Are Questcor Pharmaceuticals' Explosive Earnings High Enough to Shoulder the Risk?

Are Questcor Pharmaceuticals' Explosive Earnings High Enough to Shoulder the Risk?

While Questcor Pharmaceuticals has been reporting phenomenal sales, growth, and earnings per share, a growing investigation by multiple government agencies should concern any prudent investor.

Questcor Pharmaceuticals reported third-quarter results on Oct. 29. The numbers were nothing short of fantastic. Sales were up 68%, EPS up 73%, and there was a 45% increase in vial shipments of its drug. In light of the results, Questcor raised its dividend by 20% to $0.30 per share, an annual dividend of 2% per year.

Questcor makes and sells a drug called Acthar Gel, which was originally developed to treat infantile spasms, a rare disorder, and sold for $40 a tube. Questcor then bought the rights to it. Questcor steadily boosted up the price to tens of thousands of dollars while also marketing the drug for all sorts of other uses.

Questcor benefits from a grandfather clause in the law that doesn't require the use of clinical trials to prove its marketing claims since the drug was already approved by the Food and Drug Administration in the 1950s. This has allowed sales and profits to skyrocket along with its share price.

The less glamorous side of Questcor
Things are going financially quite well for Questcor. At least for now. Could that change? The company disclosed in September 2012 that it was being investigated by the U.S. Attorney's office in Philadelphia for its promotional practices. Investors had blown this off as the stock continued to escalate to new highs. However, on Oct. 30 in its conference call and 10-Q filing, it disclosed another attorney's office investigation and the SEC joined in an expanded investigation. That doesn't sound good.

Normally you might be tempted to blow off such matters, but examine the language in the 10-Q. The quote you should be particularly concerned with is "the investigation to review our promotional practices and related matters." Two observations.

One, it uses the present tense and not the past tense in regard to promotional practices. This means that if Questcor is found guilty of something, it could be widespread, ongoing, and extremely damaging to its financial situation and reputation.

Two, what is "related matters"? This term is quite vague and could mean anything. Why is the SEC involved? Usually the SEC gets involved only when a company has made an improper claim to the public or illegal insider selling took place.

The worst part is that just a couple of weeks before this revelation, insiders such as CEO Don Bailey were selling millions of dollars worth of stock on the open market. It's not yet known if this was done with knowledge about the expanded investigation. However, the timing seems too coincidental, especially with the disclosure that came with the earnings report.

Should investors be worried?
An example of what could happen to Questcor Pharmaceuticals did happen to shareholders of Avon Products on Halloween. Avon Products has been in trouble with the Department of Justice and the SEC over bribery allegations. Avon offered both organizations a settlement offer, and they both told Avon to take a hike. The risk of sizable financial penalties was enough to cause the stock to get clocked as much as 24% in that single day. Questcor could potentially have a similar fate or worse.

It's possible that part of the problem is that Questcor doesn't even disclose all of the active ingredients in its drug. According to a report by Citron Research, this practice is illegal. Questcor has defended this practice by saying doing so would be like Coca-Cola revealing its secret formula. Of course, Coca-Cola's soda isn't a prescription drug, and Coca-Cola doesn't fall under the same marketing rules.

If the investigation ends up with Questcor being forced to reveal its active ingredients, that could open up the possibility of a cheap generic being developed by a company such as Teva Pharmaceutical Industries . Teva makes and sells a variety of generic creams and gels that compete with popular brand-name drugs. If Teva were to make a generic copy of Acthar, it would, as new generic drugs tend to do, severely crash Questcor's sales and profits. Teva Pharmaceutical, I'm quite confident, would love to take a large chunk of Questcor's multibillion-dollar business.

Foolish final thoughts
While the numbers out of Questcor make it quite a tempting investment, the risk is too great. Playing the game of hoping nothing comes out of a multi-agency government investigation is like playing the financial version of Russian roulette. I'd avoid Questcor until more details and potential consequences emerge.

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Nickey Friedman has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola. The Motley Fool owns shares of Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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