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THE RISE AND FALL (and RISE?) OF ELAN

(Or How Accounting Can Compensate for Strategic Shortcomings—for 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, Elan’s 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 world’s 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, Elan’s stock price crashed to $1-2 in 2002 (total market value around $600 million).

WHAT HAPPENED?

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Forecasted and Reported Annual Earnings of Elan Corp.

0

0.5

1

1.5

2

2.5

1996 1997 1998 1999 2000 2001

Ea

rnin

gs

Pe

r S

ha

re

Forecast

Actual

Forecast is the most recent mean analyst forecast for the fiscal year. Both forecast and actual data are from IBES.

Elan: A “Growth Company”

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Forecasted and Realized Quarterly Earnings of Elan Corp.

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

Mar

-95

Sep-

95

Mar

-96

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96

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-98

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99

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-00

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-01

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01

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-02

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02

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-03

Sep-

03

Mar

-04

Sep-

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Mar

-05

Sep-

05

EPS

Data Source: I/B/E/S

Actual

Forecast

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Daily Stock Prices of Elan Corp.(2/14/2000 - 1/9/2003)

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Sto

ck P

rice

Note: The Dow Jones Healthcare Index prices are scaled by 1/10.Data Source: Yahoo Finance

Elan Corp.

Healthcare Index

Jan.-Feb. 2002: The Dream Turns Into A Nightmare

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Calamitous Events Worst Daily Stock Returns of Elan Corp.

Raw Excess

Date Price Return Return Event

1/18/2002 38.65 -14% -13% Elan suspends trials of Alzheimer's drug.

1/30/2002 29.25 -17% -18% WSJ questions Elan.

2/4/2002 14.85 -50% -48% Elan "comes out" with revised earnings and debts.

6/6/2002 6.89 -21% -18% Analysts question Elan's joint-ventures and debts.

6/28/2002 5.47 -17% -15% The FTC rules on Elan's anti-trust case.

7/2/2002 1.65 -66% -64% Elan announces write-offs: $420-$630 million.

7/9/2002 1.8 -18% -14% Top executives resign.

8/1/2002 2.17 -14% -11% Elan announces restructuring plan and disappointing Q2 earnings.

10/1/2002 1.05 -46% -48% Elan announces $400 million write-offs and $142 million cash charge.

Note: The Dow Jones Healthcare Index is used as the benchmark for calculating excess returns.

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What Did Investors Know, and When?

It Is Clear From Elan’s 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 Elan’s Financial Reports?

Consider the Following Three Major Issues:

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I. Accounting for Research & Development (R&D) Costs

Accounting Rule: All R&D expenditures—particularly heavy for drug companies—have to be immediately expensed in the income statement, thereby decreasing short-term reported earnings.

A Bind: Current hit to earnings for uncertain future benefit.

Elan’s cure: 55 Joint Ventures (JV)

Elan

JointVenture

Partner

Outcome: Rather than incurring R&D 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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Elan’s Commentary:

“We don’t 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, Elan’s chief scientific officer).

Main Source: 1/30/02. The Wall Street Journal Europe. P 1.

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II. Accounting for InvestmentsBut if Elan doesn’t record R & D expenses, the joint ventures do.

So what is gained?

Reporting Rules

Investment <20%: Cost/Market

Investment>20% but 50%: Equity Method

Investment>50%: Consolidation

Elan’s Joint Ventures

Elan

JV 19.9% Ownership

Most of the JV partners were moribund companies. “Some of the best bargains can be made bottom fishing.” (Lynch, Elan’s CFO).

Outcome: The financials of the JV were not consolidated into Elan’s 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, Elan’s executives “freelanced” as buyers executives.

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GAAP Violations: Where Were the Auditors?

If revenues (licensing income in Elan’s 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 Elan’s case), equity method is called for despite < 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 “arm’s length transaction.”

The “original sin”—GAAP requirement to expense all R&D 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 IssuesElan probably paid too much for “growth”

acquisitions. For example, the in-process R&D 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.

Elan’s 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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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 Ireland’s 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).

More recently:

Source: Elan's 2004 Financial Report.16

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 amortized…The 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 R&D: $259.0 million vs. 2003 R&D: $331.4 million.

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Stock Prices

Daily Stock Price of Elan Corp.

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Data Source: Yahoo Finance

ELAN

Healthcare Index

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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 Mention—Management.

The Warning Signs are Often Out There:

For example: 19.9% Investment in Subsidiaries. Revenues, yet no R&D, 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).