PDL BioPharma (PDLI) was a biotech research and development company until recently when it spun-off the research and development portion of the business, leaving behind six employees and seven patents to protect. The patents protect PDLI’s antibody humanization technology, and will be expiring between 2013-2014, at which point the remaining shell company will be dissolved. Until then, PDLI’s remaining six employees are working to monetize the patent pool through sale, securitization, or in the worst-case scenario, generating royalty revenue (no actual production is involved) and effectively maintaining a 100% dividend payout ratio. With clear guidance from management provided in the most recent conference call, valuation boils down to a simple discounted cash flow analysis.
Background and Science
PDLI’s patents protect “novel methods for producing, and compositions of, humanized immunoglobulins”. Immunoglobulins (more commonly known as antibodies) generally identify abnormal foreign material within the body such as allergens, bacteria, and viruses. It’s a normal and important component of the immune system. However, when immunoglobulins are synthesized artificially and introduced in an effort to help the body identify a target for therapy, the immunoglobulins themselves are sometimes recognized as foreign. The process of humanization makes it less likely for the patient’s body to recognize immunoglobulins as foreign, and therefore increases treatment efficacy.
PDLI’s seven patents generate royalties on nine medical treatments in use today, including some of the most expensive cancer and autoimmune disease treatments. Humanized antibody treatments are not normally a first choice for therapy because they are expensive, often have serious side effects, and frequently experience decreasing efficacy over a long course of treatment. However, research in this field and prescription rates have been increasing as side effects become better understood and more manageable.
PDLI is currently in a legal dispute with MedImmune, a licensee that has been responsible for 14, 16, and 18% of revenue in ’08, ’07, and ’06 respectively. In 2008 MedImmune made the claim that their products do not infringe upon PDLI patents, and that no royalty payments are owed. Another claim was made in 2009 that MedImmune should be entitled to a lower rate based upon a settlement PDLI made with Alexion, an unrelated thrid party. These claims are both still being worked out.
PDLI can best be valued by discounting future cash flows. I set up a pessimistic and optimistic forecast for future earnings based on management forecasts from the most recent earnings conference call. Management expects 2009 revenue to grow by about 30% but then completely subtracts out revenue from MedImmune, yielding an estimate of $310 to $325 million (10% growth from 2008). In a response to a caller’s question, the CFO estimated MedImmune related revenue to be between $35 and $45 million. Management also forecast sales, general, and administrative expenses between $12 and $15 million per year. In my pessimistic forecast, I assume revenue of $310 million that grows at a rate of 0% and SG&A of $15 million. In the optimistic forecast earnings are $370 million ($325 + $45 from MedImmune) in 2009 and grow at a rate of 30% (CAGR for royalty revenues have been 43% since 2003) with SG&A at $12 million.
My model has PDLI paying $1/share each year in dividends, consistent with the 2009 announced dividend rate. All other cash flow is held as cash until liquidation at the end of 2013. Long-term assets are considered to be valueless, and long-term liabilities are limited to debt, which receives special treatment discussed below. Non-cash net working capital of negative $18 million is maintained until 2013 at which point it’s reduced to 0 and deducted from cash flow for the year. Assuming the worst (that liabilities are liquidated now and assets remain until the end) only changes the NPV by about $0.02, so holding NCNWC flat is a fair and immaterial assumption. Each period’s share price is the present value of next year’s share price plus the dollar dividend. The final period’s share price is equal to the ending cash balance per share.
There are two outstanding debt issues, both of $250 million and both convertible. The notes that mature in 2023 are putable at par in 2010 and have been callable since 2008. The 2012 notes are not putable at any time, but will become callable in 2010. Both issues are currently trading at a discount to par and yielding around 9%.
Every bi-annual dividend payment of $0.50/share increases the bond conversion rate and decreases the conversion price per share. I modeled this as an annual $1 dividend to estimate the conversion rates in ’10 and ‘12. The relationship between share price, the conversion ratio, and shares outstanding has an interesting dynamic. Low share prices in early years increases the dilution effect of bond conversion because the dividend yield is high. Of course, no share dilution takes place unless the share price in a given period exceeds the conversion share price. A high current share price increase the conversion price, but it also increases the ending share count and decreases the present value of shares. The feedback loop is stabilizing if the share price is increasing until 2013, but destabilizing if the share price falls. This is a function of the dividend payout rate relative to earnings. I modeled the repayment of debt as though the bonds aren’t callable, which exposes PDLI to potential dilution.
In reality, however, with the bonds callable at par, repaying the debt shouldn’t cost more than $500 million total, and share dilution should only happen if PDLI decides to repay debt with stock instead of cash, which would be a dollar for dollar, equal value trade. In my pessimistic scenario, debt is repaid with no conversion, and shares outstanding remains at 119 million. In my optimistic scenario, the putable bonds have a conversion price below the expected share price resulting in varying amounts of dilution based on the discount rate. The 2023 notes that have a conversion premium are held on to until the final disbursement. But again, the stock dilution I modeled is unrealistically pessimistic because management can call the bonds back as soon as they are over par value.
Running the DCF at a range of discount rates yields the following valuations:
PDLI has been trading in the $7 range, indicating that the market is both expecting a pessimistic scenario to materialize and discounting it at a high rate. This analysis also doesn’t include the opportunity PDLI has to repay debt early, saving around 10%, and the effort management has been making to sell the patent portfolio as soon as possible. PDLI presents an attractive opportunity for hungry biotech companies to acquire an asset that produces an immediate and high return on investment, boosting revenue and margins. Efficiencies may exist for companies already making royalty payments or expecting to make royalty payments in the future.
Some celebrity investment funds have picked up on this company, with Baupost owning 13%, and D.E. Shaw and Renaissance owning 3% each.
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