K-V Pharmaceuticals - One Of The Best Risk/Reward Scenarios You'll Come Across

Jul.29.13 | About: AMAG Pharmaceuticals, (AMAG)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

In our July 15, 2013 email to GeoInvesting premium members we discussed the K-V Pharmaceuticals (KVPHQ.PK) Chapter 11 bankruptcy case. Shares were trading around $0.60 at the time of our email. Specifically, we questioned why shares have been strong in recent trading sessions. Shares traded around $0.20 toward the end of June 2013 and reached a high of $0.82 just a couple of weeks later on July 10. SEC filings clearly state that if the company emerges from Chapter 11 under the proposed reorganization plan that ownership interest of shareholders (around 50 million shares) who own the current stock will be cancelled and new stock (around 12 million shares) will be issued to a group of investors (Rights Offering). This investment group includes Deutsche Bank Securities, who will in total provide $275 million in financing. We decided to short KVPHQ. The stock retraced its entire bullish move by July 19, 2013. We have since covered our short position and are now long KVPHQ.

After further due diligence, prompted by a correspondence with one of our premium GeoInvesting members, we now know why some investors are making a speculative bullish play on the stock. As disclosed to our premium members in a July 23, 2013 alert:

In our 7/17/13 email we issued an update on the K-V Pharmaceuticals (OOTC:KVPHQ) story, now trading at ($0.18). In our article, we stated that new information had shed some light on the K-V bankruptcy. While we originally went short the stock on 7/15/13, our 7/17/13 update introduced a possible bullish thesis. As we stated in our follow up report, this was a high risk/reward play. With the recent decline in share price we believe that the risk/reward is even more favorable now. We are still long a small speculative position and look to add to our position at these levels.

K-V shares have rebounded and now trade around $0.50.

There are some facets to this story that could result in the current Chapter 11 reorganization plan to be cancelled, or at the very least revisited, and could possibly result in the current equity holders not losing their ownership interest in KVPHQ. If these factors play out, we believe, based on our own analysis and conversations with various special situation investors, that the stock could be worth well north of $5.00. The most glaring piece of evidence that could make the short KVPHQ play a very risky and devastating proposition comes right from the SEC filings that deal with the bankruptcy.

From section 7 of the Rights offering:

"Except as set forth in Section 7(b), this Agreement (including the Commitments) may be terminated and the transactions contemplated hereby may be abandoned at any time by any Investor upon the occurrence of any of the following:

at any time after September 12, 2013 (the "Confirmation Order Date"), if the Bankruptcy Court has not entered the Confirmation Order with respect to the Chapter 11 Plan on or prior to such date; provided, that the Confirmation Order Date may be extended by the Company on one occasion until the date that is no later than October 12, 2013 (subject to the provision in the last sentence below) solely in the following circumstances: (1) following the date the Bankruptcy Court has entered the Agreement Order and prior to September 12, 2013, a Regulatory Action has occurred;"

True to form, SEC jargon from this passage is not easy to decipher, but the key element of this past issue is the phrase "Regulatory Action", which could be interpreted as a legislative action taken by the U.S. Government that could lead to the cancellation of the current Chapter 11 plan."

As we will discuss, a bill that would greatly improve KVPHQ's business outlook and shield U.S. pharmaceutical companies from negative competitive forces (Pharmacy Compounders) is imminently due for a vote in the U.S. Senate. If the Senate approves the proposal, it would later go to the House of Representatives for final ratification. We believe that the Passage of this bill by the Senate before September 12, 2013 could cause the current Chapter 11 plan to be cancelled. We do feel that the bill will pass the Senate floor. If it does, we believe KVPHQ will surpass its recent high of $0.82. The following quote from a July 19, 2013 KVPHQ SEC filing supports our belief:

"In addition, since the tragic meningitis outbreak, compounding pharmacies have been subjected to heavier scrutiny and inspection by the FDA and State Boards of Pharmacy, and there have been calls for new and/or stronger legislation with respect to compounding. The U.S. Senate Committee on Health, Education, Labor & Pensions recently approved legislation (S. 959) providing for increased federal regulation of certain types of pharmaceutical compounding. Supporters are attempting to obtain full Senate consideration."

Further confidence that the bill has a high probability to pass comes from knowledge that this bill has been "hotlined," which suggests that it could be passed by unanimous consent. Such a process can be accomplished by phone.

As stated on coburn.state.gov:

"This can be used to quickly move non-controversial bills or simple procedural motions - to pass complex and often costly legislation, in some cases with little or no public debate."

"In order for a bill to be hotlined, the Senate Majority Leader and Minority Leader must agree to pass it by unanimous consent, without a roll-call vote. The two leaders then inform Members of this agreement using special hotlines installed in each office and give Members a specified amount of time to object - in some cases as little as 15 minutes. If no objection is registered, the bill is passed."

It is extremely important to realize that if we essentially eliminate pharmacy compounders from the equation due to the passage of this Bill, K-V's competition becomes immaterial overnight; And as we will discuss, its revenues could balloon to north of $400 million, equally as fast. (K-V revenues were only $23 million in 2012).

We think there is a very good chance that the Convertible Subordinated Note Holders who will only recover 10.87% of their $201 million claims under the current plan, compared to senior note holders who will receive 100% recovery ($231 million), will offer strong opposition to the plan if a regulatory action improves KVPHQ's business prospects so that it will be able to service its debt.

We have been in contact with a shareholder activist, Zvi Rhine - a principal at Sabra Capital Partners, who is helping to lead a charge to propose a Chapter 11 reorganization plan that will preserve ownership interests. We are comfortable riding the coattails of Mr. Rhine, who has had success in other special situation plays. For example, Mr. Rhine claims that he started purchasing shares of Great Wolf Resorts at around $2.00 in late 2010 and was instrumental in making sure that Great Wolf maximized shareholder value when it received a $5.00 buyout proposal from Apollo Global Management in March 2012. His involvement led to competing buyout bids that ultimately led to the company being acquired for $7.85 by Apollo in April 2012.

While there is no guarantee that a new Chapter 11 plan to preserve equity interests will be approved, the Risk/Reward Ratio of Going Short or Long KVPHQ is Quite Clear

  • Short $10,000 worth of KVPHQ (around 20,000 shares) and make $10,000 as the current stock goes to $0 as a result of the current Chapter 11 plan being approved.
  • Go long $10,000 worth of stock and make $90,000+ if/as the stock approaches $5.00 or more if the current Chapter 11 plan is abandoned in favor of one that preserves equity interests.

The choice is obvious to our team, which is why we covered our short position in KVPHQ and are now aggressively long this name.

We have found it interesting that TheStreet.com ran a video on July 24, 2013 where Rick Szambel of Albert Friedman, presented a short thesis without considering the very real bullish view that we are about to present. The commentator, Debra Borchardt introduced Mr. Szambel as someone "who follows all these bankruptcies and really knows what's going on with them" and inquired as to why people think this stock (KVPHQ) is worth something. Rick went on to make the following statement:

"The main reason why people buy these bankruptcies is just misinformation, they just can't understand what's going on."

It is ironic that Rick himself may be the one who is misinformed and just does not understand the whole KVPHQ story.

Brief History

While we continue to perform more research, here is a brief snapshot of the bullish view on owning shares of KVPHQ. Apparently, a major reason contributing to K-V Pharmaceutical filing for Chapter 11 bankruptcy on August 6, 2012 was the result of competition from pharmaceutical compounders who are a manufacturing medication (17-alpha hydroxyprogesterone caproate, "17P") that competes with one of KVPHQ's drugs, Makena. KV licenses Makena from Hologic, Inc. (NASDAQ:HOLX). Compounded drugs are not FDA approved. As described on its website:

"Makena is a prescription hormone medicine (Progestin) used to lower the risk of preterm birth in women who are pregnant with one baby and who have delivered one baby too early (preterm) in the past. Makena was shown to work based on a lower number of women who delivered babies at less than 37 weeks of pregnancy."

The price point of the pharmaceutical compound product was/is significantly less than KVPHQ's, which greatly hinders the company's ability to capture enough market-share in order to generate enough cash flow to service its debt obligations.

Bad News is Good News

The first piece of news that is improving KVPHQ's future outlook - and may continue to do so - arose from the unfortunate October 2012 fungal meningitis outbreak caused by a compounded steroid injection (unrelated to K-V's drug). Since then:

"...certain hospitals, physicians, specialty distributors appear to have shifted from using compounded drugs like 17P, which are neither approved nor regulated by the FDA, to using Makena®, resulting in increased revenues." (Page 21 of Exhibit 99.1 from July 19, 2013 8-K)

The positive trend in sales of Makena since the meningitis outbreak is clearly evident. Please see page 15 exhibit 99.2 from the above mentioned 8-K.

Makena Performance Metrics

Makena (hydroxyprogesterone caproate injection) is the Debtors' single-most valuable product. The information below addresses certain key performance metrics related to Makena.

Three Months Ended Total Prescriptions Vials Shipped to Customers
9/30/2012 3,037 3,770
12/31/2012 3,452 6,810
3/31/2013 43,02 8,410
6/30/2013 4,821 11,017
Click to enlarge

Additionally, Zvi Rhine pointed out to us that Makena's market share has gone from 3 at the end of 2012 to about 15% where it currently stands. We verified this finding after reviewing bankruptcy court documents and analyst reports. Mr. Rhine estimates that KVPHQ would be in a position to be able to start servicing its debt obligation if Makena is able to have greater than 30% market share while maintaining pricing power (as a result of competition from compounders, K-V was forced to reduce the price of its Makena injections).

Well, a new bill that is about to go to the Senate floor may be just the prescription needed to revive ailing market share, while at the same time allowing the company to command greater pricing power.

The Bill

A bill to increase regulation of pharmaceutical compounders could be voted on by the Senate in the next couple of weeks. The name of the bill is S.959 - Pharmaceutical Compounding Quality and Accountability Act. If both the Senate and the House pass the proposal and it is ultimately ratified, it would likely eliminate/curtail competition for Makena, allowing K-V Pharmaceutical to capture significant market share (possibly, close to a "monopolistic" position) and increase prices. As we understand through various conversations with investors who are well versed on the facts impacting the K-V story, Bill S.959 will basically eliminate the ability of foreign pharmacy compounders to sell product to the U.S. market. U.S. local compounders will be allowed to sell product on a very limited basis.

Such a scenario would obviously be a huge positive for K-V and should negate the current Chapter 11 proposal and put the company in a better position to service its debt obligations.

Bullish View

The Current chapter 11 plan stipulates that:

  • Senior Secured Note Holders will recover 100% of their claims- $231M
  • Convertible Subordinated Note Holders will recover 10.87% of their $201M claims- $22.0M
  • General Unsecured Claims will recover between 56.2% and 73.6%- $20.5M

The first catalyst that could lead to K-V's shares rising dramatically would be the Senate's approval of bill S.959, which could come any day now. Thus, the bullish view from current equity investors would contend that a Chapter 11 reorganization plan could be constructed to preserve the equity interest of the common shareholders, while also satisfying creditor obligations.

The new plan could entail satisfying Senior and General Unsecured creditor obligations with a new lending facility and resetting the exercise price of the Subordinated Notes to current prices that are convertible into 8.7 million shares of common stock. A much-improved outlook for K-V should make this scenario plausible. We calculate that K-V could soon be in a position to operate at an annual EBITDA run-rate north of $265M. Armed with this information, we believe an Equity Committee should be able to put in place a credit facility of at least $500 million. We think many investors would agree that a net debt-to-EBITDA ratio of less than two is a reasonable debt load for this quality of business. As long as a new plan can satisfy Senior and General creditor obligations in full of around $250 million by September 12, 2013 and at least match the $22.0M recovery of the convertible notes under the current plan, we think it could be hard for courts not to seriously consider plan alternatives.

If equity investors would be able to succeed in bringing a new plan to the table that is eventually approved by the court, K-V's shares would likely be worth considerably more than they are today. Those who support this bullish view are treating this investment as a "call" option with significant upside with a time to expiration of September 12, 2013. If the Senate passes Bill S.959 the premium of the "option" should increase significantly.

The bullish view is also supported by an opinion that doctors will decrease the amount of prescriptions written for the 17-alpha hydroxyprogesterone caproate ("17P") compound due to the increased controversy pharmaceutical compounders are facing.

Valuation- $4.75 to $16.60

It is extremely important to realize that if we essentially eliminate pharmacy compounders from the equation due to the passage of Bill S.959, KV's competition could be immaterial overnight. Makena is the only FDA approved drug for its indicated use.

Activist investor Zvi Rhine believes that KVPHQ could be worth $4.75 to $8.00 if a new Chapter 11 plan that preserves equity interests is approved. He performed a discounted cash flow analysis taking into account the potential future income stream that KV could receive if Bill S.959 becomes law, while also keeping in mind that KV has exclusivity on Makena only until 2018.

We have also preformed our own analysis and determined that KVPHQ could be worth at least $5.75. We applied the following assumptions:

  • Passage of bill s.959 gives Makena treatment a near monopoly, attaining 85% market share
  • Total addressable patient market from KVPHQ investors presentation- 140,000 women per year
  • Very conservatively assume that only half of the potential patient population will use Makena- 70,000
  • Number injections Patient receives per treatment- 15
  • Net price of each injection- $450
  • Gross Margins ("GM") based on 2012 10K- 90%
  • Annual Operating Expenses based on investors presentation- $100M
  • Fully diluted shares outstanding- 60M (includes an assumption that convertible notes will convert upon a revised chapter 11 plan).
  • Debt- $450M
  • Since Makena has received orphan drug status KV has exclusivity on Makena until 2018.

The Math

  • Number of women who will use Makena per year (85% Market share * 70K women patient population will seek treatment)= 60K
  • Makena Sales ($450 price per injection * 15 injections per treatment * 60K) = $405M; coincidentally, at one time analysts had predicted that Makena sales would reach $400M in 2013).
  • Gross Profit (90% GM assumption * $405M sales) = $365M
  • Operating Expenses= $100M
  • EBITDA ($365M - $100M) = $265M

Since KV only has exclusivity on Makena until 2018, we believe an EV/EBITDA of 3-4 is conservative given the massive cash flows in the first few years and the uncertainty of cash flow after 2018. It's also worth noting that K-V will be shielded from taxes for many years due to substantial NOLs, so the majority of operating income goes right to the bottom line.

Our price target solving for price assuming an EV/EBITDA multiple of 3 and 60M shares outstanding equates to $5.75.

We only assumed that half the patient population would use Makena. This is probably too conservative of an assumption. If we were to ratchet up our patient use assumption to 75%, we come up with a price target of $16.60. In fact, according to Zvi, Chapter 11 court documents reveal that 105,000 (75% of our 140k potential market assumption) of woman currently use either Makena or the compound equivalent. Furthermore, these documents also include financial projections where operating expenses are assumed to be about $60 million which is lower than our $100M estimate.

Keep in mind that our analysis, as well as Zvi's, does not include any contribution from three other products K-V currently sells and/or plans to re-launch.

There are certainly factors that could positively or negatively impact our target, such as dilution as a result of completing a secondary offering, a private placement or other types of financing as part of a revised chapter 11 plan that retains equity interests. However, even if we unrealistically triple the shares outstanding we still come up with a price target of $1.92. Price per injection and market share assumptions could also fluctuate.

Conclusion:

This is one of the best risky bets we have seen in sometime. There is plenty of publicly available information to support the bullish thesis. Unfortunately, the info is buried in pages and pages of boring SEC and court documents. Luckily, the vigilant investor can take advantage of this information confusion and possibly make massive profits.

The challenge for the "bulls" will be that the events required to help their case need to happen rather quickly. Any new plan proposed by an "equity committee" will likely face severe opposition from some of the players who are slated to receive new shares under the current plan. They no doubt realize that K-V's fortunes could soon turn decisively positive and that the stock issued to them could result in a windfall investment.

We will continue to monitor the story for positive or negative developments related to the bullish as well as bearish thesis.

Disclosure: I am long KVPHQ.PK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.