Cephalon Explains Off Balance Sheet Mechanism

Cephalon ( CEPH) executives held a conference call Monday afternoon to defend a financing vehicle that pushes marketing costs for two drugs off its balance sheet.

In other words, Cephalon appears to have an Enron ( ENRNQ) problem, or at least that's what skittish investors believed Monday, as they pushed the company's shares down $8.63, or 13%, to $55.99 per share. The stock was off as much as 23% earlier in the day.

But a clearly frustrated Frank Baldino, Cephalon's CEO, speaking to investors on a conference call, says the $50 million off balance sheet-financing arrangement is in the best interests of the company's shareholders and shouldn't be tarred with the Enron brush.

"I understand the concerns people have for creative financial structures that can obfuscate what's really going on inside a company -- this is not one of those deals," he says. "This is not the type of deal that has garnered so much attention of late, and our stock should not have taken the impact it did today."

Robertson Stephens biotech analyst Mike King sponsored the conference call. He rates Cephalon a strong buy and believes the accounting concerns are overblown. His firm has a banking relationship with the company.

The financial structure in question involves an outside joint venture company formed last December with two of Cephalon's institutional investors. The investors put up $50 million in exchange for equity in the joint venture, known as CNS Marketing. The $50 million is being used to fund physician-sponsored studies aimed at expanding the potential use for Provigil and Gabitril -- two of the company's drugs.

The joint venture has a life of two years, after which Cephalon will repurchase the investors' stake for $72 million, or a 20% return. The company will then amortize the costs of the joint venture on its books over 10 years.

Monday night, Cephalon executives defended the joint venture, saying it was an opportunistic way for the company to expand its commercial activities for the drugs beyond what it would normally spend on sales, marketing and research, but account for the costs at a later time.

Baldino insisted that the $50 million was a "rare opportunity" to make an even larger investment in the commercial efforts of its drugs, and was not an effort by the company to shuffle expenses off its books to make earnings appear stronger.

In fact, he said that if Cephalon decides to buy back the joint venture early, it would have no impact on the company's sales or earnings. Cephalon is expected to earn 15 cents per share in 2001 and $1.03 per share in 2003.

"When we proceeded with this deal in December, the environment was different than today," he said. "There's a lot of scrutiny on transactions like this today, so if this was the case in December, we probably wouldn't have done the deal."

But despite all his assurance, there are some questions Baldino didn't answer. He won't disclose the identity of the joint venture's investors, nor did he clearly explain why this $50 million in added spending on Provigil and Gabitril couldn't simply be paid for out of the company's coffers. Cephalon has about $600 million in cash on its books.

The company had also been very skimpy on details of the off balance sheet financing until today. Cephalon issued a press release with scant details on the deal on Dec. 20. So far, nothing further has been filed with the Securities and Exchange Commission, although the company says details will be included in its upcoming annual report.

In the post-Enron world, in which companies are being taken apart for even the smallest accounting anomaly, Cephalon's explanation, while logical, was still causing some head-scratching on Wall Street.

As one skeptical fund manger said, "Would Amgen ( AMGN) do something like this? I don't think so." This fund manager had no position in Cephalon until today, when he went long because he believes the stock is now oversold.

The real motivation for taking some expenses off the balance sheet, according to this fund manager and others, was so Cephalon could keep earnings growth -- and its stock price -- strong. Cephalon has been rumored to be seeking another acquisition -- probably a smaller, oncology biotech firm -- so it needs to keep its stock high for use as M&A currency.

But whatever the reason, investors Monday were certainly selling first and asking questions later.

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