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Given its expanding product line, it's a wonder that



hasn't added motion sickness medicine to its formulary.

Certainly, investors in the Wilmington, N.C.-based company need something to settle their stomachs. Over the last four trading days alone, aaiPharma has dropped 23%, jumped 9%, slid 11% and, on what passed for a quiet Tuesday, dropped 3%.

AaiPharma's lurching offers a lesson to investors in the drug industry: Extreme volatility isn't just the province of tiny biotech companies that have a lot of dreams and no revenue. No, even a fast-growing niche player like aaiPharma -- a maker of pain management drugs whose $34.3 million profit for 2003 doubled year-ago earnings -- can find that analysts look at the same data and come to profoundly different conclusions.

In this version of Rashomon Meets Wall Street, the analyst coverage includes several bulls, one longtime bear and one analyst who has become increasingly concerned about aaiPharma. The last is Adam Greene of First Albany, who dropped his rating on aaiPharma to neutral from buy on Feb. 5, triggering the first sharp drop in the stock. That was the second time in less than two months that Greene had lowered his rating.

Quality Questions

The shift in the focus of Greene's attention on this stock helps to tell the tale of the frantic action in aaiPharma. The first time Green cut his rating -- to buy from strong buy -- he talked about an overheated stock price. The second time, though, he worried about the quality of sales and earnings, in part echoing comments made by bears on the stock.

Greene warned clients last Thursday about that growing uncertainty, and the market took notice. His fears rippled through the market on the day aaiPharma's stock sank by 23%.

Greene's source of worry is the company's inventory and its decision to set aside a $15.9 million reserve to account for products that are returned. "This reserve is likely to further fuel speculation regarding the quality of sales and earnings," Green wrote last Thursday. "We are moving to the sidelines and prefer to wait for the dust to settle." He doesn't own shares; his firm is a market-maker in aaiPharma's stock.

Not Seeing Eye to Eye
Analysts' divergent earnings estimates on aaiPharma

Analysts' reports and Thomson First Call

The company conceded that it had experienced returns of one product that were "significantly greater" than had been experienced in any other quarter. Returns in previous quarters "had not been significant," the company said. But because the gap widened between estimated product returns and actual returns, the company said it had established the fourth-quarter reserve of $15.9 million against revenue.

Greene's comments took place on a day when the company appeared, on the surface, to have delivered a decent fourth-quarter earnings report. Quarterly earnings rose 31% from a year ago on a 24% gain in revenue.

But beneath the surface, analysts noted that fourth-quarter earnings from operations fell by 8% and that fourth-quarter results were aided by an $11.5 million breakup fee -- the consolation prize from

Cima Labs


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, which walked away from a merger with aaiPharma because it got a better takeover price from



. That deal is still pending.

Analysts have said that one reason aaiPharma refrained from entering a bidding war for Cima Labs is aaiPharma's long-term debt, which is uncomfortably high in relation to stockholders' equity. Last year, its long-term debt was $338.8 million, vs. stockholder's equity of $145.9 million. In 2002, the long-term debt was $277.9 million vs. stockholder's equity of $99.5 million.

Savage Debate

Greene's report seized on an issue that has been pursued more emphatically -- and described more colorfully -- by Michael Krensavage of the Raymond James investment banking firm. Krensavage dropped his rating on aaiPharma in March 2003 to underperform from market perform -- and he hasn't changed his mind.

In a Dec. 15 report to clients, Krensavage said that aaiPharma has a "deteriorating core business." Although a recent acquisition of four drugs from the Irish drug firm



should aid earnings and sales, the analyst argued that this deal was a "temporary remedy to a failed business plan."

Krensavage warned that the Elan transaction would add to aaiPharma's already high debt burden. He said that Elan had raised prices on these drugs, "boosting the possibility that wholesalers already have bloated inventory." And he worried that generic competition would knock down revenue that aaiPharma had expected to gain from these drugs.

He forecast a dramatic drop in earnings, to 57 cents a share in 2005 from his estimate of $1.03 EPS for 2004. Both predictions are the lowest among analysts polled by Thomson First Call.

For the 12 months ended Dec. 31, aaiPharma reported earnings of $1.17 a share last year -- 14 cents higher than Krensavage had predicted and 3 cents higher than the analyst consensus.

In his December report, Krensavage repeated his previous contention that aaiPharma was "inflating its earnings" by "stuffing the channel."

That's a practice by which companies can goose quarterly results bysending large shipments to wholesalers, ignoring or neglecting the fact that inventories will build up because customers won't be able to purchase all of the products.

Distributors often will make unusually large purchases of a manufacturer's product in advance of a price increase on that product, and Kensavage had argued in several reports last year that wholesalers were carrying above-average levels of inventories for many of aaiPharma's top-selling products.

Krensavage -- who doesn't own shares and whose firm is a market-maker in aaiPharma's stock -- repeated many of these concerns in a research report on Feb. 9, the day aaiPharma's shares dropped 11%.

He noted that another company had received earlier-than-expected approval from the Food and Drug Administration for a generic version of one of those drugs acquired from Elan. "We remain concerned that drug wholesalers have bloated inventory of aaiPharma products," he wrote.

Even though the company created a $15.9 million reserve for returned products, Krensavage said he believed aaiPharma "has an additional $28 million of product languishing in the

wholesaler distribution channel." He maintained his underperform rating.

Top company executives told analysts Feb. 5 that they are "very comfortable" with the level of product inventories now.

Swinging for the Fences

And aaiPharma certainly has its fans. Of eight analysts tracked by Thomson First Call, four have buy recommendations. One of them is David W. Maris, of Banc of America Securities, who started covering aaiPharma on Dec. 10 with a buy rating. He has kept that rating. Maris' favorable research report on Feb. 6 no doubt played a role in aaiPharma's brief rebound after the 23% dive.

"We believe that the market's negative reaction

on Feb. 5 is overdone," he said. "Earnings quality concerns and lower-than-expected

first-quarter 2004 guidance ... fueled investor worries."

Greater-than-anticipated product returns and the increase in reserves "only served to stoke the fire of previous market concerns of channel stuffing the company has endured for quite some time," Maris added. But he said the company's accounting treatment for the product returns and reserves are "reasonable and not reflective of widespread channel issues."

Maris expects aaiPharma to earn $1.46 per share this year and $1.70 per share for 2005. That 2005 estimate is triple the prediction by Krensavage of Raymond James. Maris doesn't own shares in aaiPharma; his firm is a market-maker in the stock and has performed investment banking services for aaiPharma in the last 12 months.

Maris stuck to his guns Feb. 9 -- keeping his buy rating -- when aaiPharma's stock fell on the news that another company had received FDA approval to market a generic version of a painkiller that aaiPharma had acquired from Elan in December. He wrote clients that aaiPharma is still analyzing the impact of the generic competitor on its EPS guidance, adding that "while the possibility for a downward revision to our earnings estimates exists, we do not believe our forecasts are materially at risk."

Maris characterized aaiPharma's stock as "clearly not for the faint of heart," but he added that it is trading at a 41% discount to the average price of its peer group -- a discount, he argued, that is "unwarranted."