Deutsche on biopharma: buy Inhale, Cell Therapeutics; hold Abgenix, Alexion; sell Vertex, ISIS

By Ronda Fears

Nashville, Tenn., June 12 - It is tough to gauge the credits on most U.S. biopharmaceuticals, but a report Wednesday by Deutsche Bank Securities convertible analysts focuses on the hardest - unrated credits of firms without other public debt and with low revenue streams as well as no profitability.

The analysts recommend buying Inhale Pharmaceuticals' two issues and Cell Therapeutics. They say hold the Abgenix and Alexion convertibles. And they suggest selling Vertex and ISIS Pharmaceuticals.

"Many U.S. biopharmaceutical credits are driven by the market's perception of the future potential of drugs and products currently in development. For many, current revenues are small compared to operating expenses and many do not have a commercially viable product at all," analysts Jeremy Howard, Jonathan Cohen and Robert Barron said in the report.

They chose six companies - Abgenix, Alexion, Cell Therapeutics, Inhale, ISIS Pharmaceuticals and Vertex - none of which are rated or have other public debt outstanding to illustrate the difficulty of gauging credit spreads for the convertible bonds in the sector.

The analysis focused on companies without significant revenues or profitability and so excluded those with established products, such as Cephalon.

The credits were analyzed with reference to cash on the balance sheet, current cash burn rates, liabilities identified and due over the next five years and the number of products in different stages of clinical trials. To derive the implied credit spread for each bond, a 60% stock volatility input was used.

Inhale has a 3.5% due 2007 and 5% due 2007, but the analysts noted that the 5% issue has only $61.4 million outstanding so liquidity is limited.

"Inhale is certainly risky, but it is not the 'one chance' credit that is often perceived," the analysts said.

Inhale's risk revenue base will remain a cause for concern until its inhaled insulin product Exubera is in the market. The product is not yet the subject of a New Drug Application filing.

"However, management believes that profitability is achievable in the foreseeable future (4Q 2005), and the company does appear to have sufficient liquidity to stretch to 4Q 2005 and even through 2006," the analysts said.

"Given an adequate cash position, a cost structure which is becoming increasingly reliant on partners and identifiable fixed charges going forward, we are recommending a conservative credit spread of L+1,200 bps for both the Inhale 3.5% 2007 and the (illiquid) Inhale 5.0% 2007."

The implied credit spread for these bonds, assuming a stock volatility of 60% is 1,370 basis points (3.5% of 2007) and 1,540 basis points (5.0% of 2007). Using Libor plus 1200 basis points, the theoretical value of the 3.5% is 54.15 and the 5% is 63.53, roughly 4 points and 7 points above their respective closing prices.

"Inhale's spreads have widened significantly through 2002, providing an interesting entry point for investors taking a longer term view," the analysts said.

"The spread is wider on the 5% 2007 even though it has a higher coupon and matures before the 3.5% 2007 bond because only $61.4 million of the original $230 million remains outstanding. Both issues are subordinated and have the same guarantor."

Deutsche Bank equity research currently has a strong buy rating on Inhale stock with a price target of $18.00.

Cell Therapeutics has a 5.75% due 2008. The Deutsche analysts said the company has roughly three years of cash and will need to raise more capital as the majority of its product pipeline is in Phase II. The company has a very low market capitalization, the analysts added, and on balance is a misunderstood credit.

"Cell Therapeutics is not dissimilar to Abgenix. It appears well funded, albeit less so, versus its current burn rate. But its product pipeline does not indicate profitability in the foreseeable future as there are relatively few products in Phase III. We therefore feel that Cell Therapeutics will need to access the capital markets again by 2004," the analysts said.

"We are concerned about the market cap of Cell Therapeutics, which has recently shrunk to $214 million, potentially limiting access to the capital markets. This is somewhat counterbalanced by the pipeline which appears to be fairly deep with Phase II products."

Given the reasonable cash position, controllable cost structure and identifiable fixed charges, the analysts recommend a credit spread of Libor plus 1,300 basis points for the Cell Therapeutics 5.75% 2008.

"This is significantly tighter than the implied credit spread of L + 1,600 bps (assuming stock volatility of 60%), hence our buy recommendation," the analysts said.

"Using L + 1,300 bps, the theoretical value of this bond is 58.07, a full 5 points above its recent level. Like Inhale, Cell Therapeutics has suffered a severe deterioration in spread since April, and with the yield recently rebounding off 20%, this again looks like an interesting entry point."

Abgenix has a 3.5% due 2007. Deutsche said the company has a liquid cash position and potentially low burn rate, but the majority of its products are only in Phase II.

Still, Abgenix is one of the strongest credits in the report, the analysts said, and would be a good buy at lower levels.

"There is significant risk in this credit," the analysts said.

They recommend a Libor plus 900 basis points spread for Abgenix, the same as the implied spread on Abgenix' 3.5% due 2007 using 60% volatility. "So although we like the credit in this space, we would not recommend adding this bond at current levels."

The analysts said a spread in the Libor plus 1,000 to 1,100 basis points range would be an attractive entry point, however.

"We caution that Abgenix may actually need all its liquidity as the majority of its new drug pipeline is only in Phase II status and if the burn rate remains as high as it was in Q1 2002 for the remainder of the year, our L + 900 bps will need to be re-evaluated," the analysts added.

Alexion has a 5.75% due 2007. Deutsche analysts noted the company will need to raise more capital as a majority of its pipeline also is in Phase II. They also note the company is heavily invested in one drug, with a very low market cap.

"Alexion's product pipeline appears to lack depth in comparison to other convertible bond issuers and its small market cap gives us cause for concern," the analysts said.

With nearly $360 million cash and securities on the balance sheet at Jan. 31, $183 million of identifiable fixed charges through 2007 and a burn rate of roughly $30 million, Alexion at first appears a reasonably strong credit, the analysts said.

But capital expenditures are likely to increase if Alexion's pexelizumab goes to phase III and it is also clear that Alexion will need to raise more capital, the analysts said, adding that Alexion also has a market cap of less than $300 million, which could hamper its ability to access the capital markets.

"Alexion 5.75% 2007 is trading on an implied credit spread of L+1,400 bps (using a 60% vol), a spread that we view, conservatively to be correct," the analysts said.

"We therefore recommend a HOLD on this bond, and would not recommend adding at current levels."

Vertex has a 5% due 2007, and while the Deutsche analysts said it was the best credit of the bunch, the metrics do not warrant a spread of 700 basis points, so they suggest selling on overvaluation.

"Vertex is the only issuer for whom subordination has a meaningful impact on the credit of the convertible bond. Vertex is the best credit in this report and we feel a spread of L + 800 fits its credit profile and balance sheet risk," the analysts said.

While recognizing the sizable cash position of roughly $700 million as of March 31 and the fact that its Agenerase sales contribute cash, the analysts identified some $835 million of charges that Vertex will incur in the future. They also note that since the commercialization of Agenerase, the burn rate has stepped up, illustrative of management's willingness and ability to increase and advance products in the research and development pipeline.

"The pipeline itself shows only one Phase III candidate, another HIV drug (collaborator partner GlaxoSmithKline) and four Phase II drugs, only one of which is partnered," the analysts said.

"This could signal an even more pronounced cash burn rate as the other three Phase II drugs move forward without collaboration to help defray expenses."

They also highlight that in the identified contractual obligations, nearly half the amount, or more than $400 million, comes from leases, which are assumed to be senior to the subordinated convertible.

In October, the company bought back $30 million of the convertible for $18.9 million at an average price of 63, reducing the outstanding balance to $315 million.

"We view such action favorably, as indicative of management's willingness to manage the balance sheet opportunistically," the analysts said.

"Vertex 5.0% 2007 is trading on an implied credit spread of L+700 (using a 60% vol). We view this to be inconsistent with its credit profile. We feel a spread of at least L + 800 bps is more in line with Vertex's credit profile and inherent balance sheet related risk. However, we recognize large portions of the operating burn rate to be discretionary, and even with the recommendation of L + 800 bps, Vertex remains the best credit in this report. L + 800 bps implies a theoretical value of 72.5 on the bond, 3 points lower than its last closing price. Thus we recommend a SELL on this bond on valuation grounds only."

The analysts noted that downside is limited by the company's apparent willingness to buy back bonds in the mid-60s.

ISIS has a 5.5% due 2009 that the Deutsche analysts suggest selling because the spread is too tight. They also note that while the company has a lot of cash today, it may need to raise more capital.

"The cash burn in Q1 2002 increased very significantly, $22 million for Q1 versus $15 million for all of 2001, as the company put cash to work in anticipation of proceeds from its recent April 2002 convertible offering," the analysts said.

"With fixed costs in excess of $300 million over the next five years, ISIS appears to be adequately funded. However, with the majority of its pipeline in Phase II or pre-clinical status, we believe that ISIS may still need additional liquidity."

It is a concern that management stated that ISIS had sufficient liquidity for several years in its 2001 10-K and then issued $125 million of new convertible debt shortly afterwards, the analysts said.

"Based on its liquidity position and current burn rate, we feel that ISIS should trade somewhere between Abgenix and Inhale. Based on our analysis, Abgenix is a stronger credit and therefore we recommend a spread for ISIS of L + 1000 bps, 100 bps wider than Abgenix'spl0 L + 900 bps," the analysts said.

"This makes the ISIS 5.5% 2009 bond a clear SELL for us, as its implied credit spread (using 60% stock volatility) is 850 bps."

Inhale Therapeutic 3.5% due 2007 - Buy

Convertible Price: 49.227 bid

Parity: 13.26

Premium: 276.9%

Yield to maturity: 19.19%

Current Yield: 7.03%

Stock Price: $6.69

Equity Market Cap: $324 million

Outstanding: $230 million

Ranking: Subordinated

Inhale Therapeutic 5.0% due 2007 - Buy

Convertible Price: 53.07 bid

Parity: 17.44

Premium: 209.9%

Yield to maturity: 20.32%

Current Yield: 8.95%

Stock Price: $6.69

Equity Market Cap: $324 million

Outstanding: $61.4 million

Ranking: Subordinated

Cell Therapeutics 5.75% due 2008 - Buy

Convertible Price: 50.765 bid

Parity: 17.88

Premium: 186.7%

Yield to maturity: 19.3%

Current Yield: 10.73%

Stock Price: $6.08

Equity Market Cap: $214 million

Outstanding: $175 million

Ranking: Subordinated

Abgenix 3.5% due 2007 - Hold

Convertible Price: 76.875 bid

Parity: 42.39

Premium: 82%

Yield to maturity: 10.42%

Current Yield: 4.51%

Stock Price: $11.69

Equity Market Cap: $926 million

Outstanding: $200 million

Ranking: Subordinated

Alexion Pharma 5.75% due 2007 - Hold

Convertible Price: 62 bid

Parity: 11.61

Premium: 438.2%

Yield to maturity: 19.62%

Current Yield: 9.76%

Stock Price: $12.36

Equity Market Cap: $224 million

Outstanding: $120 million

Ranking: Subordinated

Vertex Pharmaceuticals 5.0% due 2007 - Sell

Convertible Price: 75.377 bid

Parity: 17.45

Premium: 334.8%

Yield to maturity: 11.02%

Current Yield: 6.52%

Stock Price: $16.10

Equity Market Cap: $1.22 billion

Outstanding: $315 million

Ranking: Subordinated

ISIS Pharmaceuticals 5.5% due 2009 - Sell

Convertible Price: 79.053 bid

Parity: 46.92

Premium: 69.6%

Yield to maturity: 9.51%

Current Yield: 6.76%

Stock Price: $7.80

Equity Market Cap: $423 million

Outstanding: $125 million

Ranking: Subordinated

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