West Coast Editor
Hit with shareholder lawsuits and a tumbling stock price, Elan Corp. plc said the Securities and Exchange Commission has begun a probe into the Dublin, Ireland-based firm’s accounting practices and analysts predicted regulators will keep a closer eye on bookkeeping across the board.
“People weren’t looking at biotechs as companies that were inflating revenues,” said Eric Ende, analyst with Banc of America Securities in New York. “People chose not to look. That wasn’t the story. Now, all of a sudden people are saying, What’s the quality of these revenues?’”
Elan’s stock (NYSE:ELN) closed Friday at $14.80, up $1.31, but was trading at more than $40 at the start of the year.
The shares’ decline began with a Jan. 30 article in the Wall Street Journal detailing how Elan established research and development vehicles through joint ventures, and then took back the JVs’ funding by way of a licensing fee, which went on the firm’s books as revenue.
About a week later, the plunge began in earnest, after Elan cited in a press release about its financial results for 2001 “current market concerns relating to off-balance sheet arrangements through [Qualified Special Purpose Entities] structures,” and allowed that it “has two QSPEs which it has not consolidated in its financial results as presented under U.S. generally accepted accounting principles.”
Elan’s stock fell 17 percent after the newspaper article, and 50 percent more after the financial report. The company vowed to “vigorously defend” against the lawsuits, and said it “welcomes the opportunity to resolve all matters raised by the SEC in light of recent allegations made against the company in the media and in shareholder lawsuits.”
Max Gershenoff, a spokesman for Elan, said the firm has 55 joint ventures working on 53 compounds, three of which are in Phase III trials, 16 in Phase II, eight in Phase I, and 26 in the preclinical stage. He said some reports about the company have failed to point out the ventures are steadily advancing their products.
But it’s not the drugs that are under suspicion; it’s how the company accounts for the work done by JVs. Ende didn’t want to talk about Elan specifically, but acknowledged the “off-balance sheet” problem.
“[Some of] these companies are fabricating revenues financing cash flows, turning them into operating revenues, paying themselves with their own money,” often through the vehicle of JVs, he said. “They [take] drugs with an enormous amount of development risk and put them in these shells.”
Andrew Gitkin, analyst with UBS Warburg, said he is “very suspicious” about off-balance sheet accounting, and recalled previous work in the assisted-living and nursing home industries, which “were notorious for shielding income statements from losses, and unduly inflating revenue. I’m very schooled in that area of accounting.”
Others are becoming more schooled in it although the practice has been under everyone’s noses for a long time. An industry insider who asked not to be identified said “everything [Elan is] doing has been known for years. They’ve been anal about disclosure.”
Only the scrutiny is new, and it’s striking far and wide. A recent example is Cephalon Inc., of West Chester, Pa., which saw its stock (NASDAQ:CEPH) decline 13.4 percent Monday, ending at $55.99, after a short report by Sterling Financial Investment Group, of Boca Raton, Fla. which echoed a paper in January by the Rockville, Md.-based Center for Financial Research and Analysis, said Gitkin.
The two reports questioned, among other things, Cephalon’s joint venture formed in December to boost U.S. sales of Provigil (modafinil, a sleep disorder therapy to which Cephalon got worldwide rights in the Group Lafon buy) and Gabitril (tiagabine, an epilepsy treatment gained in the Sanofi-Synthelabo deal). The two-year JV for post-marketing studies was funded through a $50 million investment from a pair institutional investors.
A “finicky” market took the Sterling report seriously, Gitkin said, although the Cephalon JV hardly resembles anything done by Elan. Not only that, but it’s relatively small, and it’s the only one Cephalon has.
“I saw the original report and laughed at it,” Gitkin told BioWorld Today. Cephalon’s shares were recovering by the end of the week, closing Friday at $57.68, up $3.51.
Michael King, analyst with Robertson Stephens, called the claims in the Sterling report “baseless.” Ende agreed.
“In my mind, although this doesn’t match with accounting rules of capitalizing [research and development], Phase IV studies to generate data so you can have greater marketing material are not true R&D,” he said. “The money is from outside investors, and [Cephalon] is not doing anything to inflate revenue.”
Jeff Mustard, director of communications for Sterling, shrugged off the criticisms of his firm’s report.
“That’s usually what happens when people get slammed, and they have nowhere to run and nowhere to hide,” he said. “Our report was pretty strong.”
Frank Baldino, Cephalon’s chairman and CEO, noted “the whole industry’s been caught in the Enron downdraft,” referring to the troubled energy trading firm.
“There’s nothing wrong with the way these things [done by Cephalon] are accounted for,” he said. “They satisfy all the SEC rules, and they’re fully disclosed.”
What investors worry about, he added, is forming partnerships that exaggerate revenues or hide debt neither of which Cephalon has done, he said.
Chip Merritt, director of investor relations for Cephalon, noted the company disclosed the JV in December through a press release and talks with analysts.
“Everybody yawned,” he said. “Nobody cared. But in the future, this is going to speak to investment bankers. Everybody’s going to have trouble.”
Gitkin, too, said the environment will become tighter.
“I’m sure if Frank Baldino had seen this back in December, he wouldn’t have done it,” he said. Merritt acknowledged that Baldino has publicly said as much and noted that, in a nervous market, the slightest suspicion can mean consequences.
Whatever the outcome of the Elan investigation, Merritt said, reports such as Sterling’s and CFRA’s are likely carry weight, at least for a while.
“We asked them to give us something specific, and they didn’t,” he said. “We’re fighting the null hypothesis. It’s part of the game, and it’s a bad game.”