Description
Elan (ELN-LYONS -- $27) LYONs due 12/03
Elan was first submitted by Scott 102 in April when the stock was above $11. The company’s circumstances have changed significantly since Scott’s proposal. Based on our analysis of information not currently well understood by most investors, as well as recent developments at the company, we now find this a very compelling investment opportunity. The common stock and the LYONs have been battered based on liquidity concerns related to the company’s ability to make good on the put provision of the LYONs (which are also puttable for common stock – at this level, over 500mm shares would have to be issued, an unrealistic proposition), as well as concerns regarding Elan’s accounting, its off-balance sheet vehicles and several other factors. We believe these concerns are significantly overblown, just as a lack of attention to detail re the off-balance sheet vehicles and the company’s accounting were in part responsible for the absurdly high valuation that Elan received just a couple of years ago. We are recommending the LYONs here as it has not been six months since Scott’s common stock write-up, although we feel just as strongly about the common, particularly for risk-tolerant investors.
Elan has become a value realization play, with some very apparent catalysts, as well as a reasonable margin of safety. As this is a repeat idea, I will focus on our analysis as opposed to the business of Elan. Below I outline our analysis of the balance sheet, as well as the ongoing businesses, and how we expect to realize significant value through the purchase of the LYONs (or the common)…
Assets
Stated Adjustments Adjusted
Cash $903.6 $100.0 $803.6
Securities:
Elan-owned $1,300.9 $650.5 $650.5
EPIL II $247.0 $50.0 $197.0
EPIL III $174.0 $50.0 $124.0
6/30/02 sale $0.0 ($50.0) $50.0
$2,625.5 $800.5 $1,825.1
Notes:
Cash reduced by $100mm to allow for burn rate, severance, etc.
We apply a 50% discount to carrying value of securities. Probably conservative based on our conversations with the company.
For other assets, see liability section below.
Liabilities
Senior Notes $646.5 $0.0 $646.5
Convertible $62.6 $62.6 $0.0
LYONs $1,013.4 $253.4 $760.1
EPIL 2 Notes/EPIL 3 Notes$840.0 $0.0 $840.0
Product Obligations $900.4 $487.7 $412.7
EPIL 3 guarantee $148.0 $0.0 $148.0
Pharma Marketing $481.3 $192.5 $288.8
Autoimmune $203.0 $203.0 $0.0
Product Acquisition $24.5 $0.0 $24.5
ADS Payment $18.0 $0.0 $18.0
Legal $0.0 ($100.0) $100.0
$4,337.7 $1,099.2$3,238.5
Notes:
The Senior Notes are not due until 2008. We apply a discount to the LYONs of 25% (more on this later as it relates to our investment). Currently, the Lyons trade at over a 50% discount to the put value. You really have to work hard to get supply on these, although I have seen much worse. This week, depending on the broker/dealer, we have been quoted from $25 to $30 on the ask. We anticipate that the company might repurchase LYONs in the open market if they continue to trade at such a discount. The remaining liabilities are fairly complex and have caused much investor confusion. We attempt to simplify things here. Certain of these liabilities are related to assets and/or other parts of the businesses, and we have taken that into account, although out spreadsheet here is fairly simplistic.
EPIL 2 and EPIL 3 are off-balance sheet financings that own portfolios of biotech investments. These assets are included in the asset table above. Elan is liable for the deficiency between the aggregate debt of $840 million and the value of those assets, so the actual liability will probably be significantly less than $840 million. Product obligations represent the deferred purchase price on product lines acquired by Elan. The $487.7 reduction consists of (1) the portion attributable to Elan’s Hospital Supply product line—to be sold (see below) of $191.2 and (2) the balance attributable to their Dermatology line, which was abandoned to the seller. Pharma Marketing is an off-balance sheet securitization that holds royalty streams to Elan products. The theoretical maximum repurchase value—to liberate the royalty streams—is $481.3. A more realistic purchase price (to be determined by auction) is estimated above. Other liabilities are not material, although Elan is party to numerous shareholder derivative litigations and an SEC investigation. We have estimated an aggregate liability of $100 million above the company’s D&O insurance for this, although the risk is clearly not perfectly identifiable.
Business Valuation
Revenues Valuation Proceed-Adjust Adj Valuation
Drug Delivery $250.0 $300.0 $0.0 $300.0
Products $717.0 $2,509.5 $0.0 $2,509.5
Hospital Supply $210.0 $630.0 $191.2 $438.8
Diagnostics $75.0 $100.0 $0.0 $100.0
Contract Manufacturing $125.0 $125.0 $0.0 $125.0
Royalties from Sold Products $100.0
Facilities Sales $50.0
$3,623.3
Notes:
Below are our best estimates for product sales for 2002. We apply a multiple of 3.5x revenues to these products to derive a fairly conservative value. Most drug companies trade at 5-10x revenues, even after the recent market drop and the ratcheting down of drug company multiples. We anticipate that the drug delivery business will be sold at 1.2x revenues, a somewhat arbitrary number, but nonetheless conservative. Our best information is that Hospital supply (3 products) could be sold shortly for approximately $630 million, which nets approximately $440 to ELN afterthe deferred purchase price obligation described. The remaining line items are fairly self explanatory.
Product estimates
Zanaflex(genericized) $40.0
Skelaxin $168.0
Sonata $100.0
Zonegran $75.0
Myobloc $30.0
Pain management $54.0
Frova $100.0
Other $150.0
$717.0
As reflected in the following table, we estimate the value of the Elan common, on a semi-liquidated basis (a realistic scenario), to be approximately $6.30 per share. We are not entirely certain as to what Elan will ultimately look like, what its run-rate earnings will be, etc. However, we are fairly certain that we have been fairly conservative in estimating asset and liability values, which provides a significant cushion given the apparent upside here. Additionally, unless there is significant fraud at the company (which we doubt), we think the market has overreacted to “liquidity” concerns, to the off-balance sheet issues (which have now become much more identifiable, etc.). At worst, we suspect that: the asset sales may be more difficult than we expect; the LYONs may be difficult to repurchase at a discount prior to the put date (this would actually be a good thing in a sense for LYONs holders, although it would reduce the equity value by approximately $0.70 per share) and; we don’t have a great sense re the legal liability. Currently, with the equity valued at $770 million, we have approximately a $1.5 billion cushion to work with. You can do you own sensitivities re assumptions that make you uncomfortable. For example, assume ½ point revenue multiple lower on product sales and our value goes down by $1.00. Etc. The point is, the cushion seems very sound and the upside appears significant.
As it relates to the LYONs, for the sake of simplicity, investors have the opportunity to earn approximately 100% on their investment over the next 15 months. We suspect that the company may repurchase the LYONs in the open market as the company’s liquidity becomes more apparent, depending on timing, etc. Obviously, one may be able at some point to sell the LYONs in the open market for a discount to put value, which sort of creates a moving matrix of absolute returns as well as IRRs. We project that by December 2003, Elan will have more than enough liquidity to repurchase the LYONs, even assuming none are purchased prior to then.
One last thing – this analysis does not include any value for Elan’s pipeline. The most significant pipeline product is Antigren (50% ownership -- phase III currently), which many estimate has the potential to be a $3 billion + drug. In evaluating the LYONs versus the common, it really comes down to your risk preference, as well as the sensitivity that you apply the value realization model. We think it is likely that Elan has realizeable value well in excess of $7. We also recognize the risks associated with achieving the restructuring plan. The LYONs appear to offer fairly impressive absolute return potential with significantly less risk. For those wanting a potential call on the pipeline or those that believe this analysis may be conservative but who are still gun-shy, a mix of both may make sense.
ASSETS + VALUE OF BUSINESSES $5,448.4
LIABILITIES $3,238.5
EQUITY VALUE $2,209.9
SHARES OUTSTANDING 350.0
EQUITY VALUE PER SHARE $6.31
CURRENT SHARE PRICE $2.20
Catalyst