* Citron Research alleges fraud
* Valeant categorically denies allegations
* Pershing Square adds to position -report
* Valeant shares cut losses, last down 18 pct (Adds background, updates share price, market values)
By Caroline Humer
NEW YORK, Oct 21 (Reuters) - Valeant Pharmaceuticals International Inc’s stock plunged as much as 40 percent on Wednesday after an influential short-seller accused the company of using specialty pharmacies to inflate its revenue, an allegation that the drugmaker denied.
Citron Research, a short-selling firm run by Andrew Left, alleged that Valeant’s previously undisclosed ties to specialty pharmacies, including Philidor and R&O Pharmacy Inc, helped the company create “phantom sales” of its products or push more product through distribution channels than sales would warrant.
“Citron believes the whole thing is a fraud to create invoices to deceive the auditors and book revenue,” the research note said.
In response, Valeant said it does not record sales of drugs that are stocked as inventory at such pharmacies in its consolidated financial reports and said sales are recorded only when the product is dispensed to the patient.
“We categorically deny the allegations made in the Citron report,” a Valeant spokesperson said.
“Citron’s false and misleading statements about Valeant appear to be an attempt to manipulate the market in an effort to drive down Valeant’s stock price. Valeant ... properly accounts for sales to, and inventory at, Philidor and Philidor’s network pharmacies.”
Nevertheless, the Citron report accelerated investor concerns over drug pricing and sales practices in the pharmaceutical industry which have come under scrutiny in Congress and from U.S. presidential candidates.
Valeant is viewed as the most aggressive drugmaker in raising prices on their medications to boost sales, a strategy that has made it a darling among investors including billionaire hedge fund manager Bill Ackman. Last week, Valeant disclosed that such practices are under investigation by federal prosecutors in New York and Massachusetts.
The Citron Research report hit shares hard shortly after 10 a.m. EDT (1400 GMT) in New York trading and fell to a low of $88.50, before losses were cut and the stock closed down 19 percent at $118.61.
The fall in Valeant’s stock price represents about a $550 million loss for hedge fund Pershing Square Capital Management, which holds a 5.7-percent stake in Valeant, and is managed by Bill Ackman.
Pershing Square did not have an immediate comment but business television station CNBC reported Ackman added to his stake on Wednesday.
In a note to clients, Nomura analyst Shibani Malhotra said the weakness in Valeant’s stock offers a buying opportunity, as the brokerage firm believes the concern raised by Citron is likely “misinformation.”
Shares of some Valeant competitors, including Allergan Inc , Endo International Plc and Mallinckrodt Plc also fell sharply. Allergan and Endo each said that the majority of their drugs are distributed through traditional wholesale and retail channels, not specialty pharmacies.
Specialty pharmacies are designed to deliver medications with special handling, storage and distribution requirements, often for patients with complex conditions.
“The allegation as I understand it is that they are using specialty pharmacy (companies) as a place to store inventory, which is a revenue-recognition story. And aggressive revenue-recognition policies can augur bad things,” said portfolio manager Les Funtleyder of ESquared Asset Management.
Funtleyder said the spotlight on Valeant could discredit its business model of buying drugs, or acquiring other drug companies, and sharply raising drug prices instead of aggressively pursuing research and development.
“That could help the industry in the long run by putting less emphasis on acquisitions and financial engineering, and more on research,” he said.
Valeant disclosed last Wednesday that the U.S. government requested information on pricing and on programs that help patients cover their out-of-pocket expenses for Valeant’s drugs. Those drugs are often distributed by specialty pharmacies.
On Monday, during a conference call with investors, Valeant defended its pricing and declined to comment further on the federal investigations, saying it was cooperating with authorities.
The company also disclosed new information about its dealings with the two pharmacies, which distribute specialty drugs to patients. Valeant said it had purchased an option to acquire the pharmacy Philidor and was already consolidating its results. Valeant also said it sought to recover about $69 million from R&O pharmacy for medicines it provided.
Valeant chief executive Michael Pearson also told investors that the company was moving away from growth based on pricing increases to focus on volume of sales. He vowed to commit more to research and development in 2016 and said it was trying to sell one of its businesses dependent on price increases for growth.
Independent Canadian equity research firm Veritas said it saw significant unquantifiable risks overhanging Valeant.
Veritas analyst Dimitry Khmelnitsky sees Valeant at risk of losing its “secret sauce” that made it a darling of many investors due to the pullback in its share price. Valeant has traditionally used its highly-valued shares to pursue accretive acquisitions and fund the business with debt.
The Wednesday selloff cut Valeant’s market capitalization by about $9.6 billion to $40 billion after being valued as high as $90 billion in early August.
ValueAct, the San Francisco-based activist investor known for working closely with management teams, suffered a $422 million paper loss on its investment in Valeant in Wednesday’s fall, a stock it has owned since 2006.
Billionaire investor Carl Icahn told CNBC on Valeant: “I wish I was short. I was thinking of going short. I understood why that company really was overpriced ... But I don’t have any long positions, I’ll say that.”
Valeant’s connection with the pharmacies Philidor and R&O have also been examined by Bronte Capital, another hedge fund that, like Citron, has been critical of Valeant.
Valeant, based in Canada for tax reasons, tried to acquire competitor Allergan in a hostile takeover in 2014 but failed, drawing investor scrutiny.
The latest data indicated that short interest positions in Valeant’s stock in the U.S. market have more than doubled since mid-August, jumping to 7.1 million shares at the end of September.
Traders who sell securities “short” borrow shares and then sell them in the hope the price will fall, so they can buy them back more cheaply, return them to the lender and pocket the difference.
Reporting by Caroline Humer and David Gaffen; Additional reporting by Carl O'Donnell, Euan Rocha, Michael Flaherty, Ransdell Pierson and Deena Beasley; Editing by Michele Gersberg and Nick Zieminski