Deutsche: Buy ICN on weakness after spinoff of Ribapharm

By Ronda Fears

Nashville, Tenn., April 16 - Uncertainty over whether the spin-off of Ribapharm would go ahead caused a slump in ICN Pharmaceuticals Inc. shares and in the valuation of the ICN 6.5% of 2008 convertible bond. Deutsche Bank Securities convertible analysts believe the issue is undervalued and recommend it on the weakness.

"The recent cheapening of ICN 6.5% 2008 to a 27.3% implied volatility (using Libor plus 500 basis points) discounts a great deal of uncertainty," said Deutsche analysts Jeremy Howard, Jonathan Cohen and Robert Barron.

"We feel that the bond should be able to support a richer valuation." But, the analysts also note that "the ICN/Ribapharm story is not without risk."

The best points in favor of holding the convertible, the analysts said, are volatility, a well underpinned credit, high yield and call protection through July 2004.

Factors that make it risky, the analysts said, include shareholder unrest, no guarantee of favorable tax treatment and the loss of Ribapharm revenues.

The IPO of Ribapharm was completed successfully last Thursday, raising $260 million (pre-shoe) in new cash and allowing ICN to tender for all of the $194.6 million of its 8.75% senior straight notes, thus leaving only the convertible debt.

ICN has said it will proceed with a full spin-off of its remaining Ribapharm stake by distributing Ribapharm shares to ICN shareholders as soon as it receives a favorable IRS tax ruling, which is expected by yearend.

The Ribapharm IPO filings confirm the position of the ICN 6.5% 2008 convertible following the full spinoff. The bond will be jointly and severally guaranteed by both ICN and Ribapharm and will convert into a basket of approximately 1.5 Ribapharm shares and 1.0 ICN shares.

Volatility of the basket is likely to be at least in the mid-40% area, the analysts said. With the joint guarantee providing a "best of" credit option in the future and with solid ratios at ICN even without Ribapharm, the analysts are comfortable with the credit spread of 500 basis points over Libor.

The high coupon is particularly attractive for outright funds, the analysts said, noting that only 17 convertibles in the Deutsche liquid universe have higher coupons. Moreover, the analysts said the current yield of 6.23% is highly attractive in current environment.

Hazards could be created, the analysts said, by the conflict between ICN and two major shareholders that have filed opposition nominees for the May 29 election to the ICN board of directors. Those are Franklin Mutual Advisors and Iridian Asset Management.

The main negative for convertible investors is the conversion into a basket of ICN shares and Ribapharm shares, the latter with no historical data. The current 260-day historical volatility of ICN is 38.6%, but the crucial question is how volatile a basket of 1.0 ICN and 1.5 Ribapharm shares would be.

"Because Ribapharm has only a couple of days of trading history, we cannot observe its volatility empirically. Therefore, we constructed a proxy basket of: 1.0 ICN shares and 1.5 Enzon shares," the analysts said.

"Enxon is a good proxy because it also receives royalities from Schering-Plough for a Hepatitis C treatment as its main source of revenue. Enxon has a HVol of 59.3% and a market cap of $1.69 billion."

The weighted ICN / ENZN basket had a 260 HVol of 49.5%, the analysts said. Despite the less than 1:1 correlation between the stocks, the analysts noted, Enzon's higher volatility pushed the basket volatility up, rather than down.

"There are a couple of health warnings here. We do now know how easy it will be to borrow and trade Ribapharm shares, or what will happen to liquidity in ICN following the spin-off," the analysts said.

"But if the spin-off were to occur tomorrow, an efficient market would give a market cap of $1.07 billion to ICN and $1.6 billion to Ribapharm - offering grounds for hope that both stocks will trade well."

ICN 6.5% 2008, as of April 15 close

Price: 104.377

Parity: 82.965

Premium: 25.81%

YTM: 5.66%

Current Yield: 6.23%

Implied Volatility: 27.3%

Delta: 66.2%

Equity Price: $28.42

Call: July 21, 2004

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