Salomon analyst: Buy Sepracor 7% convertibles on weakness

By Ronda Fears

Nashville, Tenn., March 19 - Salomon Smith Barney convertible analyst Stuart Novick recommends buying Sepracor Inc.'s convertibles on the weakness they are experiencing in the wake of the sell-off following news that the biotech firm's new allergy drug has been rejected. He prefers the 7% issue of the company's three converts due to their shorter maturity and higher yield, but noted there is an elevated risk that Sepracor will be unable to pay off any of the convertibles.

"With all three converts now well out of the money, investor thoughts of ultimate conversion into equity faded into the background while concerns over the company's eventual ability to make good on the bonds were pushed to the fore," Novick said in a report Tuesday.

"The credit concerns caused the bond floors on the 5.75s and the 5s to drop and their premiums to shrink, leaving only the first maturing 7s relatively unscathed."

In addition to the 7% convertible due 2005, Sepracor has a 5.75% convertible due 2006 and a 5% convertible due 2007. All are rated CCC+.

Sepracor's dive came after the FDA told the company that it would reject its application for a new allergy drug, Soltara. Regulators were concerned that patients in clinical studies had not reached peak concentrations of the drug, leaving its safety subject to question.

The upshot for the biotech company is that it may now need to conduct further studies on Soltara, delaying a potential introduction by a year or more. More important, the rejection means that the ultimate approval of the drug is now in some doubt.

The news cut almost 60% off the price of Sepracor shares and the curveball hurt the convertibles on two fronts.

First, with the stock down, the bonds' optionality evaporated, particularly for the 7s and the 5.75s, both of which have conversion prices in the $60 range, Novick said.

Second, the analyst added, and on a more fundament note, the development means that Sepracor has no new blockbuster on the near-term horizon. The next candidate for approval in the company's pipeline is roughly one year away and holds less promise than Soltara.

"That suggests the company will have to continue siphoning cash from its balance sheet, meaning further financial erosion until such time as Sepracor comes up with a blockbuster," Novick said in the report.

"The company does have a substantial pile of cash, $500 million of which was added last November when it issued its 5.75% convertible bonds of 2006. Estimated total cash is approximately $840 million. In terms of maturity, the new issue was shoehorned between Sepracor's other two converts."

Aside from those three bonds, the company has no other debt, the analyst noted, adding, however, that the company's cash burn remains substantial.

The delayed launch of Soltara is a mixed blessing, he said, since it should reduce Sepracor's losses for the next year in the absence of ramped up marketing costs. But, he added, the red ink is now likely to persist for at least the next couple of years - longer than prior expectations.

Thus, net losses through 2004 could potentially top $650 million, Salomon estimates, about $100 million more than previously projected. That would leave Sepracor with less than $200 million in cash at the time the $300 million in 7% converts of 2005 mature.

All three issues are putable at par in the event of a takeover, but Novick said he wouldn't bank on a buyout offer since such a development could potentially alienate all of Sepracor's major partners except, of course, the buyer.

Novick said the major risk is that Sepracor may be unable to generate adequate income through its pipeline in the next few years as it continues to spend heavily to develop one or more new drugs.

"There would then be a real possibility that cash would dwindle to the point at which none of the three converts would be paid at maturity," Novick said in the report.

Novick also pointed out that if the yield differential between the 7% bonds of 2005 and the last to mature 5% bonds of 2007 were to widen, he'd swap into the 5s. At the present time, the thin 50 basis point spread between the bonds favors the 7s of 2005 since investors would, in theory, get paid first rather than gamble on the extra 0.5%.

"But since we're not quite convinced that even the 7s will get paid at maturity, enough of a yield spread between the issues would cause us to rethink our position," Novick said in the report.

"In other words, we see the Sepracor situation as an all-or-none outcome in which either all of the issues will be money good (in the event of a takeover or a big cash generation occurrence like the commercialization of one of the company's drugs) or none of them will."

The three converts rank pari passu to one another and would be subordinated to any senior debt incurred by the company. There is currently no bank line ahead of the converts. The addition of a bank credit facility, he noted, would push the three converts into a subordinated position in the capital structure, so he would favor the first maturing 7s on a relative basis.

Sepracor 7% due 2005 (CCC+)

$300 million

Convertible Price: 74

Common Price: $21.90

Current Yield: 9.50%

Yield-To-Maturity: 16.71%

Common Yield: 0.00%

Conversion Premium: 110.30%

Investment Premium: 8.20%

Breakeven: 5.52 years

Conversion Price: $62.44

Conversion Ratio: 16.016

Call: Dec. 20, 2002 at 103

Fair Value: 74.44

Delta: 36.2%

Spread: 1500 bps

Investment Value: 68.17

Option Value: 6.27

Volatility: 60.0%

Upside Participation: 83%

Downside Participation: 39%

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.