As of late there has been a lot of chatter about how Vertex's (VRTX) stated intention to retire some debt into equity is bad for current shareholders. The chatter has been relentless by Vertex short sellers all over the message boards and even in some other posted Seeking Alpha articles. However, I strongly disagree.
Let us go back to school for a moment and think of an antiquated term called "Net Asset Value". Net Asset Value is the term that owners, i.e., shareholders can look to if the company is completely liquidated, i.e., goes bankrupt. Net Asset Value is calculated as total assets less total liabilities and intangible assets.
The presumption with Net Asset Value - NAV - is that in a complete liquidation, the intangible assets would have zero value; however, in reality, that is often not the case.
For the rest of this article, the financial statement values will be in thousands. The per share amounts are stated as is.
At the end of the 2012 fiscal year, Vertex had $2,759,288 in total assets, $1,524,906 in total liabilities, and $663,500 in intangible assets. This implied a NAV of $2.62 per share. At the end of the first quarter of 2013, Vertex had $2,392,234 in total assets, $1,415,402 in total liabilities, and $250,600 in intangible assets. This implied a NAV of $3.32 per share. The large reduction in intangible assets was due to a write down of VX-222 as stated in the most recent conference call [see transcript].
Vertex has convertible debt to the sum of around $400,000. The conversion price of the debt is $48.83 per share and is callable on or after October 1, 2013. Vertex holds a provisional redemption option (soft call) that allows the debt to be called prior to October 1, 2013 if the closing price of Vertex shares is above $63.48 per share for 20 of 30 consecutive trading days.
In the scenario where the 20 days for Vertex to be above $63.48 per share expires on May 9th, one would consider stock dilution to be a major issue. This has been the thesis and pitch by the majority of the Vertex naysayers for the last two weeks.
Yet does that thesis hold up in the court of facts?
Let us first look at what the balance sheet looks like after conversion assuming that assets are the same: $2,392,234 in total assets, $1,015,402 in total liabilities, and $250,600 in intangible assets. Adding roughly 8,200 shares to the 218,652 shares outstanding as of the end of 1Q:13 brings our total shares outstanding to 226,852. This implies a future NAV after conversion of $4.96 per share, or an increase of 49.39%.
The conversion would lower debt, lower interest expenses, and create a higher NAV which are all strong positives for shareholders. When you factor in the increases of late with implied "market" value in Vertex based on development of its pipeline and diminishing Incivek sales, reducing its debt burden only makes good business sense. And further assuming that the "market" value after VX-661 remains unchanged at roughly 17.5 billion, this implies a future market price of $77.14 per share after the so called "apocalyptic" dilution the short sellers are promoting.
The mistake these short sellers are making is presuming that the amount of 'dilution' that is supposedly going to occur on the 9th of May or soon after is a surprise. Whereas the efficient market hypothesis would dictate that this event is already priced in because the public already knows the material fact.
So what does the savvy investor do? First let's get a little background.
It is a well known figure that roughly 90% of options buyers lose money... and that was certainly not the case last month.
After the pop that occurred with the latest VX-661 data, most of those call options writers (sellers) are in the red. So it is in the interest of these options writers to sell short and drive the price down, or sell puts and drive the price up to get out from underneath the 344 million dollars the call writers are in the red on paper before the May expiration where those losses become real.
I have looked at both sides of the trade, and I will spare you the math, but it looks well nigh impossible that the options writers could recoup a higher % of their money by pushing the price up then by pushing the price down. So down she is going to go... and has gone since the pop, but the relevant question is how far will she continue to go? Let's shelve that question for the moment.
The other consideration is that there is currently an extremely high amount of open interest for the May put options in the forty to mid fifty dollar range. What incentive do the writers have to target these levels? If 90% of options buyer lose money, that implies that 90% of options sellers make money... and also that there is a 90% chance that Vertex will not drop below the mid fifties.
When you sell a put, you have to have capital and margin available to cover the cost of the potential called purchase. In the interim, the put seller has the capital from the sale.
My theory and assumptions are that the institutional ownership of Vertex stock who sold the majority of the May calls (which are now 344 million in the red) are both looking to reduce their losses by selling short and concurrently selling puts in the forties and mid fifties because they believe the stock cannot fall that far. With the conglomeration of capital, they will then flood the market with purchases which will drive the price back up in an effort to get back to even.
Main street will be left scratching their heads claiming it doesn't make any sense... they will claim, "The stock was supposed to go down! I lost all this money!" - always famous last words on Wall Street.
On April 19th, a large group of people lost a lot of money. They are trying to get it back. Do yourself a favor, and don't put yourself in a position to get fleeced. If you play big money's game, just remember they make the rules.
If I was trading Vertex at the moment, I would strongly look at selling the May $55 puts or even doing a vertical spread to control my risk. I would most certainly not be in a naked short, the time to close that position was last week.
I am long Vertex stock and May and July options. All of my positions are in the money and I have no intention of making any trades within 72 hours.