Orexigen (OREX) announced details of a $115 million financing deal Monday. The financing consists of $115 million in coverable notes due 2020. The interest on these notes equates to 2.75% and is paid twice a year. The notes can convert to 122.125 shares of Orexigen per $1,000 principal amount, which translates to a share price of $8.19 per share, nearly 33% higher than the current trading price.
Convertible bonds are often used as a mechanism for a company to get cash today, while delaying any possible dilution to the stock. It is also popular because the coupon rate can be a lot lower than a simple straight forward bond. This happens because the notes can convert into shares.
One drawback of convertible notes is that it can create a substantial short position in an equity. A common practice for holders of convertible notes is to short the equity, thus playing the arbitrage between the convert price and the current price. Consider that a bond buyer is typically looking for a more conservative investment vehicle rather than a quick pop. Bond holders are interested in the interest that a bond provides while also wanting protection.
If you have 10,000 shares worth of convertible bonds at $8.19, you may well short 10,000 shares of the equity at the current price. You would, in theory, never have to buy shares to cover, because the conversion will give you the necessary shares. In effect, by buying the convertible bond and shorting the equity, you are share neutral and your interest is protected. If the stock goes down you make money on the short position. If the stock goes up you already have the shares to cover. There are negatives to playing such a strategy, but for the most part, it is common practice.
Retail investors should understand the size and scope of any convertible notes that a company has. These bonds give potentially strong power to a small number of banks or institutions. In the anti-obesity sector, Orexigen investors can look at what happened to Vivus (VVUS) to see what can potentially happen when a big player gets a sizable stake in a company. First Manhattan essentially voted in a new Board of Directors at Vivus with just a 10% stake in the company. On the other hand, anti-obesity competitor Arena Pharmaceuticals (ARNA) is flush with cash, and convertibles are but a very small portion of the company.
Orexigen has stated that it will use the funds from the transaction for general corporate purposes. The company has an application for the anti-obesity drug Contrave submitted in Europe, and is anticipating a resubmission of its application in the United States in the coming months. If approved in the U.S., Contrave would join Qsymia from Vivus and Belviq from Arena in the marketplace. If approved in Europe, Contrave would be the first to market there. Qsymia was rejected in Europe, and Arena pulled its application for Belviq in lieu of getting a rejection because there was not enough time for the company to respond to study concerns.
Obesity is a world-wide problem, but prescription anti-obesity drugs getting insurance coverage is a challenge facing the sector. With over a year on the market, Qsymia garners about 10,000 prescriptions per week, while Belviq is at about 5,000 with about 6 months on the market. By comparison, generic phentermine, a long time weight loss drug that is less expensive garners about 130,000 weekly prescriptions.
In my opinion, the initial excitement over the Orexigen plan to resubmit its application to the FDA has now worn off. It will be 6 months at a minimum before we really hear anything. In the meantime, Orexigen investors would be wise to follow the sales data of Qsymia and Belviq, as well as insurance traction here in the U.S. Currently about 40% of covered lives in the U.S. have some form of obesity treatment coverage. I see no harm in being on the sidelines with Orexigen for the near term. Why not see some early 2014 data before making that decision?
Additional disclosure: I have no position in Orexigen or Vivus.