Salomon says Vertex Pharmaceuticals risk worth the yield for tolerant investors

Nashville, Tenn., Nov. 14 - Vertex Pharmaceuticals Inc. is more a victim of guilt by association and has suffered largely due to the slide in the biotech sector over the past year rather than ailing from poor fundamentals, suggest Salomon Smith Barney convertible analysts. Stuart Novick, convertible analyst at Salomon, said the risk/reward tradeoff is worth the 12.4% yield, given a belief in the underlying stock story and credit support.

Vertex shares have lost three quarters of their value since they topped out at around $100 a year ago, a recent Salomon report noted, as the stock peaked in November 2000 and then faded along with a number of other biotech companies. More than anything related to the company specifically, the Salomon convertible research team believes it was negative sentiment toward the sector that was responsible for the pullback in Vertex.

"The Vertex Pharmaceuticals 5% convertibles offer a compelling yield and what we'd consider to be an attractive risk/reward tradeoff. At present, the issue carries a 12.4% yield to maturity and is pegged to participate in approximately three quarters of a 25% upside move in the common shares over a one-year investment horizon. On the flip side, the bonds are likely to fall less than 40% as quickly as Vertex shares if they were to decline by another 25% in the coming 12 months," said Novick in the report.

"Additionally, the issue looks to be about 4% undervalued given our assessment of the appropriate credit spread and volatility. Specifically, we've put a 900 basis point credit spread on the bonds, tantamount to a single B credit, with a volatility measure of 60%. Given recent 100-day volatility of over 80% on Vertex shares and the 90%-plus implied volatility on Vertex calls, we think that the 60% figure is on the conservative side.

"For risk tolerant investors, we believe that the Vertex convertible bonds are a worthwhile holding as part of a basket of biotech holdings. The uncertainty surrounding nearly all of the names in this sector makes it more appropriate, in our view, to hold a number of them for the purpose of diversification. We count 33 biotech company coupon convertible bonds presently outstanding that mature in the 2006-2008 timeframe. Out of those issues, only a handful offer a richer yield than the Vertex bonds, and none offer the relative balance sheet support through the combination of cash and spending rates that this issue does."

Vertex's third quarter results topped expectations, the report said, noting that expectations were modest. In third quarter, Vertex lost 18c per share, or $13.5 million, compared to the consensus estimate of a 27c per share loss. In third quarter 2000, Vertex posted a smaller loss of $5.8 million, or nine cents on a per-share basis. Vertex posted better-than-expected operating results in the last five quarters, the report added, although the bottom line has been in negative territory in each of those periods. Stepped up research and development spending more than eroded any lift from added revenue, the report said.

According to Vertex management, fourth quarter should bring a moderate amount of improvement to both the top and bottom lines. The company is on track to generate revenues of between $44 million and $52 million, a sequential improvement of 10% to 28%, with per share losses shrinking to something in the range of 9c to 15c.

Vertex's strong cash position and modest cash burn suggest more than adequate credit support for the time being, Novick said in the report. At Sept. 30, Vertex had cash and marketable securities of about $730 million, down from roughly $814 million at the start of the, pegging the company's quarterly cash burn at just under $30 million. In terms of expected cash life, even if one were to use an annualized burn rate of $160 million to reflect a stepped up rate of research and development spending, Novick said the company would have more than six years of cash on its balance sheet. But the report said that Vertex's expenditures this year appear to be running at just about $25 million, which would stretch the expected life of the company's cash well beyond the maturity of the convertible in 2007.

In fact, the report said, at that spending rate, Vertex would have ample funds with which to redeem the convert in six more years. Another recent use of cash involves the repurchase of outstanding debt. In third quarter, Vertex bought back $30 million of its convertible bonds, recording a $10.3 million one-time gain in the process. Management said the company may buy back more debt in the future.

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