As mentioned in my most recent article on the implications of the horrific crash in Ophthotech (NASDAQ:OPHT), increasingly my attention within the biotech space is away from the juniors, as being too risky and often poorly managed. Having covered all the larger biotechs and recently having written my first article on an outstanding mid-cap biotech, Incyte (NASDAQ:INCY), that left Alexion (NASDAQ:ALXN) as the most important mid-cap I have had little to say about since beginning to focus my analysis on this one sector.
The only comment I recall making on ALXN was in a June 19, 2015, article titled Is Biotech Finally In A Bubble?, in which I listed some biotechs in order. I had this to say about the second on the list, ALXN:
Alexion: This ultra-orphan $37 B market cap company trades at a high P/E using non-GAAP numbers and a very high P/E on GAAP EPS. A few companies are gunning for its lucrative Soliris franchise, so there are both volume and pricing pressures that could bring the stock down.
Conclusion: Possible bubble valuation.
At that time, ALXN was trading around $184. As I write this, it has closed Tuesday at $110, a price it first reached in September 2012. Another way to look at it is that ALXN is trading below any price it appears it traded at since October of 2013.
Yet no product has been recalled. No make-or-break clinical trial has failed. The sales trend is upward, the company is profitable, and it has an important niche in a part of the biotech field in which it is the pioneering innovator.
With issues swirling around the company and the stock potentially at an attractive entry point, this struck me as an interesting time to write my first article on what I believe is the largest market cap company focusing on rare diseases.
Introduction to ALXN
The company was founded in 1992 and IPO'ed in 1996. In 2000, ALXN acquired an antibody company, Proliferon, and renamed it Alexion Antibody Technologies, Inc. In 2007, a breakthrough humanized antibody, eculizumab, was approved by the FDA and the EMA for treatment of the ultra-rare, serious disease PNH (paroxysmal nocturia hemoglobinuria). Due to the very small market size and serious nature of PNH, Soliris quickly became the most expensive drug in the world (though its cost has now been surpassed). Soliris, which blocks an overactive part of the immune system called the complement system, was later approved for a different, also ultra-orphan very serious condition, aHUS (atypical hemolytic-uremic syndrome).
Yet, there was some trouble brewing. The company had recurrent problems at the plant manufacturing Soliris; it continues to have an unresolved FDA inspection that resulted in "483" violations.
Additional issues surfaced. As the second quarter (i.e., most recent) 10-Q states (p. 48):
We are subject to FCPA, the U.K. Bribery Act, and other anti-corruption laws and regulations that generally prohibit companies and their intermediaries from making improper payments to government officials and/or other persons for the purpose of obtaining or retaining business and we operate in countries that are recognized as having a greater potential for governmental and commercial corruption. We cannot assure that our compliance program, policies and procedures will always protect Alexion from acts committed by its employees or third-party distributors or service providers.
In May 2015, we received a subpoena in connection with an investigation by the Enforcement Division of the SEC requesting information related to our grant-making activities and compliance with the FCPA in various countries. The SEC also seeks information related to Alexion's recalls of specific lots of Soliris and related securities disclosures. In addition, in October 2015, Alexion received a request from the DOJ for the voluntary production of documents and other information pertaining to Alexion's compliance with the FCPA. Alexion is cooperating with these investigations. At this time, Alexion is unable to predict the duration, scope or outcome of these investigations.
This could be non-trivial issues, as the document goes on to caution:
Any determination that our operations or activities are not, or were not, in compliance with existing United States or foreign laws or regulations, including by the SEC or DOJ pursuant to its investigation of our compliance with the FCPA and other matters, could result in the imposition of a broad range of civil and criminal sanctions against Alexion and certain of our directors, officers and/or employees, including injunctive relief, disgorgement, substantial fines or penalties, imprisonment, and other legal or equitable sanctions. Additionally, we could experience interruptions of business, harm to our reputation, debarment from government contracts, loss of supplier, vendor or other third-party relationships, and necessary licenses and permits could be terminated. Other internal or government investigations or legal or regulatory proceedings, including lawsuits brought by private litigants, may also follow as a consequence. Cooperating with and responding to the SEC and the DOJ in connection with its investigation of our FCPA practices and other matters, as well as responding to any future U.S. or foreign governmental investigation or whistleblower lawsuit, could result in substantial expenses, and could divert management's attention from other business concerns and could have a material adverse effect on our business and financial condition and growth prospects.
That was a bit of a problem, but perhaps there is worse.
Before I get to that, if I may get on a soapbox for just a sentence or two to say that I take these disclosures seriously. I think it's a sign of a market frenzy that they are ignored. I remember that a sign of the 2002 bear market ending was some minor accounting issue raised on Omnicom (NYSE:OMC), a strong company, sending the stock down on no real problem. However, investors were jumpy in the wake of Enron, WorldCom and other real problems. That was a classic buy point.
However, we now have this almost lackadaisical response by investors, calmed by years of rising stock prices.
The current mess
This is how I reported it in a blog post on November 12 titled Alexion Keeps Dropping - I'm Still Not Interested:
Alexion, a rare diseases pharma company, has dropped some more to close at $113.62 Friday. The company has delayed releasing its 10-Q due to its internal investigation of a whistleblower's allegations of improper sales practices for its key drug Soliris.
If a company is innocent and knows it is innocent, I would think it would simply report the existence of the internal investigation, file the 10-Q, and report to the public and SEC promptly when there is a finding.
This is not ALXN's first brush with controversy.
Last year, possible violation of the Foreign Corrupt Practices Act was reported: DOJ investigates Alexion for bribery.
ALXN has also had a long history of repeated violations of Good Manufacturing Practices at the plant that manufactures Soliris, including bacterial contamination. These have apparently been found by the FDA in 2011 and again in 2012; and again this year (different violations).The stock is down, but I will still stay with the highest quality companies in the sector.
I also added a comment on a point I'll discuss later:
Finally, the company acquires rare disease companies at big premia and then emphasizes non-GAAP accounting.
I go through this because this was from one month ago. Also, the links in that post are valid, and demonstrate the specific issues as reported by the financial media.
And now we have this press release from Monday morning:
-- David Brennan, Alexion Board Member and Former CEO of AstraZeneca PLC, Named Interim CEO --
-- David Anderson, Former CFO of Honeywell, Joins Alexion as CFO --
... Mr. Brennan succeeds David Hallal who has resigned for personal reasons, effective immediately. Mr. Hallal has also resigned from the Board. Spencer Stuart has been engaged to commence the search for a permanent CEO.
... Mr. Anderson succeeds Vikas Sinha, who has left Alexion to pursue other opportunities.
The CEO is canned "for personal reasons," and the CFO suddenly decides "to pursue other opportunities."
Now, here's the thing. After the drop to the $114 range one month ago, ALXN rallied sharply on no news. The Q3 earnings report had already been released, which will be discussed later. Yet, the stock hit $132 just on December 9.
So while, yes, it's a big percentage drop from that price to the $110 close on Tuesday, it's an insignificant drop from the price it was at when I wrote that little blog post.
Therein lies the problem for me. Canning both the CEO and CFO has, in the past, led to stock price crashes. Yet, the Street, to me, was almost shrugging a month ago, when I took so seriously the delay of the 10-Q, a Valeant (VRX) level tactic, that I did a blog post on a company I was not even covering. And now I wonder if there is really more insouciance than is prudent.
Let's look and see if the operational strength of this company is so great as to justify a price that leaves the stock at 67X TTM GAAP EPS.
First, where I always begin when analyzing a company, some observations on the balance sheet, then the P&L statement.
The ALXN balance sheet: Lots of air
This is one of the perplexing situations where, due to heavy R&D expense and share buybacks, a company that has operated Soliris profitably for years shows the following balance sheet. This is from the Q3 press release, which was issued on October 27 (even though the company then decided not to file its quarterly 10-Q report with the SEC in a timely manner):
|September 30,||December 31,|
|Cash and cash equivalents||$||761,989||$||1,010,111|
|Trade accounts receivable, net||676,837||532,832|
|Prepaid expenses and other current assets||241,768||208,993|
|Property, plant and equipment, net||931,060||697,025|
|Intangible assets, net||4,467,726||4,707,914|
|Accounts payable and accrued expenses||$||530,083||$||460,708|
|Current portion of long-term debt||122,942||166,365|
|Other current liabilities||36,066||6,234|
|Current portion of contingent consideration||81,848||55,804|
|Long-term debt, less current portion||3,129,384||3,254,536|
|Facility lease obligation||224,442||151,307|
|Deferred tax liabilities (1)||343,794||528,990|
|Total stockholders' equity (1)||8,504,103||8,258,616|
|Total liabilities and stockholders' equity||$||13,293,462||$||13,097,881|
(This is Table 5)
First, the company is clearly quite liquid, so there should be no issues on that front.
Second, total shareholder equity is $8.5 B. Intangibles and goodwill, however, total $9.5 B.
From the Q2 SEC filing, we see about $1 B in Treasury stock.
So even after accounting for buybacks, this company has operated profitably and turned its profits somewhat into share buybacks and mostly into intangibles and goodwill. Before getting to the main source of them, the P&L needs to be looked at.
ALXN - Superb underlying profitability
Soliris is a gold mine, but actual EPS was only $0.42:
|Three months ended||Nine months ended|
|September 30||September 30|
|Net product sales||$||798,524||$||665,791||$||2,251,495||$||1,902,107|
|Cost of sales||71,095||54,057||190,708||175,463|
|Research and development||195,687||165,664||551,288||518,437|
|Selling, general and administrative||230,128||212,520||694,491||621,019|
|Amortization of purchased intangible assets||82,036||36,608||242,185||36,608|
|Change in fair value of contingent consideration||40,290||29,684||30,676||45,707|
|Total operating expenses||548,705||458,012||1,522,694||1,288,360|
|Other income and expense:|
|Foreign currency (loss) gain||(1,011||)||2,795||(3,740||)||1,755|
|Income before income taxes||158,114||139,359||471,677||423,596|
|Income tax expense||63,776||323,116||165,113||345,815|
|Net income (loss)||$||94,338||$||(183,757||)||$||306,564||$||77,781|
|Earnings (loss) per common share|
|Shares used in computing earnings per common share|
Note that the cost of sales, or COGS, is only about 9% of revenues. That includes a high COGS ratio for the two minor products the company sells other than Soliris. The Soliris profitability is therefore nicely higher than 91%.
Investors can look at the underlying profitability of a company different ways. One way I think about it is to mentally continue the corporation along with its existing capital structure and the same stock-based compensation. But I ask, what if R&D ceased? And, in the case of special line items above, namely "Change in fair value of contingent consideration," what happens if that did not exist? (Apologies, but I have not researched whether there is any predictability in this line item or whether it can jump around from being a cost to a line item profit center). And of course, amortization charges reflect debt, so one way or another, they are real.
So, I mentally adjust the stated pre-tax operating income of $179 MM and add the R&D expenses of $196 MM and the change in the fair value of the contingent consideration of $40 MM to get underlying theoretical earnings of $415 MM. Then, while I cannot know if the tax rate would change somewhat, I subtract taxes at the same 40% rate the company uses for its reported earnings in Q3. This gives $252 MM, or $1.11 per diluted share.
Note the company guides to a lower tax rate for the full year of about 33%. So that would change this adjusted number somewhat.
At about $4.45 per annual adjusted after-tax earnings (could be higher using a 33% tax rate) versus a $110 stock price, ALXN is not at all cheap. Clearly, it requires profitable growth to justify its share price, given this adjusted P/E.
Is this likely? Let's look at Soliris and the other two younger products.
A brief look at ALXN's product list
Soliris treats two ultra-orphan diseases, PNH and aHUS, and has no approved competition for them. Yoy sales growth is low-double digits now, and there may be no price flexibility anymore, with annual charges in the $400,000-500,000 per patient.
The company had a failed Phase 3 study this year for a new indication in severe myasthenia gravis, but hopes to gain regulatory approval nonetheless. I'm not expecting that, as prescribers are free in the US to use an approved drug off-label. But we shall see. Other indications are being sought for Soliris but cannot be relied on.
The patent on eculizumab (Soliris) expires in the US in 2021. Other patent protection is being sought but may not be protective; see pp. 10-11 of the 2015 10-K for details including EU protection.
The next important product, which came via acquisition and is growing rapidly, is Strensiq. Sales soared from low numbers to $61 MM in Q3 (All these sales numbers are as reported in the press release, not audited and not submitted to the SEC).
There will be further sales growth here, though to what number remains to be seen. Strensiq will not be suitable for additional indications, and should have US patent protection to at least 2026, likely beyond that date if patent term extension is granted.
The young product, Kanuma, acquired by acquisition, had nominal sales. The deal that brought Kanuma to ALXN is a potential sore spot with me. It ties together the debt load and intangibles and goodwill issue, so it is discussed next.
Kanuma and the 2015 Synageva deal
On May 6, 2015, ALXN announced:
Alexion Pharmaceuticals, Inc. and Synageva BioPharma Corp. (NASDAQ:GEVA) announced today that they have entered into a definitive agreement pursuant to which Alexion will acquire Synageva for consideration of $115 in cash and 0.6581 Alexion shares, for each share of Synageva, implying a total per share value of $230 based on the nine day volume-weighted average closing price of Alexion stock through May 5, 2015. The acquisition strengthens Alexion's global leadership in developing and commercializing transformative therapies for patients with devastating and rare diseases.
The transaction... is valued at approximately $8.4 billion net of Synageva's cash. The transaction is expected to accelerate and diversify Alexion's growing revenues, and Alexion expects to achieve annual cost synergies starting this year and growing to at least $150 million in 2017. In addition, the transaction is expected to be accretive to non-GAAP earnings per share in 2018.
The Baker Brothers were involved:
"This transaction provides Synageva shareholders with immediate value and the opportunity to participate in Alexion's long-term growth potential," said Felix Baker, Ph.D., Chairman of Synageva's Board of Directors. "I am excited to be joining the board of Alexion, a leading, global biotechnology company that is aligned with the mission that Synageva was founded upon - to serve patients who would otherwise be left behind."
Synageva was founded by one or more Roche (OTCQX:RHHBY) employees and utilized certain Roche/Genentech technology.
The reaction from the industry was less impressed than ALXN was, based on cost of the deal, which was struck as the biotech sector (NASDAQ:IBB) was peaking. For example, the opinion of the expert at Bloomberg was quoted as saying this:
"It raises questions on what hidden value Alexion sees in Synageva's pipeline," wrote Asthika Goonewardene, a Bloomberg Intelligence analyst. "Given the limited contenders in rare diseases, this may also have been a result of a bidding war."
As a reminder of the way things were in Q2 2015 in biotech, the next paragraph portrays a soaring ALXN stock as a left-behind:
Alexion has lagged behind the biotech industry's stock-market surge, with its stock rising 93 percent in the past three years, or about half the increase in the Nasdaq Biotechnology Index.
Nearly doubling in three years was only half the average performance!
This point is why it's irrelevant to me as to how high ALXN once traded.
There are many potential values that Synageva could bring to ALXN over time; it's too soon to opine on whether this was a good deal for ALXN shareholders, though I'm a bit skeptical given the overvaluation prevalent at the time. And to some extent, since half the deal cost was in cash and half in stock, the stock part involved trading one overvalued asset for another. That's a 1999-type phenomenon and ultimately does not harm Alexion's shareholders, but only if they accept that ALXN was overvalued in Q2 2015.
What about the next-generation Soliris?
As ALXN discloses in its 10-K (p. 23), "other companies have initiated clinical studies for the treatment of PNH, aHUS..." With potential US biosimilar competition for Soliris as soon as 2021, ALXN has been moving along into Phase 3, the alleged next-generation version of Soliris, with a longer duration of activity, ALXN1210. The company has disclosed the design of a Phase 3 study for PNH. It compares "1210" given at about 3,300 mg every eight weeks with Soliris given at its usual 900 mg dose every two weeks. So the total dose is about the same.
This raises the question of what would happen if Soliris were given as 1,800 mg every four weeks or 3,600 (or 3300) every eight weeks. How much as ALXN looked at that?
The question is raised here because if Soliris falls to biosimilars in 2021, questions of how to use the biosimilars will be raised. If a payor has the choice between ALXN1210 as a branded product for $500,000 per year and a biosimilar to eculizumab at a much lower price, will some biosimilar company study its biosimilar both at the Q2 week labeled regimen and also at a Q4 week regimen? There is, after all, only so much patient convenience that an insurer will pay for when these sums of money are involved.
One of many questions I ask is whether 1210 will have to cut its price from the Soliris price range to something closer, perhaps much closer, to that of biosimilars in order to be acceptable to insurers and PBMs. Nothing would surprise me as the medical payment world (d)evolves.
Note, there is a Phase 3 study of 1210 in aHUS using the same dose as in the PNH study, but there is no comparator Soliris group in this study.
I'm just not sure how to value ALXN1210. It certainly has a positive present value, but it's guesswork as to how biosimilars will do versus this drug versus any competitors that attack these diseases with their own proprietary branded IV, subcu, or oral drugs.
Comments on the investigation
The now-fired CEO, David Hallal, had a sales background, and there are now Federal investigations of bribery in foreign territory and improper sales practice(s) in the US.
On Nov. 9, the company said this:
At this point in time, the Audit and Finance Committee's investigation has not identified instances where Soliris orders were not placed by customers for patients or any facts that require the Company to update its previously reported historical results.
But on Monday, Dec. 12, the company modified that sentence within this paragraph:
The previously announced Audit and Finance Committee investigation is nearing completion. At this point in time, the Audit and Finance Committee's investigation has not identified any facts that require the Company to update its previously reported historical results. The Company continues to assess these matters from an accounting, disclosure and internal controls perspective, and expects to file the Form 10-Q for the period ended September 30, 2016 in January 2017 or earlier.
So, it omitted the following phrase between Nov. 9 and Dec. 12:
"...the ... investigation has not identified instances where Soliris orders were not placed by customers for patients...
These omissions suggest that something highly improper has been found.
Which to me raises the question about whether the Foreign Corrupt Practices Act has likely also been violated. Why stop within the US?
Concluding thoughts - ALXN may get cheap enough to buy
In addition to all the above considerations, the rare disease space is getting more competitive, but it's a difficult one. ALXN may - or may not - have gained some truly important technology from Synageva.
Overall, though, I come back to the main points that I linked to when quoting from my blog post of last month: the manufacturing issues with Soliris. I never liked ALXN at its 2014 and beyond valuations because the idea that a life-saving, ultra-high-priced, highly-profitable drug did not have squeaky clean manufacturing chops suggested that the company was cutting corners improperly.
Now we have inferential evidence that in addition to the FDA's opinions about Soliris manufacturing issues, the company may well have been cutting sales corners in the US and possibly abroad.
Clearly, GAAP EPS of $0.42 for a $110 stock is hardly a bargain. My secondary analysis, which obviously is one of several ways to view the stock, also suggests that since Soliris may fall to generics within five years, the underlying profitability of ALXN is not compelling, either. And that assumes that the data presented in the Q3 press release are valid; a questionable assumption, at this point.
Now, what about trading this stock.
I have listed this is a short sale candidate, but I'm not a good short seller, and since I'm just an individual managing family money with no need to generate alpha via short selling, if I did not sell VRX short a year or so ago when I wrote that it was at least 10X overvalued when it was around $100, I'm certainly not going to sell ALXN short now.
However, the "never one cockroach" situation may apply now. ALXN is being valued as a growth stock even now, and the stock keeps being resilient to these shocks. I may just be a fuddy-duddy old guy, but in the setting of a relentless ramp up in P/Es in SPY and in the secondary stocks, I think that it's more likely that reality could set in and take ALXN down again. When stocks were cheap, I mentioned the OMC non-issue in or around 2002. When stocks were chronically undervalued, such as when J&J (NYSE:JNJ) suffered a big hit to its stock price when the first cyanide Tylenol poisonings were reported decades ago, buy-the-dip began to come into favor. But that was before bubble stock (and then bond) markets began to appear, and then to even appear normal and part of the financial landscape.
As with the mostly upward price action for ALXN in the past month, with a big but brief stochastic price reset downward, this period could be frustrating for a short seller. But I just do not see that this company has shown it is more than a one-hit wonder. Soliris was a great invention, and showed how ultra-rare diseases could allow for once-unthinkable product pricing. Congratulations to all concerned in this humanitarian and commercially-successful achievement. But the rest of the company's product introductions have stemmed from acquisitions. So, ALXN is a quarter of a century old, and it has commercialized exactly one product from internal development. For companies effectively the same age, look what Gilead (NASDAQ:GILD), Celgene (NASDAQ:CELG) and Regeneron (NASDAQ:REGN) have done in comparison. Yet all are at or below ALXN in P/E, without the baggage it now has.
Several things may have been mishandled at ALXN. The evidence ranging from manufacturing, to possible violation(s) of the FCPA, to very possible improper/illegal sales practice(s) in the US, combine with a very high P/E, very high price:sales stock to lead me to avoid buying this particular dip.
Trading stocks is, obviously, tricky and uncertain business. Facts compete with rumors, which may or may not have validity. When a 10-Q is withheld even after a quarterly press release has been issued, even what is factual becomes uncertain.
As an interested biotech observer and investor, and in fact one who has traded ALXN from the long side (though not in 2016), I expect clear and convincing answers from the board, and promptly. I would like the company to include a comprehensive explanation of manufacturing deficiencies about Soliris. Why did they occur? What have been the issues there, and what problems, if any, remain in the company's view? Why should investors, not to mention doctors and patients, trust that the company will do better with Soliris and its other products in the future? Should the long-time CEO, now chairman, Dr. Bell, be subject to any criticism for any manufacturing and/or sales lapses? Meaning, are the CEO and CFO being tossed under the bus? After all, Mr. Hallal only became CEO in January 2015. The manufacturing issues are of longstanding nature, and the questions about the FCPA may go back to activities before then. Does ultimate blame, if any really exists, belong at the now-Chairman, previous-CEO level?
I wish I knew, and express no opinion on these questions. But I think that shareholders deserve answers.
I have no comment on what an existing ALXN long "should" do.
I also hesitate to provide a downside target for any potential short seller, though I do not know why this stock could not trade down to, or below, 5X trailing "real" sales per share.
For myself, I see no case for a new money investor to go long ALXN here. The valuation is too rich, the remaining product life of Soliris is too short, and there are just too many unknowns in too many spheres of this company's business to allow me to make any financial projections. Plus, the board sought out and approved a very expensive acquisition smack dab at the peak of the biotech frothiness.
In contrast, numerous large-cap biotech stocks are cheap to the market and have little or no issues such as ALXN has. All of the biotechs with market caps above $30 B strike me as superior stocks for investors to consider placing money in compared to ALXN.
Thanks for reading and sharing any comments you may have.
Disclosure: I am/we are long INCY, CELG, GILD, REGN, RHHBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.