By Ronda Fears
Nashville, Tenn., April 10 - The convertibles of generic drugmakers have interesting participation with the stocks but understanding the credit is essential, which is what steered Deutsche Bank Securities convertible analysts to make their picks among King Pharmaceuticals, Teva Pharmaceuticals, Ivax Pharmaceuticals and Alpharma.
"Upside/downside analysis flatters lower credit quality issues because it does not account for credit spread expansion in the stock down scenario," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Wednesday.
"But for holders of the underlying stock or for investors who can get comfortable with the credit, a number of these convertibles offer highly attractive risk/return profiles.
Credit analysis reveals that King Pharma and Teva are the most attractive from a fixed-income perspective, the analysts said, and the two Ivax bonds are moderately attractive.
The two Alpharma bonds have significant credit downside, the analysts said, and are unlikely to achieve the theoretical downside performance suggested in analysis because it is contingent on the credit not deteriorating, "an assumption we hesitate to make at this time."
Thus, the analysts' pick for best buy of the group is the King Pharmaceuticals 2.75% due 2021 with an "up and coming credit story" and an excellent profile. The convert trades with a 48.9% premium and 4.07% yield to put. There is hard call protection until Nov. 20, 2006, when it becomes putable at par.
There is a difference of opinion on King Pharma between the two rating agencies, the analysts said, noting that King Pharma's recent $400 million senior secured bank revolver maturing in 2007 is rated one notch above the converible, or Baa3, by Moody's while S&P rates it equal with the convert at BB.
"Given the relatively modest amount of debt on the balance sheet, and given its success at integrating acquisitions, we believe KG to be a possible candidate for upgrade by the agencies in the next 12-18 months," the Deutsche analysts said.
"We do note, however, that collateralization of the bank facility may be inconsistent with an investment grade rating."
Using a credit spread of 325 basis points over Libor, the analysts said the upside/downside profile of 58.9%/23.3% is extremely good. If the King Pharma convert were to be upgraded one full notch then a credit spread of 250 basis points over Libor would be more appropriate, the analysts said. Thus, implied volatility of the bond would decrease to 33.7% from around 37%, and an asset swap market would likely develop for the bond.
Teva also is attractive from a fixed income perspective, the analysts said, but they recommend the 0.75% due 2021 over the 1.5% due 2005 for better participation. The analysts also warn that investors should beware of the impact of the Middle East conflict on this Israel-based firm.
Ivax is a good best risk-adjusted convert, too, the analysts said, but recommend the 4.5% due 2008 over the 5.5% due 2007 for defensive exposure, asserting one could afford to be wrong on the stock if they are right on the credit.
Alpharma should be avoided until the credit improves, the analysts said. Debt ratios were poor in 2001, the analysts said, and the theoretical downside participation for the 3% due 2006 is probably too optimistic. Alpharma also has a 5.75% due 2005.
In fiscal 2002, King Pharma posted an extremely strong operating margin of 43%, the analysts noted, while Teva and Ivax had similar operating margins of 17% and 22%, respectively. Alpharma posted a dismal 2.5% operating margin and had $102 million of EBITDA but only 25% came from operating income.
Interest coverage at King Pharma of 29.1 times was excellent, the analysts pointed out, but Teva and Ivax also had reassuringly good coverage ratios of 9.8 times and 6.4 times, respectively. Alpharma, however, was unable to meet interest expense with operating income.
From a balance sheet standpoint, the analysts noted that the debt-to-total-capital ratios of Teva, Ivax and Alpharma are all fairly similar, within a 51% to 57% range. King Pharma has a significantly lower level of debt, at just 15% of total capital.
Looking at debt-to-EBITDA, the ratios for Teva and Ivax are virtually the same - 3.09 times and 3.02 times, respectively - while King Pharma's is less than 1 time. Alpharma's debt-to-EBITDA is 10 times, the analysts said, a function of poor operating performance in 2001.
Cash and equivalent positions of Teva and King Pharma are very healthy, the analystss said, providing additional comfort and liquidity to help fund future merger and acquisition activity. However, none of the four companies are burning cash in the traditional sense, the analysts added.
Alpharma posted a loss for fiscal 2001 of $38 million, but anticipates returning to profitability in 2002. The analysts noted that as part of the ongoing restructuring at Alpharma, the company recently announced plans to exchange $110 million of the two convertible bonds for equity.
Table 1: Participation rates for + 25% / -25% move in stock price over 12 months
| Upside | Downside | Participation | Recommendation
|
| Convertible | Participation | Participation | Spread
|
| King 2.75% 2021 | 58.91% | 23.33% | 35.58 | Buy Best Buy in Sector
|
| Teva 0.75% 2021 | 34.67% | -5.62% | 40.29 | Buy
|
| Teva 1.5% 2005 | 22.15% | -15.98% | 38.13 | Hold / Switch
|
| IVAX 4.5% 2008 | 46.57% | -19.15% | 65.72 | Buy
|
| IVAX 5.5% 2007 | 41.77% | -17.43% | 59.20 | Hold / Switch
|
| Alpharma 5.75% 2005 | 25.46% | -8.18% | 98.44 | Wait
|
| Alpharma 3% 2006 | 58.41% | -45.03% | 33.64 | Wait
|
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| Source: Deutsche Bank Securities Inc. (A negative downside participation rate means that the convertible rises even if the stock falls.)
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