trying to upset the primary drug.  Instead they talk to doctors about using Acthar as a secondary treatment for patients who aren’t responding to the first drug regimen.

The new sales team just started a few months ago.  I think we’ll start seeing positive results soon.  Right now, MS treatment represents less than 10% of sales.  The company estimates it could be a $400 million market opportunity.

Another way to grow…

The company’s working to get Athcar approved by FDA for treatment of IS.  This would allow the company to actually market the drug for that specific use.  Right now, a doctor needs to find the drug and order it from the company.

Needless to say many are expecting the company to grow significantly in the next few years.


QCOR’s management is taking good care of the financials.  First off, the company is highly profitable, and best of all, debt free.

Management’s estimating 2008 sales to be between $82 and $91 million with gross margins over 90%.  To top it off, they’re expecting to generate more than $60 million in cash flow.

Last quarter the company announced EPS of $0.12.  This grows significantly from their first quarter EPS of $0.02.

Nice growth, I’d like to see it continue consistently.

The company’s been using it’s free cash flow in smart ways.  They’ve been buying back shares.  They started with preferred shares owned by Shire.  Once they purchased all of those outstanding they turned their sights on the common stock.

In the last few months, the company’s acquired 2.7 million common shares on the open market and in privately negotiated transactions.  They’re authorized to buy back 7 million shares or 10% of the stock outstanding.

Right now, the company has more than $38 million in cash on the balance sheet.
I love a company with a growing top line and solid fundamentals.  I’m expecting to see the revenue numbers grow into 2009 and 2010.  Profitability should remain strong.


New management.  The company recently announced a CFO transition plan.  Normally this would give me pause, but the reasons are simple.  The CFO and his family live in Southern California.  The company’s based in Northern California.  They need someone closer to the company to oversee operations.

Also, by bringing in a new CFO, they will no doubt give the numbers a thorough review.  They might find other ways to cut costs and increase margins.

Publicity, Publicity, Publicity.  The management team works hard to stay in front of big shareholders.  Management’s already presented at more than 6 conferences this year.

Ownership.  Six of the top 10 holders of the stock are adding to their positions.  Three have added 1 million shares or more in the last few quarters.  To be honest I’d like to see management own a bit more stock, but overall the situation is great.


As always, no company is without risks.  Questcor is operating in the Pharmaceutical industry.  That means they’re subject to the whims of the FDA and other regulators. Substantial changes in policy could impact the business.

As with any drug company, production problems or adverse reactions could taint the company’s reputation.  If this happens the business would undoubtedly suffer.


For Questcor valuation focuses on revenue growth and earnings…

Questcor’s revenue growth is quite impressive.  They posted 2006 revenue of $12 million.  That grew to just under $50 million in 2007 and this year revenue’s expected to be around $90 million.

Average revenue growth for the rest of the industry’s nowhere close.

So you’d expect to pay a premium for the stock right?

Not so fast.  The company is undervalued by several metrics.  The most obvious is the P/E ratio (Price/Earnings).  It’s a simple way to compare the earnings of a company to its market value.  QCOR trades at around 11x P/E.

Not bad, but a paltry compared to the industry average of over 33x.  The 5 year average annual P/E ratio was 22x.  That means Questcor is trading for at least half of what the industry trades for.

Another important ratio is Price to Sales (P/S).  Questcor trades at around 6x.  This is less than 20% of the industry average of 31x.

Questcor’s stock could more than quintuple and it would barely be trading in line with the averages.

Return on Equity is the final measure I’m going to make.  Let’s just say it too shows Questcor’s undervalued.  Questcor’s 5 year average ROE is over 38%.  The S&P 500 posts an average ROE of only 20%.

Clearly this stock is undervalued by every metric.  Just seeing the stock trade closer to industry averages would move the price up 5 or 6 times the current level.


Questcor Pharmaceuticals (QCOR) is trading at $5.46, BUY up to $6.50.

Use a stop loss of $3.50 on this position.

Don’t forget your position sizing and stop-loss rules.




If you haven’t figured it out by now, the US economy’s in a recession.  Funny how those high paid economists can’t figure it out on their own.

Just look around.

People are worried about their jobs.  Consumer confidence is falling, and consumer spending is following suit.

Unemployment is slowly climbing higher.  It won’t be long until it’s official.  Then you can say you read it here first.  It’s a difficult time to be running a business.  It’s even more difficult investing in the stock market.

Any student of stock market history will tell you certain industries perform better than others in recessions.

The logic is simple.

Take the healthcare industry for example.  If you’re hurt, sick, or need medical care you’re not going to wait for treatment because of the economy.  The same goes for food manufacturers and grocery stores.  Just because the economy is bad doesn’t mean you’re going to stop eating.

You might not buy the prime rib, but you’ll still buy ground beef.  Right?

I know of another group of stocks that tend to outperform the markets during a recession.  It’s an industry whose products customers can’t live without.

The industry . . . Tobacco.

It doesn’t matter how bad the recession gets.  People who use tobacco products aren’t going to stop.

Now, I know many people object to tobacco companies.  Some people see their products as sinful.  We all know they’re not the most healthy thing in the world.

But we’re looking for good investments . . . not trying to save the world.  Tobacco consumers are strong repeat customers who are willing to spend money on products regardless of the economy.

That’s why investing in tobacco stocks during a recession can be a gold mine.


While researching the tobacco industry I came across a really interesting penny stock. A stock I believe is on the verge of breaking out and producing big gains for shareholders.

The company’s developed a great little niche.  They sit right in the middle of the industry.  The company buys tobacco leaves from farmers around the globe.  They process the tobacco and sell it in different types of blends to the product manufacturers.

The company is Alliance One International(AOI).

They’ve been trading on the New York Stock Exchange since 1995.  Alliance evolved into its current state after the merger of two large tobacco suppliers in 2005.  Now I’m not going to bore you with talk of the merger.  If you want to learn more about it, check out the company website.

What I want to discuss is the business.

The company conducts a relatively simple business.  They buy tobacco from farmers and on the open market (at auctions).  They process the tobacco.  Then they sell customers specific blends of the different types of tobacco.

The company doesn’t actually manufacture any consumer tobacco products.
The business they conduct is relatively simple to understand, but believe me, the work can be quite complex.


Once Alliance purchases tobacco from farmers or the auction house, they work quickly to start proper processing.  Tobacco’s a perishable commodity and delays in processing can degrade its quality or make it unusable.

The company has 24 processing facilities scattered around the world.  This allows them to quickly start processing regardless of the source.

The processing details can be quite complex.

Typically, all the tobacco is re-graded and blended to customer specifications (more on those in a moment).  The blended tobacco is cleaned and stems are removed.  The tobacco leaf is then cut to appropriate sizes depending on the end product.  Finally the tobacco is re-dried, extending its storage life, and packaged into bundles.

Finished bundles are shipped to customers on prearranged schedules.

Keep in mind at every step of the process extensive laboratory testing is conducted.


All of the processing work Alliance does is under the watchful eye of customers.  Often representatives are sent to various facilities to oversee the process.

The service Alliance provides to its customers is an important one.

Customers have relied on their experience and capabilities for years.  In some cases customer relationships go back 50 years or more.

Two of Alliance’s biggest customers are Altria Group (you may know them as Phillip Morris) and Japan Tobacco.  These aren’t fly by night customers.  These are some of the biggest tobacco manufacturers in the world.

Every customer’s tobacco requirements are different.

Customers are looking for very specific blends.  Think of it this way… every tobacco product contains a unique blend of several types of tobacco.

It could be various amounts of flue-cured tobacco, dark tobacco, burley tobacco, oriental tobacco, or semi-oriental tobacco (and that’s just a few varieties).

The different tobacco mix gives each product a unique taste.  Depending on the mixture, the end product could contain more or less tar and even nicotine.

The company currently buys tobacco grown in over 45 countries and re-sells processed tobacco to companies in over 90 countries.


The business of processing tobacco is fairly simple.  And we like simple.

I found a very interesting observation about the company’s sales process.  Most of their sales are denominated in US dollars.  That means over the last few years the company’s financial statements have been hurt by the falling value of the US Dollar.

That’s starting to change.

Right now, the US Dollar is in a prolonged upward trend.  As the company makes sales overseas, they’ll benefit from the strengthening dollar.  It also gives us a good reason to be investing now.

That’s not all I like about the financial situation.

I really like management’s focus on cost savings.  They’ve been working to cut costs and as a result they recently returned to profitability.  They’re also focused on paying down debt.

All of these actions are improving their financial ratios and metrics.

The most recent quarter was great.  In the quarter ended June 2008, Alliance generated $459 million in revenue.

It’s down a bit from a year earlier, but I’m not worried.

Gross profits were really strong, reaching $76.7 million.  That’s a solid increase of more than 6%.

Net income for the quarter is $15.3 million.  That’s more than double last year.  The company’s quarterly EPS was $0.17.

These results continue a trend started a quarter earlier.  In March the company achieved its first full year of profitability since the merger in 2005.  I think they’ve turned the corner on expenses and we’ll see some really nice results over the next few quarters.


The US Dollar strength.  As we mentioned above, a significant amount of Alliance’s business is done overseas.  As the US Dollar moves higher, it will reduce their expenses and improve overall results.

Solid institutional investors.  The company’s got a number of stellar institutional holders:  Bay Harbor, Vanguard, T. Rowe Price, just to name a few.  Nobody has a huge position in the company, but there’s lots of little holdings in the 2% to 4% range.

A very positive sign as many funds may add to their holdings.


Every company has risks.  For Alliance they face a growing trend of smoking being banned by both business and government.  But substantial portions of the world still smoke, and it’s not going to change any time soon.

Currency fluctuations are another risk. If the US Dollar starts to fall again, financial results could be hurt.

Changes in tobacco farming.  The global tobacco market is shifting.  Tobacco is now being grown in different areas and long time tobacco farmers are starting to grow other crops.  Alliance needs to stay on top of these trends.


Alliance has one main competitor.  Universal Corporation (UVV).  Alliance’s operating margin is running at 4%.  That’s 50% of what Universal generates.  Their profit margins show the same thing.  Alliance’s profit margin of 2% is half of Universal’s.

This means there’s lots of room for improvement.  I believe as the numbers improve, we’ll see the valuation climb.

The key valuation metric is the Price to Earnings ratio (P/E).  Right now they’re trading around 7x.  Universal trades at just under 10x.

Simple math shows me the company’s undervalued by at least 30%.

With improved fundamentals, a rising US Dollar, improved operating margins and profits, the company value could be significantly higher than where it’s at today.
Alliance is the perfect way to protect ourselves from a recession, and profit from movement in the US Dollar.


Alliance One International (AOI) is trading at $4.02, BUY up to $5.50.

Use a stop loss of $2.00 on this position.

Don’t forget your position sizing and stop-loss rules.


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