THE RISE AND FALL and RISE OF ELAN

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THE RISE AND FALL (and RISE?) OF ELAN

• (Or How Accounting Can Compensate for Strategic
  Shortcomingsfor a While.)
• By
• Baruch Lev

Thanks to Jennifer Tucker for her assistance in
preparing this case. The information underlying
this case is all in the public domain stock
data, Elans announcements and financial reports,
and newspaper articles. I made no attempt to
independently verify the information in this case.
January 2006
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Elan Who?

• Founded in Dublin, Ireland in 1969, and began
  trading on NASDAQ in 1984 (ADS on NYSE from
  1995).
• As of January 2002, Elan was the worlds 20th
  largest drug company with a market capitalization
  of 12 billion (20 billion in 2001). It was the
  largest Irish company, accounting at its height
  for ¼ of the total market capitalization of the
  Irish Stock Exchange.
• Elan started as a drug-delivery system company
  (e.g., nicotine patches) and developed into a
  full-range drug development company through a
  series of acquisitions in the 1990s. It focuses
  on the development and commercialization of
  pharmaceutical products using its extensive range
  of proprietary drug delivery technologies, and on
  the development of products and services in
  neurology, pain management, oncology, infectious
  disease and dermatology.
• Alas, from the heights of 65 in 2001, Elans
  stock price crashed to 1-2 in 2002 (total market
  value around 600 million).
• WHAT HAPPENED?

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Elan A Growth Company
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Forecast
Actual
Data Source I/B/E/S
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Jan.-Feb. 2002 The Dream Turns Into A Nightmare
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(No Transcript)
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What Did Investors Know, and When?

• It Is Clear From Elans Stock Price Behavior That
  Each News Item Caught Investors by Complete
  Surprise.
• But Quarterly and Annual Financial Reports,
  Audited by Independent Accountants, Are Supposed
  to Provide Investors with a Continuous Stream of
  Information, Minimizing Surprises and
  Disappointments.
• So, What Happened to Elans Financial Reports?
• Consider the Following Three Major Issues

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I. Accounting for Research Development (RD)
Costs
Accounting Rule All RD expendituresparticular
ly heavy for drug companieshave to be
immediately expensed in the income statement,
thereby decreasing short-term reported
earnings. A Bind Current hit to earnings for
uncertain future benefit. Elans cure 55 Joint
Ventures (JV)
Elan
Joint Venture
Partner
Outcome Rather than incurring RD expenses,
Elan recorded large licensing revenues from
JVs. In 1999, Elan invested 211M JV and recorded
139M licensing revenues. In 2000, 405M
investment in JV, and 299M in licensing
revenues. In 2001, 229M investment, and 173M
revenues.
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• Elans Commentary
• We dont have to do the Merck model of bringing
  everything inside. The advantage of that is
  complete control. The disadvantage is it costs a
  lot of money. (Ivan Lieberburgh, Elans chief
  scientific officer).
• Main Source 1/30/02. The Wall Street Journal
  Europe. P 1.

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II. Accounting for Investments

• But if Elan doesnt record R D expenses, the
  joint ventures do. So what is gained?
• Reporting Rules
• Investment lt20 Cost/Market
• Investmentgt20 but 50 Equity Method
• Investmentgt50 Consolidation
• Elans Joint Ventures

Elan
19.9 Ownership
JV
Most of the JV partners were moribund companies.
Some of the best bargains can be made bottom
fishing. (Lynch, Elans CFO). Outcome The
financials of the JV were not consolidated into
Elans reports. Losses and debt were
shifted to JV and obscured from investors.
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III. Separating Core from Non-Core Earnings

• Accounting Rule Extraordinary, non-recurring
  (non-core) revenue or expense items have to be
  separated in the income statement from
  recurring-core items to enable investors to
  assess the sustainability of earnings.
• In 2002, amid serious financial difficulties,
  Elan sold various product lines (divisions) and
  allegedly aggregated the proceeds with regular
  product revenues. In some cases Elan lent money
  to buyers or had a significant investment in
  buyers of the product lines. Sometimes, Elans
  executives freelanced as buyers executives.
  

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GAAP Violations Where Were the Auditors?

• If revenues (licensing income in Elans case)
  require future commitments, they should be
  apportioned over subsequent periods. (Elan
  admits, and restates earnings by 344 million).
• If firm has significant influence over a related
  company (JV in Elans case), equity method is
  called for despite lt 20 investment. (Elan had
  veto power over JV research, 50 board
  representation).
• Some buyers of product lines should probably have
  been identified as related parties. The
  concept of arms length transaction.
• The original sinGAAP requirement to expense
  all RD and other intangible investments.

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How About The Fundamentals? Accounting
Misrepresentation Often Come In the Wake of
Strategic Mishaps and are aimed at portraying
business as usual

• Strategic Issues
• Elan probably paid too much for growth
  acquisitions. For example, the in-process RD
  write-offs of some acquisitions were even higher
  than the purchase price.
• It had chosen some weak joint-venture partners so
  that it had to write off investments.
• Getting quickly to be a major drug company is
  very costly and risky.

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Is There Life Beyond Accounting Scandals?
On January 2, 2003 the Wall Street Journal (p.
D4) reported the results of a study showing that
people suffering from relapsing forms of multiple
sclerosis might benefit from the experimental
(not yet approved by the FDA) drug Antegren. The
drug is co-developed by Biogen Inc., and Elan
Corp. The worldwide MS market is estimated at
about 2.5 billion, and expected unfortunately to
grow to 4 billion by 2005. Elans stock price
increased by 13 on the news. (But, it also
increase 13 on the preceding trading day,
12/31/02. Insider trading/information leakage?)
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More recently
December 23, 2004 Three midsize drug makers
are faring better than larger rivals. Thanks to
cost-cutting programs and a narrow focus on a few
therapeutic areas, companies such as Irelands
Elan Corp.,have been bringing new products to
market and enjoying some of their best financial
results in years. (The Wall Street Journal, p.
B2).
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Still Struggling After All These Years

• On 28 February 2005, we and Biogen Idec
  voluntarily suspended the marketing and clinical
  dosing of Tysbari. This decision was based on
  reports of two serious adverse events in patients
  treated with Tysbari
• At December 31, 2004, we have 46.6 million of
  other intangible assets and goodwill and 1.9
  million of inventory relating to Tysbari Our
  reassessment does not indicate impairment at this
  stage
• Goodwill arising from acquisitions since 1998 is
  capitalized and amortizedThe average
  amortization period of goodwill is 19 years.
• Net 2004 loss under Irish GAAP 368.3 million
  vs. net loss under U.S. GAAP 394.7 million.
• 2004 RD 259.0 million vs. 2003 RD 331.4
  million.

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Stock Prices
Healthcare Index
ELAN
Data Source Yahoo Finance
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The Moral of the Story

• Comprehensive, In-Depth Knowledge of Accounting
  is Essential for Investment Decisions, Board
  Supervision, Bond Ratings, and Lending Decisions,
  Not to MentionManagement.
• The Warning Signs are Often Out There
• For example
• 19.9 Investment in Subsidiaries.
• Revenues, yet no RD, expenses.
• The Earnings-Cash Flow Gap.
• The Irish-U.S. GAAP Reconciliation.
• Questionable assets.
• Indeed, Elizabeth McDonald (Forbes, 9/18/2001)
  saw it all from public sources, but investors
  ignored the warning (price down 2 only).