Getting a Grip on Immunex's Problems

The problems for biotech companies come when they start to sell their products. That's when reality sets in.

For Immunex (IMNX Quote - Cramer on IMNX - Stock Picks), reality may indeed be sinking in. Sure, the company's rheumatoid arthritis drug, Enbrel, is selling much more strongly than expected. But the economics of the product are lousy, bears contend.

The main problem for Immunex is its need to dedicate significant portions of Enbrel sales to pay outside parties for manufacturing and patents. Also, the deal it struck with its majority owner American Home Products (AHP Quote - Cramer on AHP - Stock Picks) holds disadvantages for Immunex, one of the biggest biotechs. The upshot is that Enbrel carries gross margins -- and thus profitability -- far lower than, for instance, that of multiple-sclerosis drug Avonex for the similarly valued Biogen (BGEN Quote - Cramer on BGEN - Stock Picks). Yet Wall Street still expects Enbrel to change Immunex into a biotech rarity -- a company with consistently growing earnings.

"It's a very good drug in a market where a drug like this is needed," says one longtime bear on the company whose short position is under water. "It's not the drug's fault [that it may not live up to expectations], it's the deal" that Immunex has with American Home. He predicts, "It's going to be difficult getting to the $3, $4, $5 EPS numbers that people are banking on."

The stock, reflecting these concerns, has slipped after an extraordinary run-up that had the shorts fleeing. Immunex shares are down 15% since the company's Feb. 3 earnings release. Thursday it was up 6 3/8, or 5%, at 133 1/2.

Make no mistake: Enbrel is selling well. The drug notched fourth-quarter sales of $12.7 million, slightly ahead of expectations, and is now selling at an annualized rate of about $175 million a year, according to ING Baring Furman Selz. Immunex expects Enbrel sales of $40 million in the current quarter.

Wall Street's 1999 sales estimates for the drug fall mostly in the $250 million-to-$300 million area, with bullish outliers like Alex To of Deutsche Bank forecasting sales of $375 million this year and $800 million in 2000. Deutsche Bank hasn't done any underwriting for Immunex. (The company has often said, and a company spokesman reiterated Wednesday, that it expects Enbrel to be a $500 million-plus drug in three years. But what does the company know?) The company says it estimates that there are 17,000 to 20,000 patients on the drug, up from 10,000 to 15,000 at the end of last year.

So why the newfound investor worry? As always, it comes down to concerns about earnings. Estimates started dropping last week after the company's earnings conference call.

On the call, the company said it expects to report a loss from operations in the year's first two quarters, though it still forecasts a profit for the year. Wall Street had expected the second quarter to mark the first time Enbrel propelled Immunex back to profitability, to the tune of 11 cents a share. According to First Call, Wall Street now expects the company to earn 4 cents a share in the second quarter. Bulls think the company was just being conservative with its second-quarter guidance.

The conference-call guidance didn't affect Wall Street's expectations for the year dramatically. Mostly, it meant that analysts tinkered with their earnings models, "finding" a few more pennies of profit in the later quarters to make up for the second-quarter shortfall. Wall Street now expects the company to earn 70 cents a share this year, down from 75 cents a share before the call.

If it manages to earn 70 cents -- and one bear is modeling more like 20 cents -- that still means that at 133 1/2, the company is trading at 190 times 1999 estimated earnings.

And so the Street has begun to ignore Immunex and its guidance, which may indicate the Street isn't focused on the drug's economics.

Unlike many drugs, Enbrel isn't exceedingly profitable. The royalties the company pays to various Enbrel patent holders shaves off a small but significant percentage from the company's bottom line. These royalties amount to 6% to 10% of total sales, according to the company. Plus, there are the payments to the outside manufacturer. Still, Immunex retains a majority of the profits under its agreement with American Home.

Just how profitable is the drug? Here's a hint. The company said on its call that its gross margin on oncology products, which accounted for sales of $38.4 million in the quarter, was 81.5% in the fourth quarter. But the company didn't disclose the gross margin on Enbrel, which accounted for sales of $12.7 million in the quarter. It did say that its total cost of product sales was $11.3. Therefore about $7.1 million was from the cancer drugs, leaving about $4.1 million of costs of goods from Enbrel. That translates into a gross margin on Enbrel of 67.3%. The first quarter is always the most expensive, of course, because economies of scale haven't kicked in. The company won't comment on the gross margin for Enbrel or its profitability.

Donaldson Lufkin & Jenrette analyst Craig Parker estimates the company's overall gross margin in 1999 will be 79.9%, and Enbrel's gross margin will be 77.5%. DLJ rates the stock a market perform and hasn't done any recent Immunex banking. So the question is, Will the Enbrel gross margin rise that dramatically?

Then there's the concern that the deal with American Home gets more expensive for Immunex as time goes on. Immunex has to pay AHP to reimburse it for sales expenses. What is unusual is that the payments start small -- estimated at between 25% and 40% of sales costs -- and then grows to half the commercial expenses after the second year of sales.

"Usually the smaller company gets rewarded as time goes on and sales grow," says one analyst for a New York hedge fund that is short the stock. "In this case, as time goes on, it's a worse deal." DLJ analyst Parker says, "It's an issue, but if you believe they will sell more product with AHP as a partner than without, it's not a bad deal." On his estimate of $251 million in Enbrel sales for this year, he figures that payment will equal $90 million.

In addition, there was a scare on the prescription trends in late January when trends flattened. However, the drug may be back on track. According to prescription tracker DirectRx, a service of National Data Corp.'s (NDC Quote - Cramer on NDC - Stock Picks) NDC Health Information Services, Enbrel scrips rebounded strongly last week: New prescriptions rose 18% for the week ended Feb. 5 compared with the week ending Jan. 29.

But, the bears warn, focusing on sales trends may mean missing the bigger picture.