Seeking Alpha
Long/short equity, oil & gas
Profile| Send Message|
( followers)  

Summary

  • Deerfield debt-to-equity conversion is not necessarily a positive.
  • Scheduling of an ADCOM is not a positive event for the stock.
  • Release of briefing documents at the end of March is the next big catalyst.
  • Absent any ADCOM black swans, Afrezza will ultimately be approved by the FDA.

The story of MannKind (NASDAQ:MNKD) and Afrezza has been well-documented as interest in the stock picks up and as MannKind moves closer to the ADCOM & PDUFA dates. As most of the usual talking points, both short and long, have been beaten to death, the intentions of this article are to focus on what I believe are some important details that folks are overlooking. This article expresses my current views on the situation, and was partially inspired by some conversations I have had with long-time bull, George Rho. My intentions are to stimulate conversation and involve more people (other than George and myself) in this conversation. Most of these points are related to the Deerfield debt-to-equity conversion.

In the merit of full disclosure, I am a former MNKD long. I currently have no position (long or short) in MNKD, for various reasons. The main reasons for me being on the sidelines right now are a rising short interest into the ADCOM, wanting to see the briefing documents, and the similarities between what is happening now in MNKD and what happened to (NASDAQ:AMRN).

One of the most common long arguments I have seen is that Deerfield converted debt to equity, so that must mean Deerfield has seen the full data and is hopeful for the prospects of FDA approval, because they are moving down the capital structure. I don't necessarily believe this to be the case. For those who aren't aware, in July 2013, MNKD announced a debt financing with Deerfield. The terms of the deal are listed at the link above. My first question for the readers is: If Deerfield saw the full Phase III data, why is the deal structured in such a manner to give MNKD four separate tranches of money?

If the Phase III trials met their endpoints and exhibited no safety issues, tranches 1-3 were basically guaranteed to be paid out. If Deerfield saw the data, why would they structure the deal in such a convoluted way? Why not just give MNKD the first three tranches in one payment? The only reason that I can come up with is that MNKD is trying to save on interest expense. Perhaps I am reading too much into this structure, but it seems too quirky of a deal to not have a reason for it.

Moving on to the debt-to-equity conversion: I believe this mechanism is in place for mainly one reason: It allows Deerfield to reduce risk in the case of unforeseen events. Deerfield currently has 9.75% senior secured notes. From the recent 10K, these notes are secured by substantially all of MannKind's assets:

Our indebtedness under the Facility Agreement, including any indebtedness under the 2019 notes and any future indebtedness we incur as the result of our sale of additional 2019 notes and/or tranche B notes is secured by substantially all of our assets, including our intellectual property, accounts receivables, equipment, general intangibles, inventory (including the insulin inventory) and investment property, and all of the proceeds and products of the foregoing. Our obligations under the Facility Agreement and the Milestone Agreement are also secured by certain mortgages on our facilities in Danbury, Connecticut and Valencia, California.

The majority of the conversion was done in January, which is when the ADCOM announcement was made public.

In January 2014, Deerfield elected to convert an aggregate of $33.5 million of principal amount of the Tranche 2 Notes, pursuant to which the Company issued Deerfield 6,559,251 shares of the Company's common stock. As a result of this election, Deerfield has fully exercised the conversion option under the 2019 notes by converting all of the Tranche 2 Notes, or $40.0 million of principal, into 7,852,475 shares of the Company's common stock in the aggregate.

If MNKD is a shoe in to be granted FDA approval, why would Deerfield want to transform 9.75% senior secured debt into equity, when they could just purchase the equity on the open market?

Given the current interest rate environment, getting 9.75% on secured debt is pretty spectacular. I believe Deerfield has converted the $40M in debt in order to reduce money-at-risk for the upcoming ADCOM. Despite what MNKD management may or may not say, I do not think that having an ADCOM meeting is a positive for the stock. Once the briefing documents come out, it may turn into a positive, but it is certainly not a positive right now. The market surely did not think so either, and I don't believe Deerfield thought it was a positive. ADCOMs bring another relatively binary event that must be hurdled, and as has been talked about before in previous articles, adds tangible and intangible risk to the PDUFA process.

This conversion reduces money-at-risk by Deerfield being able to sell the equity into the market. The initial agreement between MNKD and Deerfield states that:

In addition to the foregoing conditions, Deerfield's obligation to purchase Convertible Notes at any of the three remaining closings is subject to, at each closing, the Conversion Shares issuable upon conversion of all previously sold Convertible Notes being freely tradable pursuant to an effective registration statement filed with the Securities and Exchange Commission or pursuant to Rule 144 under the Securities Act of 1933, as amended (the "Securities Act").

Deerfield is able to immediately sell these shares into the market, if they choose to. I think it is likely they have done so. In the event of anything but approval, MNKD stock will be crushed. With a third CRL, folks would certainly start to wonder if MNKD could survive for a fourth round. The Deerfield debt would be secure, but the question would then become, can the debt be serviced and how long the recovery of these funds would take. Reducing funds at risk by a third seems prudent given these uncertain circumstances and the unknown nature of the ADCOM.

One may wonder why Deerfield would sell the equity. Don't they want to keep some upside? They still have upside through up to $90M in milestone payments agreed to when the initial deal was signed in mid-2013. These payments are obviously not a $90M lump sum, but paid out when certain events occur and when sales targets are achieved. Naturally, the completion of these targets would be moving in lock-step with the stock price. I think of these as a free call option for Deerfield. This is their main upside in MNKD.

The agreement with Deerfield was recently amended to provide for more debt after FDA approval and to allow Deerfield to convert more debt into equity. From the aforementioned 10K:

On February 28, 2014, we amended our existing facility agreement dated July 1, 2013, or the Facility Agreement, with Deerfield Private Design Fund II, L.P., or Deerfield Private Design Fund, and Deerfield Private Design International II, L.P., referred to collectively as Deerfield, to provide for the issuance of tranche B notes to Deerfield in a maximum aggregate principal amount equal to (X) if the FDA approves the NDA for AFFREZZA and Deerfield purchases the fourth tranche of 9.75% Senior Convertible Notes due 2019, or 2019 notes, originally issuable pursuant to the Facility Agreement, 150% of the aggregate principal amount of 2019 notes that Deerfield has converted into our common stock on and after the effective date of the amendment, up to $90.0 million, and (Y) otherwise, 33.33% of the aggregate principal amount of 2019 notes that Deerfield has converted into our common stock on and after the effective date of the amendment, up to $20.0 million, in each case subject to the satisfaction of certain other conditions. Any tranche B notes, if and when issued, would bear interest at the rate of 9.75% per year, subject to reduction to 8.75% if we enter into a collaboration with a third party to commercialize AFFREZZA, on the outstanding principal amount, payable in cash quarterly in arrears on the last business day of December, March, June and September of each year. We are required to repay 25% of the original principal amount of any tranche B notes on the third, fourth, fifth and sixth anniversaries of the applicable issue dates of such notes, provided that the entire outstanding principal amount of all tranche B notes will become due and payable no later than December 31, 2019. The tranche B notes will be prepayable without penalty or premium commencing two years after issuance thereof.

In addition, pursuant to the amendment, the outstanding 2019 notes held by Deerfield were amended and restated such that Deerfield may, subject to certain limitations, convert up to an additional $60.0 million principal amount under such 2019 notes into common stock after the effective date of the amendment, at a minimum conversion price of $5.00 per share unless we otherwise consent. We also agreed to register for resale up to 12,000,000 shares of common stock issuable upon conversion of the outstanding 2019 notes, as amended and restated, as of the date of the amendment.

If the FDA approves Afrezza and nothing changes from now, Deerfield will provide MNKD with another ~$100M ($40M from the 4th tranche & 150% of whatever is converted - $40M already converted) at 9.25%. If the FDA does not approve, MNKD will receive $13M (33% of $40M converted). Deerfield also has received the option to convert another $60M of debt to equity. MNKD has recently registered 12M shares for if/when Deerfield decides on conversion. If the full $60M is converted to equity and sold, and Afrezza is approved, Deerfield's upside is still tremendous, with $20M in existing notes, adding another $130M in notes on top of that ($40M fourth tranche + $90M from amendment), and $90M in upside from milestone payments.

The bottom line is that regardless of the PDUFA outcome, Deerfield is pretty much in a relatively no-risk, win-win situation here. I believe that Deerfield converting shares signals the opposite of what most investors believe, due to the nature of what they are converting. One of the things I am watching into ADCOM is if Deerfield converts more debt into stock. If Deerfield converts, I do not see that as a good sign. There's no reason for Deerfield to convert 9.75% senior debt into equity, when Deerfield can purchase the same equity in the market. A conversion to keep shares just doesn't seem logical, therefore, I am assuming that any conversion before approval is a risk-management move aimed at reducing exposure to MNKD in general.

As a former long, I wish everyone the best of luck as MNKD progresses through ADCOM and PDUFA. I think Afrezza has a decent chance for PDUFA approval and a shot to be a blockbuster drug. Diabetes is a huge problem and only getting worse with the amount of carbs the world is consuming. There are some headwinds in front of MNKD, though. Growing into the valuation is one of them. I am particularly interested in seeing how well an inhaled prandial insulin can penetrate the market even though basal insulin must still be injected. This is something that is hard for me, as a non-diabetic, to grasp. There is certainly lots of praise out there from actual Afrezza users, so perhaps the uptake will be strong. Partnerships also must be definitively addressed by management. The key word here is definitive. Hopefully, management will not continue to string shareholders along with vague comments regarding partnerships. The management comments on partnerships sure do remind me of AMRN. I believe a partnership is key to the success of Afrezza. If no partnership is announced with approval of Afrezza, I would be very nervous on the prospects of partnership. Going alone is not a good choice.

Hopefully, this article will stimulate some new conversations about MNKD. I am hoping to further my MNKD knowledge through this article and the comments below. I encourage all readers to do their own research and make their own choices. Do your own due diligence. Again, good luck to all longs as MNKD heads into ADCOM.

Source: What Can The Deerfield Conversion Tell Us About MannKind Going Into ADCOM?