Deer Consumer Products Shares Halted After Factories Idled

Yesterday, August 13, 2012, the Nasdaq halted trading in Deer Consumer Products (DEER) until the company has "fully satisfied Nasdaq's request for additional information." I applaud the Nasdaq's decision, coming over a year after I first questioned DEER here, here, and here. In today's report, I will show the likely reason DEER was finally halted.

Background

Deer Consumer Products has reported spectacular growth in sales from its Chinese domestic kitchen appliance manufacturing business each of the last four quarters, as well as reiterated truly stunning 2012 sales guidance, as shown in the following table:

Click to enlarge

Unfortunately for investors, DEER's miraculous growth is completely contradicted by the simple fact that its two exclusive manufacturing facilities in Yangjiang (appearing adjacent to each other outlined in yellow in the picture below) are completely idle.

Most recently, on August 3, 2012, I had an independent third-party investigator visit DEER's two Yangjiang factories. He noted that there was no sign of any production activities or workers other than security and maintenance personnel.

Two photos from his visit appear below.

The glaring questions are now:

1) How long ago were DEER's factories shut down?

2) Why were they shut down if manufacturing kitchen appliances is as profitable as DEER claims?

3) Why was there no 8-K disclosing the factories were shut down?

4) How many historical 10-Qs and 10-Ks need restatement?

Some clues can be found in DEER's SEC filings. Consider DEER's reported headcount at year-end reported in its 10-K filings and reflected in the following table:

According to its 2011 10-K, at 12/31/11, DEER had only 437 employees (excluding sales and marketing staff), a decline of 78% from the prior year, despite a 29% increase in revenue. This contradicts the growth and earnings continuously reported by DEER and touted by Benjamin Wey of New York Global Group as the "world's largest producer of blenders and juicers."

Likewise, DEER's reported employee welfare expenses reported in its 10-Qs have fallen to almost nothing in recent quarters, hardly indicative of a growing world-class company as shown in the following table:

Conclusion

Unable to disprove the evidence against the company, for over one year DEER has attempted to shield itself from my allegations by filing frivolous and abusive defamation suits to silence me. DEER's failed approach, like that of Sino Clean Energy (SCEI), will surely end in delisting.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The Two Faces of Nu Skin

Posted in Citron Reports by Stocklemon on the August 7th, 2012

stock ticker: NUS

Over the past 5 years Citron has written about numerous Chinese companies who were being less than forthright in their disclosures in the U.S. markets.  But we now turn the tables — exposing a U.S. domiciled company that is being far less than honest about its operations in China – defying Chinese government regulation while exploiting an ambitious population eager for a formula to climb the economic ladder.

   Introducing Nu Skin  (NYSE:NUS)

In the United States, multi-level marketing (MLM) has become part of our economic fabric.  It is not our proudest achievement, but nonetheless it has become a part of our society – one that sells dreams along with an array of overpriced products that most people can live without just fine.  The U. S. has established a patchwork of little understood regulations that provide some protection for the public from the most abusive forms of pyramid schemes, mostly under the jurisdiction of the U.S. Federal Trade Commission.   ( See “Lotions and Potions” at the FTC website. http://www.sec.gov/answers/pyramid.htm  (The SEC also has both concerns and regulatory oversight in this problematic area:  http://www.sec.gov/answers/pyramid.htm ) 

By contrast, China prohibits multi-level marketing strictly and in entirety.   Pyramid schemes create victims by creating an endless chain of recruits who recruit new recruits into a wealth transfer scheme which cannot possibly be sustained.  Therefore the vast majority of the participants lose their money.  Often pyramid schemes are cloaked in the sale of an overpriced product, with new recruits being required to “invest in inventory” to gain or maintain certain levels of membership which most will be unable to achieve.  These abusive business models are understandably outlawed under Chinese law. 

China does have a law which defines and permits only “direct selling”.  Much like many Chinese companies which ignored the regulatory laws of the United States, it is the opinion of Citron Research that Nu Skin is grossly violating the laws of the PRC, and their entire Chinese business operation could be in jeopardy of seizure and other substantial risks. 

Before we introduce the evidence pointing conclusively to widespread violation of Chinese law, this discussion begins with the importance of the China market to Nu Skin.  The company was beset by challenges from various U. S. regulators in the early 1990’s, when several states were investigating the company for everything from misleading sales practices to operating a pyramid scheme.  Nu Skin realized that their future riches were not on these shores, but rather overseas, and particularly in China.

1. Greater China comprised almost 75% of Nu Skin's year-over-year revenue growth in Q2. 
2. Greater China represented less than 10% of the company’s revenue just 3 years ago, and is now 33.6%.
3. The average distributor in greater China purchased roughly $1,200 worth of product in Q2, almost triple that of the U.S. and double the average levels of prior periods in China.
4. The future of the company, and in particular, the growth story that underpins the value of its stock, is dependent on China.  As CEO Truman Hunt just stated "Emerging markets, particularly China and South Asia, will continue to drive healthy overall growth rates…"
5. Sales in North and South America contributed just 12 percent of revenue in the last quarter, with Europe just 7.7%. 

So the Chinese operation is contributing very materially to the company’s overall financial results, particularly in shoring up its flagging growth in other regions.  (Details provided below.)

With the U.S. Consumer becoming increasingly resistant to the core business of Nu Skin, they just moved their entire dog and pony show to China … but is it legal?

Here is what Nu Skin says it does.  In its most recent 10-Q, Nu Skin describes its business operations as:

“The Company operates in a single operating segment by selling products to a global network of independent distributors that operates in a seamless manner from market to market, except for its operations in Mainland China.  In Mainland China the Company utilizes an employed sales force, contractual sales promoters and direct sellers to sell its products through fixed retail locations.” 

This disclosure language is extremely significant.  Nu Skin acknowledges that their operations in China are a separate and distinct exception – obviously they cannot operate in China the same way they operate everywhere else in the world. 

Why?  Because China has strict laws regulating direct selling as well as a strict and clear and total prohibition on multi-level marketing. 

Nu Skin’s disclosures go further.  They state:

“Our operations in China are subject to significant government scrutiny, and we could be subject to fines or other penalties if our employees or direct sellers engage in activities that violate applicable laws and regulations. The legal system in China provides governmental authorities with broad latitude to conduct investigations. We anticipate that our business will continue to attract significant governmental scrutiny, particularly as our business grows and the number of sales employees and contractual sales promoters continues to increase.”

The risk here is for U. S. investors to regard the above warning as “just boilerplate”.  Citron believes that readers will understand the above-described looming threat in a completely new light after reviewing the evidence presented in this report.

   What Nu Skin Says they Do:  Direct Selling

http://www.asianlii.org/cn/legis/cen/laws/rodsa433/

Nu Skin obtained its business licenses and established its presence in China by having agreed to operate under the “Regulations on Direct Selling Administration”, essentially promising to do business as “a direct sales organization”. 

The direct selling law (linked above) is quite clear – it was structured to address a business model in which a company could legally engage direct sales staff (note all the law’s 60+ explicit references to “door-to-door salesmen”) who were expected to sell products directly to consumers — a simple and well-understood model, if somewhat dated by Western standards, that might boost employment and create a channel for the distribution of goods to consumers. 

This is a humble and straightforward business model that is certainly not founded on the promise of making millionaires.  However, note that this law, in article 27, it makes the company, not simply the salesmen, liable for violations.

It is Citron’s opinion that the most fundamental point of this report is that Nu Skin’s management used the promise of conducting the direct sales model to gain the permission of Chinese authorities to grant it business licensing, then pulled a classic bait-and-switch maneuver, and is actually implementing a pyramid sales scheme on a grand scale.

   What Nu Skin Actually Does:  Pyramid Selling

http://www.asianlii.org/cn/legis/cen/laws/ropops432/

Citron believes Article 2 of the Chinese Pyramid Sales law is utterly clear in stating its intent and it is unambiguously strict in its implementation:

“The term "pyramid selling" as mentioned in this Regulation refers to such an act whereby an organizer or operator seeks for unlawful interests, disturbs the economic order and affects the social stability by recruiting persons, calculating and paying remunerations to recruiters on the basis of the number of persons a recruiter has directly or indirectly recruited or the sales performance, or asking the recruiters to pay a certain fee for obtaining the qualification for participation.”

And lest you think that Hong Kong (where the majority of Nu Skin's China revenue is being reported) , look at the new Pyramid Schemes Prohibition Ordinance, intended to close loopholes in the former law and toughen penalties,  just put into effect this year: 

http://www.deacons.com.hk/eng/knowledge/knowledge_457.htm

The question is simple:     Does Nu Skin operate an MLM in China? 

   Yes Or No

It’s a simple question because the answer is just “Yes” or “No”. 

Citron will now present evidence uncovered that confirms that Nu Skin is in fact operating as an MLM — in multiple cities.  Citron associates engaged some undercover “customers” who helped us expose the truth. While Nu Skin is a registered direct seller, we believe they violate laws regulating direct selling, as well as the prohibition on pyramid sales, specifically by supporting the creation of a multi-level pyramid compensation scheme, as well as requiring purchases in order to participate in sales commissions or salary.  Over the course of three weeks leading up to the company’s recently held sales convention, a representative of Citron met with numerous Nu Skin salespeople.  They consistently presented a completely different compensation model than that is not written in any of the company’s literature.  Thus the hand-drawn sketches.

All of the conversations we are presenting have been taped and uploaded to a dropbox.  The purpose of these is to validate the translations of these interchanges posted with this report. 

Evidence Point #1:   On June 19 a Citron researcher met with sales representative Li Shanshan from Nu Skin in Hefei (a city of 5.7 million population).  Below is a synopsis of the meeting.  All highlighting has been added by Citron to indicate content demonstrating a blatant violation of direct selling principles and the offering of a pyramid MLM compensation scheme.  Even though this interview is presented out of sequence, we start with this one because the representative from Nu Skin actually drew a pyramid to use in her explanation of Nu Skin’s compensation scheme. 

                      

               

2012-06-19 Report of NUS Visit, Hefei, (has recording in audio file)

Here is another transcribed conversation from the same day.  Violations are again highlighted.

2012-06-19 NUS Recording Transcription, payment system

These conversastions are from visits which are follow-up from the June 6 visit in which the salesperson says whatever they seem to need to promise unlimited riches for the new recruit to join the pyramid.  Just read the attachment and follow the multiple violations.

2012-06-06 NUS Recording TRANSCRIPTION

Here are the notes from a another recorded conversation at the Nu Skin office in Hefei.

2012-05-23 Report of Joining NUS, Hefei

It should be noted that the deceptive practices of Nu Skin in China are widespread and not limited to just a few individual distributors.  Next are the notes of a representative while visiting the Beijing store and requesting information about working with Nu Skin.
 

2012-06-08 Report of NUS Visit, Beijing

and then

2012-06-12 Report of NUS Visit, Beijing

And more of the same from Shanghai:

2012-06-18 Conversation with NUS Office in Shanghai and NUS Service Hotline

In none of these cities did we find a recruitment conversation that reflected the written operational policies and procedures of the company.   Note that both multi-level commissions and the requirement to buy goods to participate in training (and thereby commissions) are the main abuses of pyramid schemes.

   Computer Systems Needed to Implement an MLM Compensation Scheme

Investors need to ask themselves:  Could a pyramid compensation plan possibly be propagated without the company’s knowledge and consent?

Think about it.  In a multi-level commission structure, each invoice, each retail sale generates a variable number of commission sharing transactions, which have to be accumulated among the credited sales person and all their “upstream” counterparts.  Even a few thousand transactions per month would create a nearly impossible computational task without a central computer system.  How could this compensation system possibly function without the company’s involvement at its core?

     The Story in the Numbers

There are very disturbing signs even though Nu Skin’s revenues in China appear to be booming in the past quarter.  First, roughly two-thirds of the Greater China’s revenue comes from just 2 SKU’s.   (This is likely why the CFO was reluctant to give the sales-by-product to one analyst on the call.)  The majority of those sales were made at the China convention. 

Overconcentration of SKU’s on products hyped at the Convention, related to recruiting

The most likely explanation is that the bulk of the sales growth was concentrated around the “business opportunity” and likely temporary. Is buying a 30-day supply supplements at $160 per month or a $300+ anti-aging skin treatment system and trying to re-sell them in China a sustainable business?  These products were heavily hyped at the convention.

Spike in Revenue-per-distributor ratio in China, Implies Alarming Risk of Channel Stuffing

This is a lot of product to re-sell and revenue was probably borrowed from Q3.  Even more eye-popping is the product purchases per avg. executive at appx $13K — these sales leaders account for the vast majority of the business done in China.  The most important question on the call was largely unanswered…:

“any sort of granularity you can give on how you track inventories, or where the product is going…?”

Chasm Between Sales Leaders and Distributors is Red Flag: 

Never in the past decade has there been such a big difference between executive growth and overall distributor growth.  While one could argue that this is a bullish sign, it clearly goes against management’s assertion that the vast majority of its products are being purchased for consumption.  The reality is that a surge in sales leaders necessitates a surge in inventory purchases, such as “Business Builder packages”  ( https://www.nuskin.com/content/nuskin/en_US/products/dist_packages/01103800.html ) , along with recruiting-related purchases to obtain status and commission eligibility. 

Remember that a high percentage of products purchased for purposes other than end user consumption is a critical indicator of a pyramid scheme in the FTC’s estimation.  MLM companies somehow are always able to calculate their pyramid commission payouts, but seem unable to ever track how much of their product is actually being sold to those outside the sales pyramid.

   Nu Skin’s Sales Driven by Promises of Achieving Massive Personal Wealth

The common themes of the above interviews are consistent and pervasive:  The point of the conversation is to induce the contact to join up to become wealthy, by buying product to become a trainee, and ultimately to become successful by recruiting multiple levels of others whose sales will result in 5% commission earnings per level.   These are all the classic techniques of pyramid schemes.  

The Chinese internet is rife with examples of the scheme in action.  There are numerous “fan sites” and Weibos reinforcing the same theme of personal wealth creation, rather than product features and benefits.

Here is just one of many examples of some content created by a rep on a “fan site”.  It’s becoming apparent that they all post the same sort of promotional material and quotes.  The image they are trying to convey is you live this carefree lifestyle and not have to go to “work” as a rep.  There is the possibility of driving Ferrari’s and making millions while helping people and realizing your true potential.   This is a typical entry:

公园就是家，有湖泊、山丘，图书馆，足球场，有缩小版的迪斯尼金银岛！有私人飞机，豪华版摩托车队，伙伴们的车停在一起就像一排鸡翅，因收藏法拉利最多被称为法拉利王子！这就是如新28年成功人的财富生活！如新中国才是最大的未来，单月收入333万美金的全球纪录，必将被中国人打破，也许就是你！

Translation:

“添our home will have lakes, mountains, soccer fields and a small version of Treasure Island!  You will have a private jet and a fleet of motorcycles and be called the Ferrari Prince because you have the largest collection of Ferrari痴.  This is the life of the successful Nu Skin rep.  The Nu Skin record of $3.3m U.S. monthly income will be beaten by a Chinese – possibly you.”

 http://so.tudou.com/nisearch/%E8%B5%B5%E7%BA%A2%E5%8D%AB/

This is a blog from a disgruntled Nu Skin sales (a bit dated, but right to the point): 

http://blog.sina.com.cn/s/blog_48aa331601000amu.html

It states that the company claims one thing but does another to the Chinese government and to the sales reps.  From the blog, it seems that the sales rep are required to buy $1500 of product and have a $10,000 a month quota to avoid getting fired.  Once you meet your quota, there are other hoops to jump through to get the 15% small team bonus and the “6th level” 5% bonus.   New Nu Skin recruits goes through 4 phases:

1)      Brainwashing and chanting slogans

2)      Half a year or so of running down savings, family and friends

3)      Infighting with team members for prospects

4)      Giving up

As a direct consequence of forcing recruits to buy inventory for themselves or to sell to others, there is a lot of Nu Skin product being offered on Taobao, Alibaba and other commerce sites, often at steep discount, which is in violation of the company’s sales policies.  For example, there are 86 listings from 36 suppliers here as of the date of publication.  http://www.alibaba.com/product-free/106435021/KIT_GALVANIC_SPA_SYSTEM_II.html

   MLM Impact on Culture and Cult-Like Behavior 

One of China’s concerns in outlawing pyramid selling schemes is their tendency to create cult-like behavior and the attendant harm to the basic social fabric.  This goes against many of the basic cultural values of China.  It undermines family ties and close friendships by encouraging recruits to regard their family and friends as sales targets – little more than prey.  It manipulates economic vulnerability and emotional weakness to convince people to subvert these values with the power of psychological manipulation. 

Take a look at these videos of the recent Nu Skin convention in Hong Kong and decide for yourself.  The first is a speech given by Cai Si Gun on June 20, 2012 (he lives in mainland China) :

http://www.youtube.com/watch?v=zq2zbuur8xk&feature=relmfu

http://www.youtube.com/watch?v=DT4U9WNdKEQ

( Hint:  These thousands of people are not celebrating face cream or nutritional supplements.  )

“Good morning everyone.

As I stand here, I remember the Hong Kong convention several years ago.  Back then, I sat on your side of the stage.  I was seeing what you see now. All the lecturers on the stage looked like ants because I sat so far away from the stage.  At that time I wondered, when can I be on the stage making speeches?  So today, I want to thank Nu Skin for making my dream come true.  Because I think Nu Skin can help all people improve their life.  Many people ask me, why did I want to join Nu Skin? The answer is simple.  It is because I love my wife.  Do you think a good husband should be successful?

Everyday my wife would come home around 10pm.  She worked late because she was a finance manager.  We had just gotten married, so you know I wasn’t happy about that. On top of that, every day when she got home, she would complain about having too much stress.  So I began to think of something for my wife to do.  At this time, a couple approached me and told me about Nu Skin.  Without thinking too much I told them I wanted to join.  I know only a few people like me.  I gave my wife Nu Skin as a gift.  It was really working, she liked it so much.  She wanted to join Nu Skin and she wanted me to join with her.  Back then, my hobby was playing cards.  I spent a lot of time playing cards because I didn’t have a dream, I felt empty.   My Nu Skin trainer’s name was Wangyi, he gave me the idea that nothing is more important than how much money you have.  He said I should focus on something where I can teach someone else to make money by working for me.  Nu Skin is all about appreciating your predecessors because they help make your successful.  They taught me how to catch an opportunity and how to overcome obstacles.  For example, one manager asks two employees to investigate the market for shoes in Africa.   The first employee told the manager Africa didn’t have a good market for shoes because Africans don’t wear shoes.  But the second employee told the manager the market for shoes in Africa is very good because there are not a lot of shoes being worn there.  This example just goes to show you everyone sees the world differently.  You cannot change the world, but you can change your mind.  Don’t scare yourself; you should try to do something.  If you never try something then you will never know the answer.  Like now, I did it and I succeeded.  Now I ask my friend to join Nu Skin, not only because it’s my job, but I also want to help them be successful, beautiful and healthy.  If you join Nu Skin, the challenge is how to control your emotion.  It’s very easy for me because I think in a positive way, which helps me accomplish things others think are impossible.  The more people you introduce Nu Skin to, the more people who will see the potential upside. Thank you. "

The reality is that the vast majority of recruits to pyramid schemes lose the money they are induced to pay for inventory in overpriced products they can never legitimately sell for consumption.

But the consequences are far worse.  Pyramid scheme MLM's are an invitation to cult behaviors, which predictably devolve to a variety of techniques bordering on brainwashing to convince their recruits that:
 

• it is a cause for celebration to yearn for wealth regardless of the consequences
• any failure is the recruit’s own fault and responsibility, based only on their own lack of motivation to be rich and successful
• they should pervert relationships with their own families and friends by treating all of them as marks for sales and recruitment

   Consequences of Violating the Law Prohibiting Pyramid Selling 

(See in particular Articles 14, 17, 18, and 19 from the law linked above.)

China’s laws are unambiguous and harsh with regard to pyramid sales.  Citron suggests that all Nu Skin investors consider the powers granted to the regulatory body responsible for this prohibition, the Department of Industry and Commerce Administration.  These include:

• Ordering cessation of violating activities
• Investigation of anyone involved
• Carrying out on-the-spot inspections by entering into the business, training gathering places, etc.
• Copying, sealing, or seizing relevant contracts and records
• Sealing up business places suspected of being involved in pyramid selling
• Applying to the court to freeze unlawfully transferred or concealed funds

… and that is just during the investigation phase. 

[The implementation of seal-up or seizure or any measure prescribed in the above actions (seal-up or seizure) requires written approval of the principal leader of the Department of Industry and Commerce Administration at or above the county level, in advance.]

There’s also a “shoot first, and ask questions later component (Article 17):

“Where it is in an inconvenient area or the investigation and handling of the case will be affected if the seal-up or seizure is not timely carried out,the seal-up or seizure may be carried out in advance and the decision on seal-up or seizure shall be made up within 24 hours and be delivered to the parties involved.”

And the Department also has the right to promulgate a warning or a notice to remind the general public.

   Political Conditions in China

Citron notes that China is in the midst of a carefully planned 10-year governmental power transition.  The theme of intolerance of corruption is particularly strong at these transition points, and the government has been responding in numerous ways to this social concern.  Citron wonders whether the incoming government will be as lenient as the outgoing, in terms of allowing this massive pyramid scheme to grow under its watch. 

   Conclusion

Nu Skin investors are exposed to the massive risk of its China operations coming to an abrupt halt due to violation of the PRC’s and Hong Kong pyramid sales laws.  The consequences would be devastating.  What would the company be worth without its China operation? 

Citron challenges the investment banking community to the following exercise.  Which of the 8 firms providing coverage would be willing to review all the evidence of Nu Skin's illegal operations in China objectively, and redraw their models to:

• remove all income from China from Nu Skin's P&L
• write down the assets for capital spent in China to the business net of multi-level sales (which would be near zero)
  • e.g. How many customers would walk into a Nu Skin store and walk out with a retail purchase?  Would there even be any "Nu Skin stores"?
• reduce the company's growth trajectory to its realistic prospects with China revenues subtracted
• project the costs of replacing all management who definitively knew and actively abetted this business development in violation of China's laws …. and …

• set a revised price target for the company's stock, to account for the risk to operating an illegal business model.

Is your skin in this game?

Cautious investing to all.

NOTE: Citron is currently seeking clarity on goods destined for mainland China coming in through Hong Kong, which would violate Chinese tax and import laws, may be the subject of future coverage.

Vivus (NASDAQ:VVUS): Why FDA Approval Is Not the Prescription

Posted in Citron Reports by Stocklemon on the July 19th, 2012

Freedom-to-Operate may be Severely Compromised

Eight years ago this month, (yes Citron has been at it this long), we published an article on Nitromed (NASDAQ:NTMD).  Nitromed received FDA approval to combine two generic pharmaceuticals and the stock catapulted to over $20 a share, with every covering analyst posting a "strong buy".  Citron pointed out the problems in their business model in the face of Wall Street.  The company ended up selling itself 3 years later for .80 cents a share.   The moral of the story is FDA approval is not a short path to riches, and the importance of intellectual property cannot be discounted when valuing a pharma company.  For a drug with purported "multi-billion dollar market potential", Citron is astounded by the weakness of Vivus' intellectual property protection, and the lack of due diligence on the Street, which allowed things to get so far without a warning flag being dropped.

http://www.citronresearch.com/index.php/2004/08/03/stocklemon-reports-on-nitro-med/

Citron has been carving to the bone on the Vivus / Qsymia weight control pill story, and is convinced this is déjà vu all over again.  Similarities include:

·                                 A "blockbuster" drug — which is just a combination of two readily available, inexpensive generics

·                                 A one-drug pharma company – with an abysmal track record long on hype and failed execution

·                                 Notable absence of a deep-pockets marketing partner, having to "go it alone" with its home-grown and risky marketing plan.

·                                 Vivus's intellectual property protection for its much publicized diet drug Qsymia appears riddled with flaws

   The Drug Story Background

With FDA approval obtained for its weight loss drug Qsymia, VVUS stock price has tripled over the last year, fattening up its market cap close to $3 billion, all for a drug that we believe will never become commercially viable.

This report will identify major problems in the intellectual property foundation supporting VVUS's weight loss drug.

Considering Vivus had a favorable 20-2 advisory panel recommendation in hand in February, the company knew FDA approval this week was a certainty.  They have had the last 5 months to sign a licensing / distribution / partnering / deal with a credible pharma marketing company.  J&J — a likely rights-holder in at least one of the patents looming over Vivus' freedom to operate — would have obviously been the company’s first phone call in February.  Instead, insiders sold virtually all their options-vested stock, and the company raised money from investors.

After all, Vivus, is a 38-person company with scant history of manufacturing or selling a drug.  Why have they not been able to sign up a marketing partner or a strategic investor for Qsymia over the past 5 months ?   Citron finds this odd … Like Kate Upton not being able to find a date.  Possibly the problem here is no one wants to get in the middle of what seems to be an inevitable intellectual property battle with J&J and/or others that will likely delay and possibly threaten the production of Qsymia.

Because of this overhanging risk, any third parties supplying topiramate to Vivus might be liable for contributory infringement for supplying an Active Pharmaceutical Ingredient – a risk for any drug supplier who knowingly infringes a patent.

   Vivus's Intellectual Property Story:  Serious Doubts about its IP Protection

"You can avoid reality, but you cannot avoid the consequences of avoiding reality."

- Ayn Rand (1905-1982)

While the company has been busy furthering their FDA submission and selling stock, Vivus has simply avoided confronting the reality that they might not even be able to go to market. 

The foundation stone of Vivus' IP protection is a patent licensing deal signed a decade ago with a Dr. Najarian, an obesity doctor and researcher who filed as sole inventor for Qsymia's two-drug combo.  One question that has been hanging over the company for years is the possibility of patent infringement on one of Qsymia's two active ingredients, topiramate, a patent held by Johnson & Johnson, who used to sell the drug as an obesity treatment before it went generic.  It affords patent protection until 2017.  It originally was filed by a researcher named Shank on June 29, 1996 (US PTO No. 6,071,537)

You do not have to be a patent attorney to read the title of the abstract:

"Anticonvulsant Derivatives Useful in Treating Obesity"

There is no evidence of the validity of this patent ever being challenged, either at the USPTO or the corresponding EP patent (EP0915697) filed here.  There are no mentions in Vivus' filings of the Shank patent, and therefore no clues as to how Vivus plans to deal with it.  They do say in their 2011 10-K: 

We are aware of issued patents for the use of topiramate alone or in combination with other specific agents (zonisamide and mirtazapine) for treatment of obesity and related indications e.g. prevention of weight gain.  We have worked closely with our patent counsel to put together a cogent patent strategy and are building a strong patent portfolio in an attempt to obtain exclusivity over the life of the patents. 

And???  You've worked on it?   What is the answer?

How exactly does Vivus overcome the Shank patent to sell topiramate for weight loss?  Citron rates this unresolved question a substantial risk factor. 

Here is an answer given by Vivus head of corporate development, Tim Morris at a recent conference when asked about the Shank patent:

TIM MORRIS: … this refers back probably to the Shank patent which is owned by Ortho. And as you guys know, topiramate was marketed by J&J for several years, it's now generic. We've talked about this in the past.

We don't believe there's any issues in terms of we've looked at the issue patents from Shank, we've looked at the issue patents for us, several patent counsels have opined on them. Both patents are issued and we think they're valid.

We don't believe there will be any concern there. Obviously topiramate is not approved for obesity. We don't believe J&J is making any money off topiramate for obesity. And so, no, we're not concerned at all about J&J. It's obviously a topic for the Street and people love to opine and write on it, but for us it's full steam ahead.

It doesn’t make a difference if you think your patents are valid…what does J&J think?  Citron notes that …Tim Morris sold ALL of his Vivus common stock the same week in February that the company received its favorable vote from the FDA advisory panel …

This is Morris's version of "Full steam ahead" : 

http://www.sec.gov/Archives/edgar/data/881524/000110465912013476/xslF345X03/a4.xml

Yet, Vivus does slip this line in their filings:

We may be unable to in-license intellectual property rights or technology necessary to develop and commercialize our investigational drug candidates.

It is impossible to assess the market value of Qsymia to Vivus until this issue is fully disclosed and resolved.

   Potential Problems in Vivus's product protection based on the Najarian patent.

As if the Stark patent issue was not enough, there are also unanswered questions about the main patent Vivus appears to be relying on behind Qsymia – the one licensed from Dr. Najarian.  A condition was introduced to the assignment agreement between Vivus and Dr. Najarian that made future milestone payments contingent on the Najarian patents prevailing over another, earlier-filed third-party patent by inventor McElroy.  The company found the McElroy patent important enough to make it a condition in the licensing agreement with Najarian.

Very soon after Dr. Najarian assigned his patent to Vivus in 2001, the McElroy patent issued, with claims related to methods for treating disorders that include obesity using sulfamates (including topiramate) in combination with psychostimulants (including phentermine).

This is a second threat to Vivus's freedom-to-operate and, it is referenced explicitly in the assignmentagreement from Dr. Najarian on October 16,2001.  (See 3.2.(ii) and 3.2.(ii) for specific references ).  In fact, payments to Dr. Najarian are explicitly made contingent on "freedom to operate" with relation to the McElroy patent. 

http://www.sec.gov/Archives/edgar/data/881524/000104746910002009/a2197107zex-10_79.htm

It should be noted that Dr. Susan McElroy is the director of psychopharmacology research at University of Cincinnati and is widely published on obesity and mental disorders.

http://www.amazon.com/Obesity-Disorders-Medical-Psychiatry-ebook/dp/B001H53VKS

http://www.psychiatry.uc.edu/FacultyStaff/FacultyProfile.aspx?epersonID=mcelrosl

   Prior art is not pretty for Vivus:

The Najarian patent has a huge problem with regard to dates.  Simply, the McElroy patent's provisional filing was earlier – Feb 24, 1999 – than the Najarian patent, which was June 14, 1999 (search for "provisional" to verify these dates).  And note that McElroy's full filing appropriately references the June 2000 Shank patent.  It includes studies in which Binge Eating Disorder patients were treated with open label topiramate in doses from 25 mg to 1200 mg.   (The use of phentermine at varying doses to treat obesity was well known at the time.)  Now, it remains possible that with the proper documentary evidence, the Najarian patent defense could "swear behind" the McElroy patent to get date precedent in the US – an uphill struggle for Vivus.  But such a claim will not hold up in Europe, because outside US jurisdictions, the provisional patent filing date prevails.  

Dr. Najarian's patent application doesn't reference McElroy until he files this Supplemental Information Disclosure dated December 13, 2001 without further description.  Najarian and Vivus obviously had to know about the significance of the McElroy patent, because the entire Vivus assignment from Najarian in October 2001 is contingent on Vivus obtaining freedom to operate without interference from the McElroy patent specifically.  But later patent filings state no reference to this important prior patent application.  Whether an intentional oversight or impermissible intentional misstatement, it leaves open the door to a ruling nullifying the Najarian patent in its entirety — yet another door opened for patent litigation.

   Obviousness is a problem for Vivus

In its simplest terms, US Patent Law requires that an invention be novel and non-obvious.  For example, simply varying the dosing of a drug which shows side effects proportional to dosage is not sufficiently novel to qualify for a patent.

The patent examiner in Dr. Najarian's case challenges this very point:  that combining two known weight loss drugs to treat obesity is obvious.  Najarian's declaration counters:   (see page 4)

"The claimed combination has surprisingly fewer side effects than the individual drugs."

"…I surprisingly found that the addition of a sympathomimetic agent such as phentermine greatly diminished the side effects of the topiramate.  Further, this allowed patients who, previously, could not tolerate topirate, to be able to take topiramate in combination with phentermine.  … "

This is an extremely important statement to the patent.application's defense.  Even if Dr. Najarian submitted this statement in good faith, he has a duty of candor with regard throughout the pendency of both the originally-filed and subsequently-filed applications to disclose all information known to the application that might impact patentability.   The question is, in light of the sizable studies performed on Qsymia to gain FDA approval, and the copious commentary on its side effects, does Dr. Najarian still believe the above statement is accurate and defensible?  No side effects observed with this drug combo ?

The huge body of clinical evidence, including Vivus' own studies submitted for FDA approval, indicatethat side effects of Qsymia are essentially proportional to dosing.  The very body of evidence that Vivus submits for safety adds to the same exact body of evidence a challenger would use to attack the Najarian patent for non-novelty and obviousness.

Referring to Vivus' own FDA Advisory Briefing Document (linked below):

"As such, the side effects of QNEXA [now Qsymia –ed.] therapy are expected to be consistent with those described in the approved labeling for phentermine and topiramate, albeit at a severity consistent with lower doses."

Any party challenging the Najarian patent will find they have been handed extremely strong legal grounds to attack its validity on the above comments. 

   Patent Ownership Uncertainties

There is further a question as to whether Dr. Najarian actually owned the patent personally, as he filed.  Or did he have an obligation to assign his invention to one or more of his employers?

At the time his assignment to Vivus was executed, Dr. Najarian was the VP of Medical Affairs and Medical director at Interneuron Pharmaceuticals.  Typically, work-related inventions such as this fall under an employee's duties under employment agreements to be assigned to the employer.  Interneuron changed its name to Indevus, and was later bought by Endo Pharmaceuticals.

Interneuron had some track record with weight loss drugs.  In fact, it was the producer of the widely prescribe Redux, recalled in September 1997, due to correlation with heart valve problems.   Redux was a correlate of one half of the infamous "fen-phen" combination.  Clearly Dr. Najarian was deeply involved in weight loss treatments.    However Dr. Najarian lists himself as the sole applicant.   Vivus entered into its Assignment Agreement with Najarian solely and personally.  No further evidence of Najarian's relationship was documented.

Further, records indicate Dr. Najarian was a staff physician at two hospitals during the same timespan he cites administering this drug combination to patients in what appear to be small informal trials referred to in his patent application.  Employment agreements both at drug companies and medical centers routinely claim intellectual property rights from trials conducted by employees in their facilities, unless specifically excepted, such carve-outs never having been placed on the record in this case.  Not to mention, he appears to have been conducting drug trials without legal oversight, and citing these to his own apparent benefit in his patent application.  If he argues they weren't "really" drug trials, but just ordinary course doctoring, he undermines his own "non-obviousness" and "novelty" arguments.  It's quite a pickle once you think about it.  

Did Dr. Najarian have full rights to assign this patent to Vivus?  Do investors really think nobody will challenge this patent?  Do they really think the best strategy for maximum economic leverage for a patent challenger has been anything other than to wait quietly until the FDA approved Qsymia, rendering the patent more relevant, on Vivus's dime?  If the patent's original applicant assigned the rights to it improperly, is the patent still valid?  Who really owns those rights ?  

Vivus has had not just the last 5 months, but 5 years since questions about the Najarian, Shank and McElroy patents were posed by analysts, to create enough clarity to go to market.  Yet to this day, all we hear from the company is assurances that they have legal opinions in hand stating "they are OK".   No joint ventures, no counterparty agreements, no releases. 

Quite a cloud of uncertainty for a "multi-billion dollar opportunity" resting on the combination of two common generic drugs, don't you think?  If this were a solid pharma with high management credibility, maybe investors could give them the benefit of the doubt.  But this management?  Read on.

   Competitive Landscape:   Generic Drug Competition

In its most recent 10-K, Vivus's disclosure speaks for itself:

"Our investigational drug candidate, Qsymia, is a combination of drugs approved individually by the FDA that are commercially available and marketed by other companies.  As a result, our drug may be the subject to substitution with individual drugs contained in the Qsymia formulation and immediate competition. "

Beyond the above uncertainties surrounding Vivus' Intellectual Property rights to this drug combination, the company faces tough market challenges trying to enforce its territory in the marketplace.  Because the generic components of Qsymia are widely available, some doctors are likely to continue to prescribe phentermine and topiramate (millions of prescriptions of each were written last year, see FDA Advisory Briefing Document excerpt below).  The clinical trials of record provide plenty of protection from liability for doctors making such choices.  This places Vivus in the unenviable position of trying to enforce non-patent exclusivity against prescribing physicians. 

In the words of Vivus' own FDA Advisory Briefing Document:

Phentermine hydrochloride at a labeled dose up to 37.5 mg/part is the most prescribed weight-loss drug in the US with approximately 6.5 million prescriptions written in 2011 [ IMS data].  A more recently approved formulation of phentermine, Suprenza Tm, was approved in 2011. ….. More than 10 million prescriptions were written in 2011 for topiramate [ IMS data ].  The majority of current topiramate use is in migraine prophylaxis.

http://www.fda.gov/downloads/AdvisoryCommittees/CommitteesMeetingMaterials/Drugs/EndocrinologicandMetabolicDrugsAdvisoryCommittee/UCM292317.pdf

While these citations lend credibility to Vivus claims about the drug's safety, the fact that bothingredients are available and in wide use as generics makes enforcing the company's patents far more challenging (and perhaps raises hurdles to negotiating reimbursement).

CEO Wilson's stated strategy, that a combination of patent protection, establishing a dosage regimen that is between strengths of generically available competition (compare 46mg Qsymia to 50 mg generic topiramate), and adding in time release features, create a barrier to entry for Qsymia generic competitors.  However, his own cited example for this strategy (during a 2006 conference call) met quite an unfortunate end.  Ditropan from Alza Corporation, which was a controlled-release formulation of oxybutinin, had its own patent ruled invalid just a month later — for obviousness.   [LINK]   The company's sales fell from $380 million prior to the ruling, to $15 million within a few years.  He stopped citing Ditropan after that.

Vivus might be granted three years of non-patent exclusivity due to providing a new clinical study and/or formulation, which is far less than the 20 years from first filing that strong patent protection might afford.  But in the face of freedom-to-operate challenges above, Qsymia might experience outcomes ranging from zero exclusivity to three years, or partial three year exclusivity, shared with generics.

Translation:  Severe pricing and competition headwinds ahead. 

Just for grins we looked up some prices on the Costco pharmacy site.  We found phentermine 15 mg at about 44c per pill, and topiramate 100 mg is about 23c per pill in Costco-sized bottles of 100.  So that would be about $20 a month for generic treatment at the top-level dosage of Qsymia (at 15mg/92mg).  And the generic approach leaves doctor and patient free to adjust or taper the proportion of the two drugs, flexibility they wouldn't have with Qsymia … and, at no extra charge.

   Vivus's Corporate History:  Failure to Execute

Vivus is not just any startup biopharma company.  It has been operating for over 20 years with the same CEO, Leland Wilson.  Vivus began its life as a publicly traded company pursuing a treatment for erectile dysfunction for males. In the mid-1990's, iIt actually produced and brought to market a treatment involving inserting a suppository into the male urethra.  Despite approval by the FDA and in Europe, a firestorm of hype, an initial sales bubble, and a brief stock run to over $1 billion valuation, the product failed to gain market share and was sold in 2010 to a 3^rd party for just $23.5 million. 

While Vivus's stock has languished in junk stock (sub $5) land for most of the last 20 years, the company has pursued a variety of highly promoted "stories", mostly concerning various attempts to introduce products to treat so-called  "feminine sexual dysfunction", including testosterone spray and vasodilators. 

Despite the company's hype-marked history, the following table is relevant to investors because Vivus's 20 year history illustrates one of the most consistent records of failure in the history of publicly traded companies in America.

Click to review VVUS 20 years cumulative results

   Insider Sales

Regular readers of Citron know that we like to follow the dollars.  There's only only thing more disturbing than the hole where a marketing or strategic partner should be — the amount of insider selling.  Insider sales in Vivus over the last twelve months are 1.7 million shares between $9 and mid $20's, and current insider ownership is down to 0.29% according to Bloomberg.  Do we have to belabor the point that this is incredibly small for a company with zero revenues that holds the license on "the next big thing"?

   Conclusion

Despite years of lead time, Vivus' executives have failed to provide strong patent protection for Qsymia.  Taken together, these points provide the best explanation yet why Vivus hasn't been able to recruit a high-profile deep-pocketed pharma partner to leverage its expertise while taking some of the risk of marketing its newly approved diet combo drug.   Instead of selling a stake to a credible pharma marketer, they sold stock – over $230 million to …. you guessed it.  The hope that a big pharma company is going to ride in pay $3 billion for Vivus is ludicrous – the strategy of trying to pierce its patent protection for a few million in legal fees is a far lower risk. 

The more marketing hype about the FDA approval of this combination of two well-known and inexpensive legacy generic drugs, the more Vivus sets up its own ambush – by legal challenges to its patent, and generic drug competition starting before they can even get to market.   

There is long track record in the US of diet drugs being horrible investments, due to having a very short half-life.  Consumers seem to move from one fad to the next, only to discover there is little that substitutes for exercise plus lowering caloric intake…. and we don’t even think this one gets that far. 

To conclude, Citron offers a two part generic prescription

·                                 For your health: 
Eat a diet rich in nutrition and exercise.  Eliminate junk food from your diet.

·                                 For your prosperity:
Invest in high-quality companies run by management with a strong track record of success.  Eliminate junk stocks from your portfolio.

Citron believes that in 1 year, Vivus's Qsymia revenues will be exactly what they are today:   0.

Cautious (and healthy) Investing to all