Jenks Healthcare Business Report March 2003

In the March 2003 issue:

Big Pharma: Time to Renew Investor Trust?

It’s unfortunate that, given how wary investors are these days, some pharmaceutical companies have tarnished their Blue Chip images. In an industry with no shortage of bad PR, it’s time to stop fooling around. See page 1

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Public Equity Market

Regardless of earnings, investors are still extremely cautious, with few results triggering any enthusiasm. No health care IPOs were filed; two secondaries priced, with differing results. See page 3

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Venture Capital Market

The pace of venture investment had been too hot not to cool down, but 35 companies still managed to raise $320.6 million this month. Biotech and Medical Devices made two-thirds of the deals, leading LPs to worry about a “biotech bubble.” See page 5

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Feature Stories

PIPE Dreams. With the chill in the public markets, seven publicly traded companies turned to private equity this month, raising $121 million. Charts on page 4. See page 5

Profile: Elixir Pharmaceuticals. The next in our series of closer looks at firms successfully attracting VC. This one managed a merger at the same time. See page 10

Jenks Healthcare Business Report

Big Pharma: Time to Renew Investor Trust?

With all of the corporate accounting scandals of the past two years, some of which were pure fraud and others aggressive—and misleading—financial manipulation (some may say there is little difference), investors cannot be blamed for being wary of anything coming from the mouths of corporate chieftains. And they are more than wary of GAAP financial statements, especially given the record of many of the country’s leading auditors. In corporate America, it is hard to get any more "Blue Chip" than the pharmaceutical industry, but the blue has been fading lately, and that is an unfortunate development for this crucial industry.

It was nearly a year ago that Bristol-Myers Squibb (NYSE: BMY) was forced to reveal that wholesale inventories of its medicines were too high in the U.S. and that reducing them would hurt 2002 earnings. BMY’s shares dropped 15% on the announcement, but that came on the heels of a 15% drop 10 days earlier when management announced poor results for a new drug that was expected to be a blockbuster, and after the ImClone Systems (NASDAQ: IMCL) debacle as well. The timing also occurred towards the end of Peter Dolan’s first 12 months as CEO of the company, perhaps the worst first year period for any CEO in recent memory.

But the excessive wholesale inventory "problem" was deeper than previously thought, and the company was forced to go back and restate its financial statements for the three years 1999 to 2001, the results of which were finally released in the second week of March 2003. The net result was that for the prior three-year period, revenues and earnings from continuing operations were reduced by about $2.5 billion and $900 million, respectively, but the financial results for 2002 were adjusted upward, although not quite as much.

The press release issued on March 12 was about the most boring document we have encountered in a while, but no one ever said reading about accounting issues would keep you up at night, unless, of course, you were the cause of those issues. Most of the inventory build-up occurred with two drug wholesalers, Cardinal Health (NYSE: CAH) and McKesson Corp. (NYSE: MCK). The inventory build-up, as we all now know, was the result of end-of-quarter sales incentives to these wholesalers, otherwise known as managing your quarterly earnings. BMY blamed the problem on an accounting principle called "consignment sales," and how they failed to accurately treat the incentivized sales to wholesalers using the specific criteria of consignment sales, causing the three-year financial restatement.

The company expects that the excess inventory held by wholesalers will be worked down by the end of 2003, and that earnings this year will be in the range of $1.60 to $1.65 per share, which means that the stock is trading at 13x 2003 earnings. That appears to be relatively low, especially with a 5.2% dividend yield, but future growth remains cloudy, and the P/E multiple is supposed to reflect the growth expectations. Only four analysts have a "buy" rating on the stock, while 18 had "holds" and 10 had "sells." Obviously, they are not convinced.

Management at BMY is trying to clear the slate for 2003, having settled, just before the accounting restatement announcement, charges by the Federal Trade Commission that it engaged in anti-competitive business practices over the past decade in an effort to prevent competing generic drugs from coming to market. It also said the company reached a deal with 29 states that sued BMY over similar issues. By dealing with all of the troubling issues one by one, management probably hoped that it would regain investors’ trust and would be able to move on to better days.

Unfortunately, Mr. Dolan was not on the conference call with analysts going over the accounting restatement, and made no pronouncements in the press release. This decision, whether intentional or not, opened the door of skepticism a bit in a market environment where even a window left open a crack will cause investors to flee. Did Mr. Dolan not get involved because it was an accounting issue that should be treated by the CFO? Did he not take an active role at the time of the announcement in order to remove himself from the taint of scandal?

We don’t know the answer to these questions, but as the CEO he is perhaps the only one who can instill some level of confidence with shareholders, and if he is not there today to answer the hard questions, who will be there tomorrow? Goldman Sachs was retained last June to assist BMY’s management in looking at strategic alternatives, including a possible sale of the company. Obviously, nothing could be done until the accounting problem was resolved, but we wonder what Goldman is telling the Board now.

Bristol-Myers is not the only pharmaceutical company suffering from a credibility problem with shareholders. Late last September, senior management of Schering-Plough (NYSE: SGP), including CEO Richard Kogan, met privately with fund managers at Putnam Investments. While there is nothing inherently wrong with this, and it remains a common practice between institutional investors and senior management to get a better understanding of what is happening with a company, SGP’s shares dropped by 17% in the days that followed those meetings. In fact, they started dropping shortly after the fund managers returned to their desks.

A few days later, SGP management significantly lowered earnings expectations for the third quarter of 2002 as well as for all of 2003. Obviously, everyone figured that the proverbial cat was let out of the bag at the private meetings, and as even a first semester business school student knows, that is a no-no. Just this month, SGP has received notice from the SEC that it plans to recommend a civil action against the company regarding possible violations of the SEC’s Regulation Fair Disclosure, notoriously known as Reg FD. Meanwhile, in early March SGP’s shares hit a six-year low after management lowered 2003 earnings forecasts (again) by 25%. To the best of our knowledge, there had been no meetings scheduled with Putnam ahead of the announcement (just kidding).

Like most of the pharmaceutical industry, Schering-Plough is suffering from competitive generic drugs, but the maker of Claritin—which had reached more than $3.0 billion in annual sales, lost its patent protection last December and is seeing its market share plunge faster than SGP’s share price—is suffering more than most of its brethren. The company also is without a replacement for Mr. Kogan, who has one foot out the door of retirement and one hand on his $50 million severance package in a deal that has to rankle investors who have seen SGP’s share price tumble from $60 to $15 in just three years. The outgoing executive, as part of the severance agreement, has agreed to cooperate with any pending or future government or regulatory investigation of SGP, which is quite generous of him since his role was so prominent in the current investigation. No wonder investors have deserted the stock, and our guess is that SGP will be put on the auction block at some point. But, as they always say, buyer beware.

The problems at Bristol-Myers and Schering-Plough, although somewhat old news, paint a picture of an industry not in control of its destiny. Add to this the brewing controversy at Merck & Co.’s (NYSE: MRK) Medco Health Solutions division, where it is alleged that Medco has persuaded doctors to prescribe drugs from companies that are paying it rebates even if competing drugs are cheaper, and you have an ever widening credibility gap.

As we were going to press, Baxter International (NYSE: BAX) announced that first quarter earnings would be almost 15% below previous estimates because of competition, and its stock immediately plunged by nearly 25%. In addition, Connecticut’s attorney general announced he was suing seven pharmaceutical companies for allegedly inflating wholesale drug prices (SGP was among those named, but not BMY). Recognizing that state AGs sue pharmaceutical companies as much for votes in the next election as for anything else, it represents yet another case of bad PR for an industry that can’t remember when it had any good PR. The U.S. pharmaceutical industry is so dominant in the world market, and so important to the future of our health care industry, it needs to turn itself around before more damage is done. The sector remains profitable, and it should be profitable, but it is time to renew investor trust in a sector that has been the bluest of blue chip for so many years.

Read the past headlines.