Elan: Just How Real Are the Irish Drug Star's Earnings?
By Bethany McLean

(FORTUNE Magazine) – Irish drug company Elan looks like an investor's dream come true--a "powerhouse," gushes analyst Andrew Forman at Warburg Dillon Read. Every quarter it meets or beats Wall Street analysts' earnings expectations, posting clockwork-like growth. In 2003, Elan says it will generate $2 billion in revenue, up from $677 million in 1998, and have a market capitalization of $20 billion, almost double its current value. Elan's biggest believers are Putnam, which owns more than 8%, and Fidelity, with over 6% (as of year-end). Daniel Tully, Merrill Lynch's chairman emeritus, just joined Elan's board of directors.

So why does Elan have so many enemies? (About 8% of its shares are sold short--about 14 times its average daily volume, vs. four times for the NYSE as a whole.) Short-sellers claim that Elan is a poster child for aggressive accounting tactics--tactics that overstate earnings. The Securities and Exchange Commission and the Financial Accounting Standards Board (FASB) are cracking down on accounting abuses, and while no one can tell whether Elan's knuckles will be rapped--and its earnings restated--even bulls acknowledge it's possible. Elan CEO Donal Geaney is sanguine: "Accounting is not what's important," he says. "Reality is much more important, and the reality is that none of these things will matter a damn." Reality, for Geaney and his fans, is that by 2003, Elan will be one of the world's top 50 pharmaceuticals companies.

But accounting has been in the headlines lately, mostly because FASB has proposed eliminating a frequently used statute that allows companies to write off acquired technology still under development--so-called "in-process R&D." Elan is a voracious acquisitor, and it takes huge write-offs. While these demolish current earnings, investors ignore such "one-time charges," and critics claim they ensure lower expenses and higher earnings in future quarters. In the first nine months of 1998, Elan wrote off $1.3 billion in charges it says "principally relate" to its acquisition of two biotech companies, Sano and Neurex. But Elan paid a total of about $1.3 billion for the pair. In other words, it wrote off around 100% of the cost. Geaney says that Elan is simply doing what accounting standards require.

Elan also uses another aggressive accounting gimmick--off-balance-sheet R&D vehicles. These are separate companies, funded by Elan and outside investors, that are supposed to develop new products using Elan's technology. Many pharmaceuticals companies set up such creatures to keep the high costs of product development off their books, and they are legitimate (although criticism is growing and FASB recently proposed that companies be required to consolidate them in financial statements). Since 1990, Elan has created four. Documents for three of them say that Elan bills its captives 160% of direct research salaries, benefits, and supplies, plus a further 110% of salaries and benefits to cover indirect costs and 80% for overhead. Mark Roberts, director of research at Off Wall Street Consulting Group, calculates that with that formula, Elan makes around $250 for every $100 it spends. Geaney says that's "completely inaccurate" and that the rate of return is approximately 15%.

The third--and what critics call the most egregious--of Elan's accounting gambits is its investments in tiny early-stage companies that plan to use Elan's technology. The companies pay most of Elan's investment back to it as a license fee--miraculously converting cash from Elan's balance sheet into net income. (Because Elan is Irish, it pays almost no tax on this licensing income, so the income drops right to the bottom line.) Elan has done some 17 such deals since 1994. Its late-1998 joint venture with Endorex is fairly typical: Elan paid $8.4 million for convertible preferred stock in Endorex and contributed $2.1 million to the new joint venture company. In return, the joint venture paid Elan an initial $10 million license fee. Warburg Dillon Reed's Forman calls this a "legitimate source of operating income," and so, of course, does Elan.

But the shorts claim that without all these handy little helpers, Elan's earnings picture is not so pretty. By Roberts' analysis, if you back out what he counts as the "excess" profit from the R&D vehicles and the licensing fees, Elan earned $0.97 per share in 1997 and around $1.21 in 1998, vs. the reported $1.58 and $1.96. (All these numbers are before the write-offs for acquisitions.) Thus, Elan's nominal P/E multiple, which is 40 times 1998 reported earnings, is 66 times what some say are its "real" earnings. Geaney points out that Elan's financials are audited and says, "We've done all the things you would expect a prudent management of a public company to do."

There are analysts who won't cover Elan and portfolio managers who won't own the stock because of these issues. Even some Elan bulls call its accounting aggressive--they just don't care. They applaud Elan's creativity in supporting its earnings while it acquires a pipeline of new products, and they say that someday Elan will derive all its profits from product sales. "They have built the company beautifully," says Ian Sanderson, an analyst at Cowen. Also unconcerned is Richard Johnson, a portfolio manager at Columbia who has been following Elan for over six years. "You've got to live with a certain amount of 'black box' in Elan's earnings," he admits. "But the black box is getting smaller."

The one number everyone does care about is growth in product sales, which accounted for about half of revenues in 1998 and, according to Geaney, will account for $1.5 billion of Elan's $2 billion in revenues in 2003. Bulls point to 1998's fourth quarter as evidence of Elan's transformation: Elan reported a 111% year-over-year increase in product sales, from $62 million to $131 million. Skeptics say that most of that growth was not internally generated but came from products that Elan acquired during 1998.

It's unclear who will win this battle. If Elan's pipeline is indeed bulging with potential blockbusters, the accounting issues may be forgotten, as Geaney promises. "We don't have a history of missing what we say we'll do," he says. "That's what annoys the shorts so much." But his aggressive accounting techniques and ambitious growth targets leave so little margin for error that it's easy to imagine the shorts having the last laugh.

--Bethany McLean