Morgan Stanley on Elan
March 23, 2004
The New Elan: An Intriguing Late-Stage New Product Story
Price (March 22, 2004) $18
Price Target $30
52-Week Range $3-20
? Resuming Coverage with Overweight-V Rating and $30 Price Target
Our price target is based on a P/E multiple of 40x our 2007 EPS estimate of $1.17, discounted back two years by 25%.
? Our Investment Thesis is Fourfold
(1) R&D platform is more valuable than expectations (the bet is mainly Antegren); (2) Successful restructuring of balance sheet resulting in less financial risk; (3) Legal risks diminish without material harm to the company; and (4) New management has the skill-set to build an integrated pharma/biotech company.
? Antegren is the Key to the Story and is Not Discounted in the Stock, in Our View
Antegren is a special product, in our view, with multiple opportunities based on its mechanism of action. The two most important are multiple sclerosis and Crohn?s disease. We forecast Antegren sales of $2.5 billion in 2008.
? We Maintain Our In-Line View of the Specialty Pharma Industry
We believe on a market-cap weighted basis that our coverage universe will perform in line with the S&P 500 as 2004 will be a year of investment with limited upside to earnings expectations. However, we believe that the positive long-term trends remain in place for the group.
Summary and Investment Conclusion
We are resuming coverage of Elan with an Overweight-V rating. Our price target of $30 is based on a P/E multiple of 40x our 2007E EPS of $1.17, discounted back two years with a 25% discount rate. Our EPS estimates are ($0.87) in 2004, ($0.41) in 2005, $0.40 in 2006, $1.17 in 2007, and $1.96 in 2008.
Our investment thesis is fourfold. (1) The R&D platform (the bet is on Antegren) is more valuable than
consensus expectations and credibility for the science will continue to become more visible over the next 12 months. (2) A successful restructuring of the balance sheet will result in a much smaller but better positioned company, resulting in less financial risk and increased credibility that Elan can be a viable enterprise. (3) The legal risks, i.e., SEC and civil investigations, will not result in material harm to the company, which would also result in a lower risk profile for the company. (4) And new management has the right skill-set to leverage existing corporate competencies and over the next 3-5 years, build an integrated pharma/biotech company.
We view Elan as an intriguing last-stage biotech story that was previously enveloped in a failed specialty pharma business model. Our history with Elan is well documented. Our skepticism of the product choices and numerous aggressive transactions under the previous management team resulted in a negative view on the stock for many years. However, that was the old Elan. The company had a catharsis in the spring of 2002 and since that time there has been significant change at the company including the simplification of the operations and major workforce reductions. New management inherited what it termed as a loose confederation of products, functions, and locations that were not sustainable, a messy corporate balance sheet, and poor investor credibility regarding both financial and operational controls, but surprisingly strong employee commitment, especially the scientists. And new management inherited what we believe to be the key value driver going forward, a late-stage R&D portfolio. New management is materially restructuring the balance sheet, working aggressively to lower legal and financial risks and repositioning the company with the appropriate (i.e., more simplified) operational infrastructure, processes, and people to capitalize on this science platform. It has purposely been low key during the past year, remaining out of the limelight and has instead focused internally on getting its ?house in order.? We believe this conservative public posture is changing -- especially during the past month -- and we expect management to get out and more aggressively tell their story. And we believe that it has a strong story to tell investors.
We believe the new product story is late-stage and very interesting and includes Antegren and Prialt but Antegren is the key. Antegren is a special product, in our view, with multiple opportunities based on its mechanism of action. The two most important opportunities at this point are multiple sclerosis and Crohn?s disease, but the product also has the potential to work in rheumatoid arthritis and other autoimmune disorders. The product is in a joint venture with Biogen Idec whereby both companies will share the profits 50/50.
The Antegren Phase II data in both potential indications were robust and published back in January
2003 in the New England Journal of Medicine. And based on the strength of those studies the two companies began two pivotal trials in both indications. The two studies in MS include over 3000 patients. The first study, named AFFIRM, is a placebo controlled monotherapy study that measures how Antegren slows the rate of disability and reduction of clinical relapses. The second study, named SENTINEL, is a combination study with Avonex with the same endpoints. The first study in Crohn?s disease, named ENACT-1, includes moderate-to- severe patients and measures the percentage of patients with a clinical response at 10 weeks. The second study, named ENACT-2, measures Antegren in a group of responders to the first study in the maintenance of Crohn?s as measured by the CDAI index. With respect to the Crohn?s studies, earlier this year Elan/Biogen IDEC announced that the primary endpoint of response at week 10 in ENACT-1 was not significant due to the unexpectedly high placebo response. However, the maintenance primary endpoint in ENACT-2 was statistically significant. Additionally, ENACT-1 data in patients with elevated CRP levels and immunosuppressant therapy did reach statistically significance. The FDA has requested an additional study. The question that remains is whether Elan/Biogen Idec will file a rolling NDA with the additional data later or file all the data together (which would probably delay the filing roughly 10 months). Our understanding is that EU regulators will update the companies with advice on a filing strategy after it reviews the maintenance data in 2Q04. We conservatively assume the Crohn?s approval comes in 2006. Regarding the MS studies, Elan/Biogen IDEC have not released results yet. However, last month the two companies made a very significant announcement that, based on discussions with the FDA following a 1-year interim look within a 2-year study, they planned on filing an NDA for Antegren in MS earlier than expected (i.e., with one-year data rather than two-year data as did the other previous MS products currently on the market). This was always a possibility if the data from the interim look was as robust as the strong Phase II data, but, in our view, it was always a low likelihood. The news was well received by the market as the stock has more than doubled on the news during the past month. What remains unclear is whether the data that impressed the FDA was in monotherapy, or in combination with Avonex, or both.
The NDA filing is now planned for 2Q04 and we expect a six-month review clock and thus the product should reach the market in early 2005 in the US. It is still unclear how the EU regulators will view the data, but our working assumption is that they will be as impressed as the FDA appears to be. The opportunity for Antegren is significant, in our view. The MS market was roughly $2 billion in 2003 in the US and an additional $1.5 billion in Europe as well and consists of four drugs (Biogen IDEC?s Avonex, Schering?s Betaseron, Teva/Aventis? Copaxone, and Serono/Pfizer?s Rebif) that most specialists view as basically equivalent in terms of efficacy. Avonex is still the leader in the US because of its once weekly injections versus more cumbersome daily/every other day regimens. Many physicians that we have spoken with believe that, because of Antegren?s stronger efficacy, cleaner side effect profile and more convenient monthly infusion dosing, that at least half of treated patients will be on Antegren as combination therapy and that the majority of treated patients will be treated with Antegren as either monotherapy of in combination therapy. This feedback suggests to us that Antegren will be a paradigm shift in the MS market. At this point until we actually see the data and increase our sample size of physicians interviews, we choose to be more conservative with our numbers.
We assume Elan/Biogen IDEC will be aggressive with pricing, especially since some of the Avonex franchise will probably be cannibalized. However, physicians believe that Antegren will also expand the treated market such that it could ultimately be a net positive for Biogen IDEC, in our view. Our full report will include more details from our physician interviews and market models. The conclusion of the work is our $2 billion sales forecast for Antegren in 2008 in the US and Europe in MS only (see Exhibit 2). We also believe that Antegren has a major opportunity in Crohn?s disease as well but at this point we have spent less time analyzing how big that opportunity could be. We have also added $500 million of revenues in 2008 to account for usage in Crohn?s disease and other potential indications. We should see data in rheumatoid arthritis in early 2005.
It may ultimately be difficult to forecast the line items in Elan?s income statement because of its arrangement
with Biogen IDEC. The two companies still have not determined which company will book sales and expenses for the various indications. Therefore, we have developed a separate Antegren income statement and allocated half of the operating income to Elan. Because we have allocated R&D and SG&A for Antegren to the separate model, the R&D expense in Elan?s income statement declines significantly going forward, because its share was previously in the income statement (i.e., before 2005), and as would be expected the SG&A never ramps up on Elan?s income statement. What is so noteworthy, in our view, is how profitable the product should be for Elan, given the relatively minimal sales and marketing costs we believe it will take to maximize the opportunity. This operating leverage and thus very high operating margins are typical of biotech stories but not usual of large cap/specialty pharma companies, and probably will surprise many investors, in our view.
The restructuring of the company is mostly complete. The recovery plan included significant asset divestitures, reduction in headcount and cost structure, simplification of the company with 55 business joint ventures either restructured or ended, and a restructuring of the balance sheet with a successful $600 million financing. The significant asset divestiture program is wrapping up as management believes that it finally has to ?draw a line in the sand? with respect to what the residual asset base will look like and begin to move forward and focus on the operations. During the past year Elan has sold multiple franchises/ businesses and/or products and closed several facilities. Exhibit 1 includes the majority of the divestitures/closings, which has reduced headcount close to 60% (from 4,700 to 2000). Considering that the pharma/biotech industry knew the assets were ?on the block? and that speed was critical, it is remarkable how successful Elan was in raising the $2.1 billion, in our view.
The restructuring of the 55 joint ventures is also done. Elan has unwound the majority of the arrangements, while some deals will not be restructured -- as some corporate partners have gone bankrupt, do not want to spend legal fees, and/or just will not come to settlement terms for unwinding the deals. Management?s goals regarding this restructuring program has been to release the company from any future claims and close out its potential legal liabilities, reclaim certain intellectual property, and give up certain product rights to its partners. At times, it would like to keep a residual interest in limited product development, but only those with very small cash contributions. Importantly, the significant managerial resources supporting this effort have now been reassigned to the residual business.
Management is working aggressively to put the company?s legal issues behind it as quickly as possible. The SEC investigation into potential accounting irregularities continues, but, in our view, it clearly was delayed because of the longer-than-expected time to get the 20-F filed with the SEC last year. We still don?t know the ultimate outcome of this investigation, whether the SEC requires the company to (1) materially change its operations and/or impose a significant and harmful fine on the company, (2) make further restatements and/or impose a less significant fine, or (3) just give Elan a ?slap on the wrist? and/or fine. We expect a fine at a minimum but have not yet factored a payment into our models.
What gives us comfort that the worst-case scenario will not play itself out is that the SEC has been investigating this company for many years. The SEC knows about the off-balance sheet vehicles (EPILs, etc.) and other aggressive accounting maneuvers, and, in our view, if the SEC wanted to take action, it could and probably would have already. The SEC has its own internal processes that it must go through to complete these types of investigations. The regulatory climate has changed during the past two years. We believe that it is probably important to the SEC that it appears it was very thorough and fair. Also, management wants to be done with this overhang on the company. Hence, we do not expect management to object to some changes and a potential fine. The one caveat with this thought process is the other constituents in this process and residual implications for the civil litigations. An admittance of certain wrongdoings may have further impact to current or former employees of board members. And an admittance of wrongdoing could also potentially ?open the floodgates? on the civil litigations. Alternatively, a minor complaint from the SEC would probably greatly minimize the financial impact of the civil cases. Management believes these legal issues should go away by mid-2004. We believe that this management team will build a successful integrated pharma/biotech company. Investors have only seen current management in retrenchment mode, i.e., ?on the defensive?, but we believe management would like to grow the business and go ?on the offensive? sooner than most investors probably think. We believe that it may surprise some investors how quickly management moves to deepen its footprint in the company?s designated therapeutic franchises. We believe that many investors gave up on the company, believing it was not worth the time to do the work. This was our view for most of 2003. And we find it a little hard to believe that we are positive on the stock after such a tumultuous ride in 2001-2002, but management and the business practices have changed. There is more visibility in the business. It is a simple company to evaluate now. Management is very straightforward, with no evasion of tough questions. And the risks are apparent. The stock has had a major move off its bottom last year as the company?s restructuring and recapitalization program appear to be moving forward successfully, and, even more importantly, the recent positive R&D announcements. However, given our recent conversations with physicians, we believe that Antegren will be even bigger than what is currently discounted in the stock. We believe investors are just beginning to appreciate the opportunity. We are forecasting total Antegren sales of roughly $2.5 billion in 2008 and believe that we are conservative with our penetration assumptions. If we are right, over the next year, the SEC issues should go away without materially harming the company, the perceived financial risks by investors will diminish, and management will execute on the promise of its intriguing late-stage R&D pipeline. With respect to important near-term milestones, management indicated that over the next 18 months, it plans to file 3 NDAs in the US (Prialt for chronic severe pain and Antegren for both Crohn?s and multiple sclerosis), 4 MAAs in Europe (Zonegran, Prialt was just completed and Antegren for both Crohn?s and MS), and 3 INDs in the US to start clinical trials for Alzheimer?s compounds.
Investment Positives
New management is doing a good job in creating a very interesting and credible company. Management is committed to transparency, open communication, simplifying the business structure, and thoughtful resource allocation for the long term. During the past 18 months, Elan has reduced its financial, legal and regulatory risk, while continuing to invest in the strategic pipeline. We attribute the positive changes to new top officers, including CEO Kelly Martin, CFO Shane Cooke, and Head of R&D Lars Eckman.
Balance sheet significantly improved. Elan has moved quickly to sell off assets (divestitures of $2.1 billion) and restructure or end its 55 business ventures. It has reduced headcount by close to 60% (4700 to 2000) and accessed the capital markets for $600 million. Before the recovery plan, Elan had $4.5 billion of liability payments. Today that debt is down to $2 billion, and importantly, with an extended maturity schedule.
Strong late-stage new product story should provide solid news flow. During 2004-2005 Elan plans to file 3 NDAs in the US (Prialt for chronic severe pain and Antegren for both Crohn?s and multiple sclerosis), 4 MAAs in Europe (Zonegran, Prialt was just completed and Antegren for both Crohn?s and MS), and 3 INDs in the US to start clinical trials for Alzheimer?s compounds. Antegren has blockbuster potential. Antegren is a special product in our view with multiple significant opportunities based on its mechanism of action. The two most important opportunities at this point are multiple sclerosis and Crohn?s disease, but the product also has the potential to work in rheumatoid arthritis and other autoimmune disorders. Given the strong Phase II MS data and our working assumption that the pivotal trial data are as robust as the Phase II data, we believe Antegren will be a paradigm shift in the MS market at a minimum, and probably a very important product in Crohn?s disease as well. We forecast total sales of $2.5 billion in 2008.
Alzheimer?s Disease progression is a wild card not in our financial models. The franchise consists of four programs: (1) a passive immunization strategy with a humanized monoclonal antibody (IND was filed in 2003); (2) A-beta immunoconjugate that combines a fragment of AN-1792 (Beta amyloid) and a conjugate that replaces a part of AN-1792 that Elan/Wyeth believe may have caused the inflammation in AN-1792; (IND to be filed in 2004) (3) Beta secretase inhibitor (IND to be filed in 2005; (4) And Gamma secretase (IND to be filed in 2006). These are high risk/high reward projects that, in our view, if any one of them worked, it would transform Elan into a major biotech company. However, this is not part of our thesis.
New manufacturing operating model should add value. Elan has aggressively invested in the expansion of its Athlone manufacturing facility. The total spend over the past three years has been $178 million. The facility has about 500 employees and manufactures very few products. In fact, capacity usage is only around 40% according to management. However, this should change as Elan slowly moves new products into the plant. The goal is around 85-90% capacity utilization in 3 years and significantly enhanced profitability, as the facility will be managed with its own P&L. Elan has just recently moved Zonegran in house and now manufactures all 3 dosage forms. Packaging capabilities are now being added. Elan plans to do some of the fill/finish for Prialt (Mallinckodt will manufacture the API) in commercial vials. And Elan is also in discussions with potential partners to contract manufacture as well. The Ireland location and tax status should help attract potential partners, in our view.
Prialt could be an upside surprise given the low expectations. Prialt is a potent analgesic for severe pain
that is infused monthly and administered via an implantable pump. Given the history with this product, we
believe that investors attribute little value to this product, such that any success would be viewed positively,
including even regulatory approval in the first place. Given management?s discussions with the FDA, management appears confident that the drug can be approved in a niche population of refractive Morphine
patients and that the planned aggressive pricing for the product could result in revenues in the $150-250 million range. Our models include a sales of $100 million in 2008.
Antegren and Prialt should be very profitable. Both products will probably need minimal sales reps and
advertising and promotion spending to get the word out to physicians and patients, as MS, Crohn?s, RA, and pain management are all specialist markets with significant ?word of mouth? regarding new successful therapies. Hence, we forecast operating margins of 70% and 90% for both Antegren and Prialt, respectively.
Investment Concerns
Legal risks are still outstanding. With the minor financial restatements in September 2003, we believe the
accounting/corporate finance side of the SEC?s investigation is complete. Hence, we believe the outstanding legal risks are two-fold but intertwined. First, the enforcement section of the SEC continues to investigate Elan since February 2002, looking at disclosures related to differences in US versus Irish GAAP accounting as well as other definitions and technical issues. Elan management continues to indicate that the SEC is not focused on criminal issues and that the SEC should be done soon with its process. Second is the shareholder civil lawsuits that, in our view, are waiting on the results of the SEC enforcement investigation. We believe Elan will probably have to pay a fine, but that the amount will not be such that materially harms the company or impacts our investment thesis.
Perceived financial risks still outstanding. Because of all the change at the company, the existence of QSPEs (EPIL II and EPIL III) and the other debt, we believe many investors still believe there is a significant financial risk at Elan. We disagree. A significant part of the $2 billion of debt is a convertible security that is ?in the money? and thus quasi equity. Elan has not only about $1 billion in cash (including the recently announced divestitures this quarter) but also a $550 million investment portfolio that it is ready to liquidate over the next 18 month plus other residual valuable assets that it could sell off and still not negatively impact its product pipeline. Hence, we believe the financial risk is now minimal.
Execution risk. Where there is significant change there is execution risk, in our view. And this change is occurring on multiple levels and very quickly. Elan must successfully build out a commercial infrastructure to sell Antegren and Prialt, and we believe deepen its footprint in its focused therapeutic areas in order to take Elan to the next level as a company.
Multiple Sclerosis market is competitive with multiple major players. The market includes Biogen IDEC (Avonex), Teva/Aventis (Copaxone) Serono/Pfizer (Rebif), and Schering AG (Betaseron). We expect all the established competitors to increase the noise level to protect their respective franchises but are not able to prevent Antegren from becoming a significant product.
Structure of Biogen IDEC Antegren venture may make it difficult to forecast the line items in Elan?s income statement. The two companies still have not determined which company will book sales and expenses for the various indications. Therefore, we have developed a separate Antegren income statement and allocated half of the operating income to Elan.
Prialt has a few tough hurdles to overcome. First is the stigma attached to this drug from the clinical trial history. Second is the narrow therapeutic window (i.e., the tradeoff between efficacy and side effects during dose titration is difficult to measure) that may scare away physicians. Third is the fact that the product will predominantly be used in implantable, intrathecal (IT) pumps and there are only 36,000 IT pumps currently implanted in patients. We have conservative patient penetration assumptions because of these issues, but the significant pricing planned by Elan should enable the product to eventually grow to $150-250 million in sales according to management. Additionally, we believe the product will have a very high operating margin (we estimate over 90%) and thus will be very profitable for Elan even at low sales levels.
Valuation and Industry View
We view the new Elan as closer to a biotech than a specialty pharma company, based on its characteristics:
currently unprofitable but with very strong growth once the company breaks even in late 2005; and the key growth driver -- Antegren -- is a biotech product with the accompanying higher barriers to entry from generic competition.
Our initial one-year price target is $30, based on a P/E multiple of 40x our EPS estimate of $1.17 in 2007, discounted back two years with a discount rate of 25%. We determine our discount rate based on risk, including clinical trial, regulatory, and commercial. We believe Elan?s risk profile is lower than what is typical in biotech because of the strong late-stage, clinical data that we have seen and the strong partnership with Biogen IDEC. Regarding the Phase III MS data, because of the FDA?s willingness to accept pivotal data based on an interim one year look, we assume the data is very strong. Hence, we are comfortable with a discount rate of 25%. We determine our P/E multiple based on the company?s revenue and earnings growth. With respect to the target P/E multiple, we estimate a forward 3-year EPS CAGR of roughly 40%, which is at the high end of the range that our biotech team forecasts for its universe. The current average for profitable biotech companies is 42x 2004 EPS. The average P/E-to-growth multiples in the profitable biotech and branded specialty pharma sectors are roughly
1.5 to 2x, which would imply a target P/E multiple in the 60-80x range. Hence, we believe our target multiple is very reasonable.
Our specialty pharmaceuticals industry view is In-Line as we believe that, on a market-cap weighted basis, our coverage universe will perform roughly in line with the S&P 500. We believe 2004 will be a year of investment with limited upside to earnings expectations. There are new important products, but in our view, few have the opportunity to significantly outperform. Competition for drug acquisition/in-licensing opportunities has increased significantly, with some larger companies reemerging as competition for specialty pharma. And we believe some companies may enter into defensive transactions that will probably end up dilutive to short-term GAAP earnings. We do believe, however, that the positive long-term trends remain in place for the group.
Analyst Certification
The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Marc Goodman.
Important US Regulatory Disclosures on Subject Companies
The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its affiliates (collectively, "Morgan Stanley").
As of February 27, 2004, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in this report: Elan Corp.
Within the last 12 months, Morgan Stanley managed or co-managed a public offering of securities of Elan Corp.
Within the last 12 months, Morgan Stanley has received compensation for investment banking services from Elan Corp.
In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from Elan Corp.
The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.
Morgan Stanley & Co. Incorporated makes a market in the securities of Elan Corp.
Analyst Stock Ratings
Overweight (O). The stock?s total return is expected to exceed the average total return of the analyst?s industry (or industry team?s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Equal-weight (E). The stock?s total return is expected to be in line with the average total return of the analyst?s industry (or industry team?s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Underweight (U). The stock?s total return is expected to be below the average total return of the analyst?s industry (or industry team?s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst?s view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner.
Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.
Analyst Industry Views
Attractive (A). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark named on the cover of this report.
In-Line (I). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark named on the cover of this report.
Cautious (C). The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark named on the cover of this report. |
