Description

Elan is an Irish pharmaceutical company with $1.8 billion in annual revenues ($5.46 per share), $2.2 billion in cash and securities ($6.45 per share), trailing operating earnings of $1.91 per share, a trailing 12 month P/E of less than 6, a price to book ratio of 1.3. The stock has been crushed this year, losing more than 75% of its value, dropping from a high of $65 to its current value of $11.40, giving the company a market cap of $3.8 billion.

The stock has been hammered for two good reasons, but the magnitude of the decline is so great that further downside risk is greatly diminished. The stock has been killed because (1) the investment community has raised serious accounting questions, which has led to an SEC investigation, and (2) there is concern about the future drug pipeline. These concerns are totally legitimate, but at current prices, there is room to make money EVEN IF the SEC investigation results in substantial earnings restatements. Here is my analysis, the Good, the Bad and the Ugly.

THE GOOD

Elan ranks among the top specialty pharmaceuticals, with five drugs—Skelaxin (musculoskeletal pain relief), Abelcet, Sonata, Maxipim and Zanaflex (muscle tone associated with spasticity)—each expected to generate more than $100 million in sales this year.

Elan has just announced that it will be marketing in the US a new drug to treat migranes, Frova, which has a half-life of 26 hours. The next best drug has a half-life of 6 hours. This market should be huge, as more than 25 million Americans suffer from migraines.

Other key neurological drugs include Permax (Parkinson’s), Naprelan (arthritis), Zonegran (anti-eliptical), Diastat (epileptic cluster seizures), Mysolin (epilepsy and seizures), and Myobloc (cervical dystonia). Antibiotics include the ubiquitous Ceclor. The company also produces Liposome.

While some of the above may seem unfamiliar, the key points here are that (1) Elan is a real company with a diverse base of successful products, and (2) product revenues amount to $1.4 billion of the $1.8 billion in revenues. This last point is crucial in addressing the uncertainty of the outstanding SEC investigation and related accounting problems.

THE BAD

In February, Elan lowered earnings guidance for FY2002, estimating earnings of $1.55 to $1.65 per share. Revenues are projected to increase to $2-2.1 billion, of which product revenue will be $1.6-1.7 billion. Some analysts speculate that even the reduced guidance may be difficult to achieve. In addition, the introduction of Prialt to the US market has been delayed by the need for another Phase III study.

THE UGLY

In January, the Wall Street Journal attacked Elan’s accounting practices. The article essentially alleges that Elan is inflating its revenues and profits through joint venture agreements in developing new drugs. The allegation is that Elan is “investing” in the joint venture, and the cash paid to the joint venture appears as an asset on the balance sheet. Then, the joint venture licenses the technology from Elan to create the drug, which is counted as revenue. Thus, by giving the joint venture $1, Elan maintains its balance sheet, and gets $1 in revenue from doing nothing more than paying itself. The SEC initiated an investigation after the article was published, the stock cratered, and the flood of lawsuits followed

In 1999, the SEC investigated similar practices. As a result of that investigation, Elan restated 1997 earnings from $.79 to $.77, but 1998 earnings remained unchanged.

HOW DO YOU EVALUATE THE VALUE OF A COMPANY THAT MAY BE COOKING ITS BOOKS?

I don’t have an easy answer to that question. My best answer is: (1) assume the worst, and (2) hope for the best. ASSUMING THE WORST, the company may have to make massive restatements of revenues and earnings. Even then, I think the company is undervalued. If the managers are completely dishonest, and every single joint venture agreement was a total fraud, revenues will plunge. But the company still has viable products. Product revenues alone were $1.4 billion last year, and projected to be $1.6-1.7 billion next year in a company with a market cap of $3.6 billion. According to Market Guide, the average price/sales ratio in the pharmaceutical industry is 12.4, far higher than the price to sales ratio for Elan even if 100% of their contract revenues were disallowed. Industry average price/book ratio is 6.5. With Elan trading at a price to book of 1.3, the SEC could knock out half its assets and the company would still be trading well below its piers. It is extremely difficult to guess how the SEC investigation might affect earnings. But the industry average PE is above 40, so there is still room for value in the face of a significant restatement. In addition, the company came out of the last investigation largely unscathed, and I can only speculate that some one should have learned something from the last round.

In considering valuation in the face of an SEC investigation, one also has to look at liquid assets and debt. Elan has $1.663 billion in cash, $370 million in quoted equities, and $170 million in managed funds. I would not expect the SEC investigation to change that. The company has $817 million in investments in public and private companies. Some of that could be subject to restatement, but it won’t all be wiped out. On the debt side, Elan does not face any immediate danger. The only debt due in 2002 is $62 million. None of the company’s debt has covenants relating to ratings. The $951 million in 3.25% zero coupon subordinated exchangeable notes due in 2018 have a put feature, but Elan has the right to repay them in stock.

SUMMARY

Even if the SEC investigation causes massive restatements, you pay $11 per share for a company that has real and valuable products, minimum $6.45 per share in cash and securities (likely more), $4.83 in projected product revenues (likely more in total revenues, because the SEC will not likely disallow every penny in contract revenue). The company has existing drugs that are leaders, and new drugs that have great potential. For me, I see plenty of upside even if the SEC investigation forces a major restatement. If the SEC forces a minor restatement, the upside is huge.

Catalyst

1) Accounting and SEC concerns will be resolved one way or the other. Even if massive restatements are required, the stock should be attractive at current levels. If the issues are resolved largely in favor of the Company, the upside could be huge.
2. New drugs, including migraine pain reliever Frova, which has a half life of 26 hours, more than 300% better than the next best product, will attract investor interest.