JPMorgan recommends 9 biotech convertibles for yield, capital appreciation, relative value

By Ronda Fears

Nashville, Tenn., April 10 - While to some degree there is still a "rationalization" of biotech stocks under way, JP Morgan convertible analyst Alexander Robinson said there are several issues in the group that would give investors yield pickup, capital appreciation and relative value.

"The convertibles offer an opportunity to participate in much of the price appreciation of the underlying common shares, while at the same time having a better total return in the event of a stock price decline, to enjoy a more senior ranking in the issuer's capital structure and to achieve a higher current yield than the dividend yield of the common shares," Robinson said in a report.

"We also note that biotechnology convertibles tend to offer important features that compare favorably to the broader convertible universe."

Robinson also noted that biotech stocks trade with unusually high volatilities, which can provide a source of opportunity for delta traders and those seeking "cheap vol."

From the universe of 44 publicly traded biotech convertibles issued by 34 separate issuers, the JPMorgan convertible analyst and the firm's healthcare equity analysts analyzed 17 of these issuers from fundamental, structural and valuation perspectives.

Three key criteria were convertible pricing that carries either favorable yield characteristics or favorable capital appreciation potential, strong company fundamentals - in particular, compelling liquidity and cash burn characteristics - and an underlying common stock on which JPMorgan has at least a long-term buy rating.

Based on these quantitative and qualitative criteria, nine convertibles were found that offer compelling value.

For balanced capital appreciation, high yield and downside protection, JPMorgan recommends Alexion Pharmaceuticals Inc.'s 5.75% convertible subordinated notes and Human Genome Sciences Inc.'s 5% convertible subordinated notes.

For capital appreciation, JPMorgan recommends CV Therapeutics Inc.'s 4.75% convertible subordinated notes, ImClone Systems Inc.'s 5.5% convertible subordinated notes and Medarex Inc.'s 4.5% convertible subordinated notes. JPMorgan has a positive outlook on the common stock of both companies, rating each buy or long-term buy.

For yield, JPMorgan recommends Invitrogen Corp.'s 5.5% convertible subordinated notes and Vertex Pharmaceuticals Inc.'s 5% convertible subordinated notes. The companies generate cash or have a solid cash cushion that should permit both to maintain many years' worth of research and development expenditures.

For attractive relative value, JPMorgan prefers Alkermes Inc.'s common stock to its 3.75% convertible subordinated notes but recommends both Invitrogen Corp.'s 2.25% and its 5.5% convertible subordinated notes.

The biotech industry has experienced unprecedented growth (91.1% in the AMEX biotechnology index) since the start of its bull market run in October 1999 despite a recalibration in 2001.

"We expect impetus for the group's stocks will continue to come from sales and earning growth, news from the clinic, pipeline progress and the addition of strategic alliances with big pharmaceutical companies," Robinson said in the report.

"The industry's ongoing rationalization of biotech market capitalizations maintains heightened volatility, however, so we advise investment only in premier biotech companies in the current environment. In 2002, exciting new products, pipeline growth and technology advancement should continue to fuel further growth for the biotech equity sector. With rationalization of biotech market capitalizations being the defining event of 2001, we foresee ongoing price volatility as investors become increasingly sensitive to disappointments."

Robsinson said the major potential of new products and technologies should prevent the biotech sector from sliding back into a sustained bear market like the 1990s. However, he said investors are likely to be more selective in stock picking and valuation.

"We recommend establishing or adding to positions in high-quality biotech stories at dips caused by high volatility," he said.

"Nonetheless, punishment can be swift in biotech, as was the case recently with ImClone Systems Inc., which has shed 26.2% of its market value following non acceptance of its drug for the treatment of refractory colorectal cancer by the FDA."

Valuation continues to be one of the toughest challenges for investing in the biotech sector, he acknowledged

Lacking visible EPS growth, innovative methods of according value to the technology and pipeline potential are being applied.

Confronted with a very complex, often idiosyncratic mixture of investment considerations, Robinson suggested investors thoroughly review the components that have consistently led to success in challenging, fast moving investment sectors.

Specifically, keep a close eye on current and near-term revenues or royalties, the size and potential risk of near-term products and deep pipelines, finances and corporate maturity, management quality and experience, sources and nature of news flow, business models, collaborations with big pharma or big biotech companies, technology platforms and scientific founders, and patents or other intellectual property.

"Globalization of biotech will foster competition and strategic alliances, which should benefit the sector's growth," Robinson said.

"Selective consolidation, which has already begun, is likely to play a big role in the future of individual companies and the sector."

Consolidation and change of control puts, credit upgrades following mergers, convert restructuring - buybacks, exchanges and flush-outs - bankruptcies and converts in limbo or busted all present opportunity to capture value, he said.

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