SMARTMONEY.COM: Special Report: Avoiding The Next Enron
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Special Report: Avoiding the Next Enron
Prescription for Disaster
By Rebecca Thomas
Of SMARTMONEY.COM
It's funny how Elan (ELN) and Enron (ENRNQ) share not only similar-sounding names but also a knack for manipulating profits using off-balance-sheet partnerships. Funny, that is, unless you're one of Elan's burned shareholders.
On Feb. 8, for the second time in three years, Elan acknowledged that the Securities & Exchange Commission is investigating how the world's 20th-largest drug company accounts for its research-and-development expenditures. The announcement followed a Jan. 30 Wall Street Journal report that revealed the existence of 55 joint ventures that Elan had structured to simultaneously shift R&D costs off its books and bring in revenue before any drugs are developed. The Irish company recently acknowledged that last year's profits would've been more than 40% lower and its debt $1 billion higher than reported if it had consolidated two of its 55 R&D vehicles onto its financial statements last year. Since the Journal's revelation, Elan's shares have plummeted nearly 60%.
In this post-Enron world, investors understandably want to know if Elan is an isolated case, or if the pharmaceutical industry is potentially as riddled with accounting problems as, say, the energy-trading business.
For the most part, truly questionable bookkeeping is an issue that plagues small, less profitable specialty-drug and biotech companies. In 1993, for example, Alza, a drug-delivery company that was recently acquired by Johnson & Johnson (JNJ), invested $250 million to establish Therapeutic Discovery, which then essentially hired Alza to develop drugs for it. Over the next five years, Therapeutic Discovery paid Alza $275 million. The effect was to artificially boost Alza's revenue line, says Philip Joos, an assistant professor of accounting at the William E. Simon Graduate School of Business Administration at the University of Rochester. Without Therapeutic Discovery, he explains, Alza would have recorded only its R&D expenses. In 1997, Alza repurchased Therapeutic Discovery for just $100 million and dissolved it, later selling the promising new drugs Therapeutic Discovery had generated.
If the Financial Accounting Standards Board had completed the job it started in early 1999, such sketchy R&D vehicles would no longer exist. But FASB ultimately backed out of a proposal that would've required drug companies to consolidate onto their books any R&D entity that they effectively controlled. "That was going to sound the death toll on these things," says Robert Willens, an accounting expert at Lehman Brothers. "Now we're back in business in terms of R&D vehicles."
Of course, that's not necessarily a bad thing. Such vehicles often allow a small firm to develop a product it might not otherwise have the resources or funding to pursue. In most cases, R&D vehicles are a perfectly legitimate, if complicated, way to do business. Rarely does the parent company profit from the venture before actual drugs are developed. And in most cases, the company will exercise its option to buy back the venture from its original investors for a premium, amortizing the expenses gradually over time (in a sense deferring rather than avoiding the costs). "It's not really sinister," says Kris Jenner, manager of the T. Rowe Price Health Sciences fund. "These things can really make sense." Even so, investors should recognize that a parent company isn't required to consolidate any revenues, expenses or debts from a venture onto its own financial statements so long as it owns less than a 50% stake, explains Brett Trueman, a professor of accounting at the Haas School of Business at the University of California, Berkeley. That can make it difficult to get a grasp on a company's real expenditures for drug development.
The good news is that big, well-established pharmaceutical companies tend to have fairly simple financial statements. "One of the nice things is that, in general, they have very straightforward, clean income statements and balance sheets," says Jenner. Morgan Stanley analyst Jami Rubin, who recently finished an in-depth review of the industry's accounting practices, says conservative accounting methodologies "are considered a given in the sector." In fact, Sanford Bernstein analyst Richard Evans says he knows of no evidence that any large cap companies "have substantial off-balance-sheet financing, revenues that can't be traced back to products, or covenants and commitments that might be triggered by a fall in stock price."
But while outright book-cooking is rare, earnings management to boost short-term performance is commonplace in this industry, as it is in many others. To help you navigate the sector, we've flagged a few of the industry's most creative bookkeeping tactics.
Joint Ventures/Alliances
Although true off-balance-sheet R&D vehicles are unusual among the majors, almost every large drug company is involved in comarketing or codevelopment alliances. These are always disclosed in the annual report - perhaps under a heading such as "alliance revenues" or "other income" - but companies often don't break out the financial details for competitive reasons. And the devil can be in those details. For example, Pfizer (PFE), which teamed up with Warner Lambert to comarket Lipitor, the cholesterol blockbuster, failed to mention that its commission rate would eventually drop substantially, notes Bernstein's Evans. Only by later acquiring Warner Lambert did Pfizer avoid the enormous financial consequences of this detail, he explains.
Channel Stuffing
To boost earnings at the end of a reporting period, a drug company may persuade a distributor to order extra weeks of inventory in exchange for some leeway in payment. Or it may announce an imminent price increase, giving the drug purchaser incentive to stock up on the product beforehand. According to UBS Warburg analyst Jeffrey Chaffkin, Schering-Plough (SGP) and Bristol-Myers Squibb (BMY) consistently maintain very high inventory levels at drug distributors, while Pfizer and Eli Lilly (LLY) typically carry low inventory levels. If these companies had simply maintained normal inventory levels last year, earnings at Schering-Plough and Bristol-Myers would've been 11% and 14% lower, respectively, while profits at Lilly and Pfizer would've each been 4% higher, he estimates.
Thankfully, channel stuffing is easily spotted by diligent analysts. Unit prescription data, which offers a truer picture of underlying product demand, is readily available from independent consultant IMS Health, notes Morgan Stanley's Rubin. Moreover, some companies will actually spell out the potential consequences of inventory unwinding in their quarterly 10-Q filings. A Schering-Plough spokesman declined to comment on the company's inventory practices. But its third-quarter 10-Q report does spell out that potential trade inventory reductions of allergy blockbuster Claritin could reduce pretax profits by as much as $175 million to $250 million - which would translate into a per-share earnings hit of six to 10 cents, Chaffkin estimates. As for Bristol-Myers, the company acknowledged in its third- and fourth-quarter conference calls that it had an inventory issue, according to spokesman Wilson Grabill. "It's not something that popped up in one quarter or that will be fixed in one quarter...but we're dealing with the situation in a way that's responsible," he says. The company has factored inventory reductions into its 2002 guidance.
Vendor Pressure
To meet a budget imposed by management, operating managers may call on any number of their company's suppliers - such as clinical research organizations or ad agencies - at the end of a reporting period to request a payment extension. Because the supplier needs the business, it's usually more than willing to accept a one-week or one-month delay. "If you can do it in enough places, you can have a dramatic effect on earnings in any given quarter or year," says Evans. "It's simply the way the game is played. It happens a lot."
Managing R&D in Acquisitions
How to treat the acquisition of in-process R&D has been debated for years among accountants, FASB and the SEC. As the rule currently stands, a drug company must immediately assign a value to any unfinished R&D it acquires (usually through a merger) and write off that amount immediately, effectively boosting earnings in later quarters. Problem is, there's potential for companies to overvalue their R&D in order to take an extra large charge that will artificially inflate future results. Although accountants and valuation experts are usually brought in to assign the R&D a fair value, "at the end of the day, the company's responsible for the numbers they report," says Dan Noll, director of accounting standards at the American Institute of Certified Public Accountants. "It's a very subjective process, although we try to be as objective as possible." The SEC cracked down on many such abuses (mostly in the high-tech sector) in the late 1990's. In some cases, it required companies to restate earnings to reflect smaller write-offs, while in others, it has simply sent out letters advising greater disclosure. Some accountants have argued that in-process R&D should be treated like any other asset and amortized against earnings over time.
Discovering Intangibles
Because the valuation assigned to a major drug company largely depends on the products in its pipeline, it's essential for investors to understand that many profit-influencing intangibles - such as a company's star scientists, product patents and clinical-trial developments - might never show up on the balance sheet, says the University of Rochester's Joos. Although periodic 8-K reports to the SEC often provide more information on such intangibles than quarterly or annual reports, a serious investor might want to consider other reliable sources, such as the U.S. Patent Office, which makes public the number of patents a drug company is granted in a given year, and medical journals, which often offer useful insight into disappointing clinical-trial results that a company might neglect to mention. For more information and analysis of companies and mutual funds, visit SmartMoney.com at smartmoney.com.
Updated February 26, 2002 8:15 p.m. EST |
