Fortunes of war
The fortresslike office at 2320 Scientific Park Drive offers a foreboding front befitting its stature as a storehouse of trade secrets — and now as the home of a company under siege. Inside the Wilmington headquarters of aaiPharma Inc., Ph.D.s supervise Ph.D.s. For more than a quarter of a century, it has helped drug companies with the research needed to win federal approval for their products. Since 2001, it also has been buying and tweaking old drugs and putting improved versions back on the market.
Yet for all their smarts, the people who ran the company tripped over simple math. When revenue lagged Wall Street expectations, aaiPharma padded the bottom line with phony sales. And when the numbers didn’t add up, federal investigators moved in, followed by lawyers brandishing shareholder lawsuits. The company ended up filing for Chapter 11 bankruptcy protection.
The top tier of management brought in to expand the company is gone, as is the grand ambition of building aaiPharma into a major drug company rather than just a contract-research organization. The company sold its drug business in July. In less than a year, aaiPharma had gone from its all-time-high share price to a penny stock attractive to only the most adventurous bottom feeders. “I think it’s a tragedy,” says Jim Waters, a former board member and an early investor. “It didn’t have to be that way. But with the short-term thinking that went on, it became more and more inevitable.”
Waters says aaiPharma fell because it focused on quarterly earnings reports. As he sees it, members of the management team feared missing Wall Street expectations so much that they dived deeper and deeper into fantasy accounting when sales slowed, then tried to hide the manipulations from investors and the board.
In June, former chief operating officer David Hurley pleaded guilty to fraud and conspiracy charges in a deal with federal prosecutors under which he agreed to cooperate in the continuing investigation, details of which have not been made public. What is known is that in 2003 sales of several of aaiPharma’s key medicines such as the pain relievers Darvon and Darvocet began to slip. Instead of reporting lower sales and earnings, the company counted products stored with distributors as revenue. The tactic is called “channel stuffing,” because products still in distribution channels are reported as sold.
A few Wall Street analysts caught on and began issuing reports critical of the company. Savvy traders began selling the stock short, betting its price would tumble. In August 2003, the U.S. Securities and Exchange Commission started questioning financial reports. After first insisting that the reports were accurate, the company backtracked and trimmed reported earnings and revenue. Caught in a downward spiral, it sank into insolvency.
Company officers declined to be interviewed for this story. In press releases, CEO Ludo Reynders talks about the new goal of becoming a CRO, which earns its money from fees charged to drug companies. That was the idea when aaiPharma was founded 26 years ago by an ambitious young scientist with an entrepreneurial bent. But he had wanted more, and in reaching for it, he lost control of his company, leaving it for others to pick up its pieces.
Frederick D. Sancilio now lives in Jupiter, Fla., where he has launched another CRO, Sancilio & Co. In an e-mail response to questions, he says he is eager to discuss what happened to aaiPharma but can’t while it is tangled in lawsuits, a federal investigation and bankruptcy filings. “There is,” he writes, “so much to tell.”
Sancilio, then 29, mortgaged most of what he owned to raise $175,000 to launch Applied Analytical Industries Inc. in 1979. He picked Wilmington because he liked the town and its location near the coast. He held master’s and doctoral degrees in chemistry from Rutgers University in New Jersey and had worked as a research chemist for Nutley, N.J.-based Hoffmann-LaRoche. After supervising the chemical analysis of drugs at Kenilworth, N.J.-based Schering-Plough, he worked for London-based Burroughs Wellcome in Greenville, where he was responsible for quality control in research and development. He oversaw modernization of the company’s labs and worked on regulatory issues.
Sancilio saw himself as more than a scientist. He was determined to use his knowledge and connections to start his own company. The idea was simple: Assemble experienced drug scientists in a lab, then lease the harnessed brainpower to companies that needed help with the complex work of perfecting and testing drugs and shepherding them through the U.S. Food and Drug Administration approval process. He struggled to nurture his shaky new business for about a year before he landed his first major outside investor: Waters.
Waters had founded a Milford, Mass.-based company called Waters Corp., which made scientific instruments such as spectrometers used to gather data about chemicals. Sancilio, a customer, had hired one of Waters’ salesmen. Waters decided to invest in the new company, which had about a dozen employees, and provide the capital Sancilio needed to survive.
Waters says he often found Sancilio to be a difficult partner. “He was very entrepreneurial. He just had those instincts. He made money while in college buying and selling houses. He was a very good salesman. And he was very smart, very good in science and technology. But he was not a particularly good businessman. He had a hard time learning how to make money, year by year, running a company. He was very venturesome. He would try new things. But he didn’t use as much judgment as would have been desirable.”
Whatever shortcomings he may have had in management he seemed to make up for in skill at building a business. Sancilio and the other scientists he recruited had connections in the drug industry, which helped the company land research contracts.
Sancilio knew what kind of work drug companies might want to outsource, and he knew how to do it. Contracts covered a variety of tasks: conducting independent chemical tests as part of drug discovery, helping solve chemistry issues with new drugs, doing clinical trials and helping clear the FDA-approval hurdles. Before long, the company’s clients included big-name companies such as Bayer AG of Germany and Eli Lilly & Co. of Indianapolis.
In 1981, Applied Analytical moved into a new lab in Wilmington. Within a few years, it added labs for microbiology and biotechnology research there, plus one in Chapel Hill in 1994. That year, industry R&D spending was estimated at more than $30 billion — $3.5 billion of it on contract work. From 1990 to 1994, Applied Analytical worked for 24 of the world’s top 25 drug companies. From 1991 to 1995, net sales went from $18 million to $34 million and net income grew from $600,000 to $3.2 million. Sancilio’s salary in 1995 was $306,000, plus a $79,000 bonus.
But contract research had its limits. Sancilio knew the returns he could get from contracts were dwarfed by what drug companies earned when they took medicines to market. Margins for CROs average 8 to 10%; those at drug companies can easily double that, with rates for the top performers averaging around 30%. A home run could be worth billions in sales and hundreds of millions in profits. As it grew, aaiPharma participated in the development of more and more of those marquee prescription drugs. (In a 2002 news article, executives boasted that its scientists had worked on 80% of the 200 top-selling prescription drugs.)
What Sancilio craved was the chance to play in the major leagues, and he thought he had found a niche. His company had developed and patented ways to improve management of dosage and drug administration, including techniques to help reduce side effects. By buying older drugs and changing them, he figured it could improve them and extend their lives. Eventually Applied Analytical would discover its own drugs.
But going from CRO to drug company required a major infusion of cash to acquire and develop medicines, then to build an international sales-and-marketing team and, finally, to mount campaigns to get doctors to prescribe them. The obvious place to go for capital was Wall Street. In 1995, New York-based Goldman Sachs paid about $19 million for 2.27 million shares of aaiPharma stock. Waters still had a bigger stake in the company, with 2.6 million shares. Sancilio remained the largest shareholder, with 5 million shares.
The company went public in 1996, netting about $45 million. It had had $27 million in long-term debt and shareholders’ equity. Sancilio was still the largest shareholder with 32%. Applied Analytical continued to expand its research capability, buying labs in Europe and Kansas and building one in New Jersey. It opened a new headquarters in Wilmington in 1999.
The company changed its name to aaiPharma in 2000 to reflect its new emphasis on creating and selling its own line of medicines. Revenue hit $100 million in 1999, when employment exceeded 1,000. Sancilio hired Philip Tabbiner in 2000 as president of the pharmaceutical division and William Ginna as chief financial officer. Tabbiner came with a solid reputation from 20 years in the drug industry, including a stint at Bayer.
Tabbiner moved up to COO in 2002. Hurley was hired to replace him as head of the pharmaceutical business. When Tabbiner succeeded Sancilio as CEO later that year, Hurley moved up to COO. As executive chairman and chief science officer, Sancilio stepped back from day-to-day management, buying a $4 million house with 7,648 square feet of air-conditioned space and a boat dock in Jupiter, Fla.
But he continued to play a role in running the company and remained its point man on Wall Street. “Fred fell in love with the stock market,” Waters says. “I think that he got a very large emotional charge out of dealing with analysts and Wall Street and sort of thinking of himself as a big businessman.”
Sancilio wanted good quarterly earnings reports — so much so that he created a culture around never having a bad quarter, Waters says. “Fred would come in and say, ‘We have to make this quarter.’ I would say, ‘Let’s do the right thing in the long term.’ And he would say, ‘No, we just can’t have a bad quarter.’” Waters says he argued that the company could afford a bad quarter or two if it needed to devote more resources to building the business or resolving problems.
The company had bought several drug lines in 2001 and 2002. The biggest deal was the purchase in 2002 of Darvon and Darvocet, two old painkillers owned by a long-time contract-research client, Eli Lilly, for $211.4 million. Revenue hit $231 million in 2002, with product sales accounting for half. But acquiring drug lines was expensive, saddling the company with debt that would balloon to more than $300 million by 2004. As long as the new drugs sold well, everything was fine. And according to the company, its drug sales were stellar.
Some analysts were swayed by the bullish reports coming out of Wilmington. Others — including David Windley of New York-based Jefferies & Co., and Michael Krensavage of St. Petersburg, Fla.-based Raymond James Financial — thought they were too good to be true.
The company’s strategy was difficult from the start, Windley says. The brands it bought faced stiff competition from newer medicines and cheaper generic versions. Improving and updating the older drugs might have worked if their purchase prices and carrying costs were low. “They were buying products in decline,” Windley says. “They were paying an unrealistically high price, and they were paying with debt.”
He checked industry data on prescriptions that had been written but could find no corresponding spikes in the medicines that aaiPharma claimed were selling so well. That suggested aaiPharma was counting shipped-but-unsold drugs as revenue, even though some of them likely would be returned. “You dig into it, and it just doesn’t match. It raised question marks. They were describing growth. The end-user data showed declines. Then when you asked management about it, they either didn’t give an answer or the answer didn’t hold up.”
His report on the company in August 2003 raised the issue in the oblique language of accounting, which was his training. He had checked five of aaiPharma’s leading sellers: Darvon, Darvocet, Brethine (for asthma) and MVI and Aquasol, two injectable vitamin formulas. Those drugs, he wrote, “are not producing noticeable end-user growth, based on channel sales and prescription volumes of AAII products, suggesting risk of carrying high inventories.”
The real broadside came from Krensavage, whose report that same month teed off on aaiPharma’s most recent acquisition bid. It wanted to buy Eden Prairie, Minn.-based Cima Labs in a deal valued at $360 million. Krensavage called the move “an act of desperation, suggesting that the company’s current strategy is inadequate.”
Like Windley, Krensavage compared reported drug sales against prescription data and found discrepancies. In one example, he looked at the company’s version of calcitriol, a vitamin D product for kidney-dialysis patients. The company began selling it in March 2003 and reported $3 million of calcitriol “into the channel” through June, Krensavage wrote, yet industry data indicated only $414,000 of prescriptions for calcitriol were sold. That left about $2.6 million — more than 85% of the reported sales — in limbo. The company said there might be some lag time in recording prescriptions, but Krensavage thought the difference far too large.
What it suggested to him was that aaiPharma’s drug sales were a mirage and that the company might struggle to pay off its debt. Cima, he wrote, had $134 million in cash; aaiPharma, just $8 million. He figured aaiPharma was mainly interested in Cima’s cash, which it could use to cover its debt. The deal never closed. Cephalon, a Frazer, Pa., drug maker, outbid aaiPharma, getting Cima for $515 million.
More serious problems were brewing. On Aug. 21, 2003, the SEC sent the company a letter asking for financial documents and explanations of drug sales. Waters says Sancilio complained to SEC officials that the company was being unfairly attacked. Despite the seriousness of the inquiry, the company did not disclose it to investors until April 12, 2004, when aaiPharma added a line to a quarterly report.
Waters says that the company should have come clean much sooner and at least looked into the issues being raised, if for no other reason than to find out why there were so many short sellers of the company’s stock. “The shorts were selling a year before the problems became apparent. Why didn’t we do a thorough investigation and find out why those guys were betting against us? There are all kinds of excuses. I kick myself for it. We should have seen there was a potential for problems.”
The company continued to report strong sales profits throughout 2003. In Febru-ary 2004, it issued a press release with what it said were final figures for 2003. Drug sales were better than ever. Fourth-quarter revenue had increased 24% over 2002, powered by a 28% rise in drug sales. For the year, net revenue reached an all-time high of $282.7 million, up 23%. Product sales rose 40%.
The stock had started 2003 trading at about $10 a share, but the upbeat reports had beaten back the short sellers. By year-end, the stock had tripled in value. Windley didn’t believe it was justified. In February 2004, he wrote, “Investors that own this stock are walking on thin ice.” His research indicated that sales of aaiPharma drugs had continued to deteriorate. He and Krensavage accused the company of channel stuffing. At best, Windley wrote, aaiPharma stock was worth $13.50 — less than half the market price.
His estimate turned out to be about $13 too generous. “The proverbial crap hit the fan in 2004,” he says. Over the next year, the company would oust its management team, default on its debts and file for bankruptcy. The stock would become almost worthless.
Hurley resigned in February 2004. On March 1, the company said that it was investigating what it called “unusual sales” in at least two of its drug lines. It delayed release of its annual report. Tabbiner resigned March 29, and Sancilio returned as CEO. Nasdaq delisted the stock April 15 because the company hadn’t filed its annual report.
By then, it faced more serious issues. That same month, it received five subpoenas from a federal grand jury in Charlotte seeking information about the sales of Brethine, Darvocet, Darvon, calcitriol and azathioprine, which is used to treat organ rejection in kidney transplants. The grand jury wanted names of employees responsible for those sales and any incentive programs aaiPharma had for the products. The company announced that some of its officers and directors had been subpoenaed to testify and that Hurley had been named a target of the investigation.
On April 27, aaiPharma said that its internal investigation found numerous instances of overstated revenue and that it would revise its 2003 sales figures downward. Unable to meet its debt obligations, the company filed for Chapter 11 May 9, listing assets of $323 million and debts of $446 million. Two days later, Ginna, the CFO, resigned. In June, with the stock trading mostly between $4 and $6, Windley issued a report calling the company a “disaster.” His new target price: $3.
In August, the company was hit with class-action lawsuits contending that investors were duped by shady financial reports. Cima also sued, complaining that it had agreed to merge with aaiPharma based on the rosy financial reports. When Cima had backed out, it had to pay aaiPharma an $11.5 million termination fee. Now Cima wanted its money back, plus $5 million for attorney fees and expenses.
Windley’s latest report on aaiPharma came out in August 2004. This time, he called the company a “horror.” Shares had briefly dipped below $2. The analyst thought that even 25 cents was generous. His new target price: zero.
Waters, who was still on the board, blamed Sancilio for not tackling the problems sooner. He persuaded the board Sept. 27 to oust Sancilio as CEO. Thanks to his contract, Sancilio got a $1.7 million severance package. He stayed on the board, though, and still had enough sway, Waters says, to persuade the nominating committee not to offer Waters another term. In his Nov. 5, 2004, resignation letter, Waters wrote that he was not nominated “because of Sancilio’s desire to remove me and because of my recent efforts made on behalf of the shareholders.” Waters is chairman and CEO of Cetek, a Marlborough, Mass.-based drug-discovery startup.
The company has spent much of this year trying to clean up the financial and legal mess and waiting to see where the federal investigation would go. The answer came in June, when Hurley pleaded guilty to fraud and financial misrepresentation in connection with the channel-stuffing scheme. That same month, he also settled a civil suit by the SEC alleging fraud. Under the settlement, he is barred from serving as an officer of a public company.
Then in July, aaiPharma produced some good news. It sold its drug business to Florence, Ky.-based Xanodyne Pharmaceuticals for $209 million — about $40 million higher than expected — and used $180 million to pay debt. Xanodyne also agreed to buy at least $30 million of research services from aaiPharma over the next three years, a sweetener that should help jump-start the company’s bid to reclaim its status as a player in contract research.
Even Windley was impressed. “I think they have kind of pulled a rabbit out of the hat with that sale price they got. It is still lower than what they paid for it. But clearly no one expected them to get that. In the darkest of days, it might have looked like they were going to have to have a fire sale of all their businesses just to meet the debt obligations. Now it looks like the contract-research business will emerge from bankruptcy intact.”
But aaiPharma still will have to work hard to land customers, especially with an aggressive competitor nearby. Wilmington-based Pharmaceutical Product Development Inc. has grown into one of the nation’s leading contract-research organizations, with sales of $489 million in the first half of 2005. And there is plenty of other competition. The North Carolina Biotechnology Center lists 78 CROs in the state, though most are small, boutique operations or branches of larger companies based in other states. Windley says the events of the last two years have so damaged the company’s reputation that it hardly has any good will left to fall back on. “AaiPharma in its current state might as well be a startup.”
In Florida, Sancilio is running his CRO startup and waiting to tell his side of the story. “I’m not dodging you or the others,” his e-mail says, “but I want to make sure the company continues its turnaround and leaves this ugly period behind.”