Elan Continues To Make Baffling Strategic Decision

By Stephen D. Simpson, CFA | May 21, 2013 AAA

When Elan (NYSE:ELN) announced back in February that it was selling its interests in Tysabri to Biogen Idec (Nasdaq:BIIB) my biggest concern was that Elan management would waste the proceeds. Elan management had made a series of questionable (if not bizarre) decisions prior to the Tysabri announcement, and I had minimal confidence that they would do the right thing – which, in my opinion, was simply to sell off the remaining assets and write a check to shareholders. Since then, the company's two major strategic decisions only reinforce my worries that Elan shareholders are not going to be well-served by management in the deployment of this cash.

SEE: Evaluating A Company’s Management

Overpaying For Theravance Royalties
Elan's first major move (after rebuffing a $5.8 billion buyout bid from Royalty Pharma) was to acquire 21% of the royalty revenue stream from Theravance's (Nasdaq:THRX) platform of partnered COPD drugs. The deal covers four drugs partnered with GlaxoSmithKline (NYSE:GSK) and the first (Breo Ellipta) approved in the U.S. and Anoro expected to be approved later this year.

The problem with this deal is the $1 billion price tag that Elan paid. Breo and Anoro could both be blockbusters, but competition is heating up in the COPD space and Theravance is only entitled to a portion of the revenue Glaxo generates from these drugs. With the net present value (NPV) of the Breo/Anoro royalties (based upon my revenue estimates) falling in a range of $400 million to $800 million, Elan is making a big bet that these two drugs significantly outperform and/or that the experimental drug in the deal (GSK961081) is a big hit.

If Elan had experience or expertise in COPD I could see the argument for Elan management pitting its judgment against that of the Street and/or Big Pharma (remember, Glaxo or another Big Pharma could have bought Theravance for 100% of their royalty streams and nobody has done so). As it stands, this looks like an expensive, high-risk deal.

SEE: Analyzing An Acquisition Announcement

More Curious Transactions
Elan has since followed up the Theravance deal with a few more high-risk moves that I believe will not build long-term value for shareholders.

In a pretty crowded press release, Elan announced multiple transactions on May 20th. First, the company will spin out its one remaining proprietary drug program (ELND005 for aggression in Alzheimers) as “Speranza Therapeutics”. Elan will spin it out with $70 million in financing, keeping 18% of the equity and certain royalty and marketing rights. A third party will contribute $20 million for a 62% stake. Investors may do well to ask why Elan didn't include this drug when it spun out its early-stage clinical assets into the company now known as Prothena (Nasdaq:PRTA).

Elan also announced that it was acquiring 48% of a start-up company called Newbridge Pharmaceuticals for $40 million, with an option to buy the remainder for $244 million in 2015. This company aims to acquire drugs for distribution in Africa, Turkey, and the Middle East, putting it into competition with well-established and well-run companies like Aspen Pharmacare, Adcock Ingram, Cipla, and Sanofi (NYSE:SNY).

Last and most significantly, Elan will spend up to $700 million to acquire AOP Orphan Pharmaceuticals – a privately-owned European drug company largely focused on drugs and therapies for rare diseases. Elan will pay $343 million upfront, with about two-thirds of that in cash, and up to $351 million more in milestones.

According to AOP's website, the company generates “over $65 million” in revenue and has four late-stage programs in hematology/oncology and cardiology/pulmonology. Here again, I have to ask if Elan is paying too high a price for a very uncertain stream of future revenue. AOP is not another Alexion (Nasdaq:ALXN) or BioMarin (Nasdaq:BMRN). I can see the company's Phase 3 drug for polycthemia vera having legitimate commercial potential (one of the current treatment options for this disease is basically bloodletting), but I have less optimism about the commercial potential of drugs for thrombocythemia, glioblastoma, and tachycardia. With two drugs in Phase 3 and another in Phase 2/3 development, though, it won't be that long of a wait to find out.

SEE: Biggest Merger and Acquisition Disasters

Building Value Or Wasting Capital?
The last bit of the May 20th announcement to talk about is the company's announced plan to pursue an $800 million debt offering to refill its cash coffers after these deals. I will be very curious to see how this offering goes, and what sort of terms the credit markets demand for this debt, as I don't believe there will be a great deal of confidence in the moves that management has made so far.

What bothers me most is that Elan paid premium prices for what I believe to be less-than-premium assets. Elan effectively said that the market was wrong on Thervance, imputing almost $6 billion in value to a company with a market cap around $3 billion at the time. Then the company decided to buy a start-up emerging market drug distribution business and a rare/orphan disease business.

Unfortunately, Elan has minimal experience with COPD, orphan diseases, or drug distribution in Africa and the Mid-East. What's more, remember that the CEO, Kelly Martin, came to Elan with 20 years of experience … at Merrill Lynch. That makes this a “trust us, we know better” type of situation where I'd argue there's no particular reason to do so.

In fact, I'll go so far as to argue that these transactions are about pride and preserving the income streams of executives rather than building value for shareholders. As such, if investors do not step up and essentially force Elan to abandon these moves and accept the Royalty Pharma offer, I think shareholders are looking at years of value erosion – slow erosion perhaps (as those royalty streams will keep cash flowing in), but erosion all the same. By contrast, Royalty Pharma is now offering $12.50 per share in cash with no risk, a deal that I think is too good to pass up.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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