Andrx Partisans Tune Out Plant Problems

Stockholders are focusing instead on the $25 a share they're set to get from Watson.
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A heavy cloud hangs over

Andrx

(ADRX)

, but most investors and analysts only see a silver lining for the Fort Lauderdale, Fla., generic drug company.

The cloud is the continuing saga of the Food and Drug Administration's inspection of an Andrx manufacturing plant in Davie, Fla. Andrx still hasn't fixed the plant to the agency's satisfaction, and until it does, the FDA won't act on any of the company's drug applications.

When manufacturing problems are severe and prolonged, the FDA can hit the offender with a fine, seize products or mandate that it be allowed to periodically review manufacturing activities for several years.

For example, in March 2005, the FDA seized batches of two drugs from

GlaxoSmithKline

(GSK) - Get Report

and blocked the sale of the drugs for several months until the company

signed an agreement to fix the problems at one plant. In May 2002,

Schering-Plough

(SGP)

agreed to

pay $500 million to improve two of its facilities.

For Andrx, its own regulatory matters have hovered over the company since September, but that doesn't seem to bother most investors because right now they own a price-protected security. In mid-March,

Watson Pharmaceuticals

(WPI)

offered

$25 for each Andrx share, and the stock has stayed within reach of that price. By early afternoon Monday, it was at $23.54.

Question of Duty

Not everybody is happy, though. A May 4 Andrx filing with the

Securities and Exchange Commission

reveals that three shareholders have sued the company, claiming economic damage due to the FDA inspections.

Two other lawsuits oppose the merger with Watson, alleging that Andrx executives breached their fiduciary duty by accepting an offer that's too low.

Most analysts don't seem too worried about Andrx, even though last week the company posted first-quarter earnings and sales that fell below Wall Street's consensus expectations. Only one analyst recommends selling the stock, while nine others are neutral and three have buy ratings.

The first-quarter results were a nonevent, according to Ken Cacciatore of S.G. Cowen. "Andrx brings some valuable assets to Watson," he wrote in a research report Friday. He predicts the Watson takeover remains on track to close in the third quarter.

"Andrx delivered a weak quarter plagued by high expenses," Deborah Knobelman of Piper Jaffray wrote in her own report. Like Cacciatore, she's neutral on Andrx and believes the takeover will wrap up on time. However, she doubts the problems with the FDA will be settled before Watson acquires Andrx.

Neither Knobelman nor Cacciatore own shares. Their firms say they conduct or seek to do business with companies mentioned in their research reports.

Satisfied Suitor

Most importantly, Watson doesn't appear concerned. A recent merger proxy excludes the FDA investigation as a reason to cancel the deal.

Before mergers are consummated, buyers and sellers agree on certain "material adverse effects" that could sink a transaction. In the Andrx and Watson merger proxy, boilerplate language refers to "any event, change, development or occurrence" that might affect "our properties, assets, liabilities, business, results of operations or financial condition ... or our ability to complete the proposed merger."

But there are also several exclusions, ranging from the general -- changes in U.S. markets due to war or terrorism -- to the specific, including the FDA probe.

The proxy says Watson could walk away from the deal if, prior to the closing date, the FDA penalizes Andrx by ordering a recall, seizing products, or causing the reduction in making or selling of four drugs. Also, Watson could exit if the FDA imposes a civil or criminal penalty on Andrx before the deal closes.

Andrx says it has provided detailed information to Watson about the investigation and will continue to provide updates. Andrx can walk away from the deal, too. Except under certain circumstances, it would have to pay a break-up fee of $70.8 million.

"We feel corrective action by Andrx takes about as much effort as picking up the phone and calling Roto-Rooter," Andrew Forman of WR Hambrecht wrote in a recent research report. He has a buy rating on Andrx, but he doesn't own shares. "We are not at all concerned that the

FDA investigation has dragged on," he says. "There is an incentive to leave the place a mess."

Forman expects the Watson deal to proceed, but if it fails, "it will likely be due to a superior offer

and not because the FDA's

investigation has spooked them." The latest FDA report suggests Andrx "has a few more months of work before it gets to launch new products," he adds.

Plant Problems

The FDA stopped ruling on Andrx drug applications in September, placing the company on what the agency calls "official action indicated" status, or OAI. This means the FDA believes the problems are bad enough to issue a fine or seize products unless the problems are corrected.

Andrx says that although the manufacturing issues are unresolved, it continues to submit drug applications to the FDA and that the agency continues to analyze them, according to the May 4 SEC filing.

The FDA conducted an inspection in January and issued a report that Andrx subsequently responded to. The agency started another examination of the Davie plant in March and produced another report the following month to which Andrx will reply.

The company said last week that its response "will primarily address ongoing and planned improvements to enhance two quality systems."

Andrx believes "it has already implemented responsive actions to certain observations in the April 2006

report," and said it's "in the process of addressing other observations and will address the remainder of the observations within a reasonable period of time."