In late September 2011, biotech MannKind Corporation (Nasdaq: MNKD) announced plans to issue $370.0 million in new debt to help fund clinical trials for its AFREZZA rapid-acting insulin compound. I have family members with diabetes, leaving me sensitive to the struggle of diabetes sufferers to keep their bodies in balance. MannKind is developing a drug-device combination consisting of the AFREZZA inhalation powder and a pre-metered, single-doze cartridge. It is meant to be used at mealtime when insulin is needed most.
Mannkind’s recent stock price increase suggests investors like what they have been hearing from the company since last summer and they especially liked the news of the raising of capital. Perhaps investors take the large debt raise as a cue that management is more confident in a positive outcome for its AFREZZA development effort.
The news set me to wondering just how much risk MannKind was taking on in the financing choice. So I sat down with a sharp pencil and a calculator to do some old fashioned, text-book driven analysis of Mannkind’s capital raise.
At the end of June 2011, MannKind had debt outstanding totaling $452.2 million, consisting of $210.0 million in senior convertible notes and $242.2 million in loans from The Mann Group, a company controlled by MannKind’s Chairman and CEO. Interest rates on the debt range from 3.75% on 2013 convertible notes to 5.75% on 2015 convertible notes. The loan from The Mann Group bears an interest burden of approximately 4.1%.
The company is running a shareholder deficit of $245.4 million, as development efforts for AFREZZA have burned up capital contributions totaling $1.6 billion. Essentially management has leveraged the knowhow in MannKind’s development pipeline. What does that mean for Mannkind’s cost of capital to support future development?
After a few entries in the calculator, I determined that Mannkind’s cost of equity is running near 13.6% and the debt cost is 5.1%. (You can find the calculations below.) Considering the relative portions of the two capital sources, the weighted average cost of capital (remember that from finance class?) is currently 9.8%. Perhaps that seems like a high number, but friends of the company will point to management’s decision to seek debt financing at what is comparatively lower cost capital than an equity raise.
The added debt has implications for shareholders. I sharpened the pencil for another round of calculations (also found below) to find the possible impact of the added debt on the beta or the risk in MNKD shares relative to the broader market. With the debt- to-equity ratio (based on market values) potentially rising to 1.63 after the new debt raise from 0.83 at the time of the announcement, the beta measure of risk more than doubles. Consequently, the required rate of return for equity investors must increase to 35.6% to get adequate compensation for the added risk.
Can Mannkind management deliver the kind of performance for investors that justifies its risky capital raise? The current consensus target price is $5.00 for MNKD shares - a 45% potential return from the current price level. A comparison with our estimated required return of 35.6% post-debt-offering suggests the bevy of seven analysts who publish estimates for Mannkind think that is where the stock is headed.
I would like to think that at least the company can be successful in its efforts to bring AFREZZA to market just for the sake of those who suffer from diabetes. For equity investors, the added debt is a doubled edge blade - resources to get the job done as well as a steeper climb to get a fair payoff.
Disclosure: Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.