SMID Cap Healthcare Convertibles : Conference Insights

by Kent Bailey and Bill Feingold

The principals of Hillside Advisors have long been fans of biotech convertibles—it’s a match almost as good as what Mr. Reese came up with mixing chocolate and peanut butter.  Unlike most industries, biotech recognizes its need for a constant flow of capital-market lifeblood and acts accordingly. Biotech companies don’t hesitate to float new shares after good news catapults the stock.

Moreover, even when their products fail, biotechs usually have valuable carcasses.  There are many reasons for this, but one we learned many years ago from a medical colleague is that big-cap pharmaceuticals like to mine the data biotechs accumulate, and not always the kind you might expect.  For example, big-cap pharma likes to know which doctors have expressed interest in the biotech companies’ projects. It helps their salespeople identify the best targets for new medications or new indications for existing ones.

Here are some of our thoughts from a recent event at which a number of convertible issuers presented.

No news in Biomarin (BMRN), but along with Incyte (INCY), most view this as a high-quality midcap biotech yet to rebound fully from the early spring selloff. In contrast, Gilead (GILD) has retraced all the way to previous highs. BMRN has a large and exciting pipeline, but most data will not read out until 2015. Also, takeout speculation in the press started in December, but we see that as unlikely given that the pipeline won't receive what the management considers full valuation. The credit is rock solid, so the bonds have held up despite the stock drop, which makes for an ugly outright profile. 

Let’s look at the Biomarin convertibles, the “A” 0.75% of 2018 and its sister “B” 1.5% of 2020, both of which met with great early demand. In a paper-starved market you don’t get many opportunities to buy essentially the only public debt of a $10 billion market cap issuer.  Since the issuance last fall the bonds have had their ups and downs, both in price and valuation.  The “B” tranche is probably a bit more appealing, since the credit appears fairly secure and the value of two more option years seems to trump the slightly better bond floor of the “A” bonds.  Put another way, the “A” bond is more susceptible to near-term time decay, so for convertible investors seeking BMRN exposure you’ll probably get a little more juice from the “B.” Neither bond jumps off the page, but if you like the name and you have to buy it through convertibles, there’s not much else you can do. Hedgers should be wary of cash takeout risk—the initial five-point expansion comes right out of your hide. If you push pretty hard you can just about get the bonds to fair value.

Both Biomarin convertibles should provide watered-down upside participation.  The “A” bond in particular is unlikely to capture much more than a quarter of the stock’s upside, if that, unless the BMRN shares move explosively higher. The “B” bond should do somewhat better, at the cost of a few points’ downside support.

For INCY, polycythemia vera (PV) is a bone marrow disorder caused by the overproduction of red blood cells.  With its approved drug Jakafi, INCY targets the most severe PV patients, roughly 25% of the population, which suffer from enlarged spleens and other constitutional symptoms (similar to myelofibrosis patients for which the drug is already indicated). INCY previously top-lined the positive PV Phase 3 RESPONSE trial data, but the full data set at ASCO showed an even more impressive symptomatic benefit and durability of response than was previously expected.  Many analysts view this indication as a potential $750m opportunity.

Last year, INCY began testing Jakafi in solid tumors last year because of the theory that systemic inflammation (which Jakafi targets) plays a major role in cancer.  This hypothesis was validated by the recent data presented at ASCO for Jakafi in pancreatic cancer.  In a predefined subgroup of patients high in C-reactive protein, an important inflammatory marker, Jakafi showed an impressive hazard ratio of .47, with a good tolerability profile.  Other solid tumor data will follow, and Jakafi in oncology has blockbuster potential.  

After some early guidance hiccups after Jakafi's launch last year, INCY has done a much better job guiding the Street conservatively and exceeding expectations, so we fully expect conservative guidance on the PV indication when approved early next year.

Hillside’s proprietary measure of bonds at risk for both time decay and absolute price loss finds INCY’s “B” tranche (the 1.25% of 2020) appreciably safer on balance than the “A” bonds, even though the “A” bonds mature earlier and trade at a marginally lower dollar price.  Still, neither bond looks like a good way to play the stock (not surprisingly since the bonds have been accumulated by a large institution), and quantitatively it is hard to justify owning either bond—both are candidates for our upcoming “20 Least Likely to Succeed” list.  Both appear likely to participate in substantially more of INCY’s downside than upside over the next year, unless the stock moves are large indeed.

Again, if you like the story (as we do) and you have to buy convertibles (as we do not), you’re probably better off in the 1.25. We think the 0.375% will be hard-pressed to participate in more than half the stock’s upside, if that, in most likely upside outcomes.  We worry that if the stock only ekes out a small gain, these bonds could easily sustain a modest absolute loss.

The summary on INCY: the convertibles are rich, as you often find with compelling stock stories. Since the name is well known by major convertible health care investors, the bonds can easily remain rich for some time—but investors need to understand that current prices may lead to disappointing performance relative to the underlying shares.

Sequenom (SQNM) bonds are trading around 94, and the credit is improving, as the cash burn is declining (management guides to year-end 2014 cash-flow breakeven) and liquidity is better thanks to $32m proceeds from an asset sale (pro forma cash is $87m). The stock has steadily increased over the past six months, and with a $340 million market cap, another small capital raise would put the company in good shape. Worth a closer look.

While Sequenom is a far more speculative story than either Biomarin or Incyte, its bonds are, in one sense, far less so. Of course, the underlying credit is substantially less proven. If the company manages to keep shoring up its balance sheet with modest cash infusions, these bonds should do what convertibles are supposed to do—provide about two-thirds of the stock’s upside with substantially less downside.

Indeed, it’s somewhat a mirror-image of Incyte. Incyte convertible holders could make losses even if the stock appreciates, while Sequenom holders can make high single-digit returns as long as the company survives.

Merrimack (MACK) continues to look attractive here. A lot of negative rumors continues to circulate about their programs, but we think it's misplaced. The bonds are covered by the pancreatic cancer drug MM-398, which should be approved in early 2015. We spoke to three different hedge guys, and all own the bonds. A cash raise, either through a stock financing or a partnership, should free up the borrow (the latter because the stock should rise, creating a squeeze). We recommend this one for both outright and hedge guys.

 The MACK convertible provides an interesting blend of the other names. Like INCY, it has substantial downside exposure because of the high dollar price. Unlike INCY, it has very little risk of premium contraction. This is one of those good-bad paradoxes you get with convertibles.

 Borrowing MACK is quite expensive for hedgers, so the bonds only trade at about a 10% premium, easily recaptured with about three years of coupon income (as long as the company sticks around). The bonds are a no-brainer swap for current MACK shareholders—not that it’s ever easy to convince equity investors to buy convertibles.

 Since the bonds are well in the money, given the borrow issue, the price point makes them tough to hold.  Difficult trades often reward those who can gut it out. We think that as opposed to INCY, where there are many ways to lose, MACK gives you a lot of ways to win.  Meanwhile, because of the low premium, convertible holders should participate in better than 80% of the stock’s upside.