Orexigen: Baupost's Long-Term Bet On Contrave

| About: Orexigen Therapeutics, (OREX)

Summary

Seeking Alpha contributor Spencer Osborne published his rather frightening views on the second Baupost transaction.

However, his article contains a series of material mistakes.

Here is how the deal is structured and why Orexigen investors must not fear Baupost.

My fellow Seeking Alpha contributor Spencer Osborne has done a great job covering Orexigen (NASDAQ:OREX) for a long time. However, I have to disagree strongly with him regarding certain interpretations of the recent Baupost transaction. (Which was the second in a short period of time and actually includes several other investors as well.)How much pie will be left for other shareholders

To avoid confusion, I will use "Baupost" for the whole group of investors participating in this transaction (just like Orexigen did in its filings) and "Seth Klarman" when I want to talk about Baupost's specific interests independently from its affiliates.

So here is the key question: How much pie will be left for other shareholders?

First of all, here is an overview of shares, warrants and convertible notes outstanding as of12/31/2015:

Click to enlarge

(Source: Company 10-K 2015)

In addition, on the first page of the 10-K we can find out that "as of February 22, 2016, the Registrant had 145,564,920 shares of its $0.001 par value common stock outstanding."

So here is the summary before the recent, second Baupost transaction:

- 2013 convertible notes: $115 million of principal, 2.75% interest, can be converted at a price of $8.19 per share until 2020. These notes will likely be settled in cash, given the huge distance between the current stock price and the conversion price. Otherwise they would add 14 million shares to the diluted share count.

- The 5 million warrants came with the first Baupost transaction and are exercisable until September 2020 at $6 per share. If the stock doesn't go above $6, these warrants will not be exercised at all.

- Presumably all options are currently under water, but this might change and a major part of the 20 million options would dilute shareholders.

After the second Baupost transaction, we need to add the following parts to the puzzle:

- Convertible notes: $165 million of principal, 0% interest, can be converted at a price of $0.75 per share until July 2020. Presuming just a small increase of the stock price, these convertible notes will likely bring about major dilution and add 220 million shares to the share count.

- Warrants: another 220 million warrants can be exercised until September 2026 at $1.50 per share. Hence, if the stock goes above $1.50, Baupost can, at any time, pay 220 million times $1.50 to the company and get 220 million shares in exchange for its cash. In this case, shareholders would suffer another hefty dilution of 220 million shares - but would also pocket $330 million of cash.

All in all, if the stock goes to $10 in 2019, we might see the following picture:

(millions of shares)

Current shares outstanding:

146

Converts 2013:

14

Warrants $6:

5

Converts 2016:

220

Warrants $1.50:

220

Options:

>20

Total potential shares outstanding

>625

Click to enlarge

So shares outstanding could potentially more than quadruple. Of all these shares Seth Klarman (i.e. not the whole group of investors affiliated with Baupost for the second transaction) would hold the 5 million shares from the $6 warrants and 100 million shares each from the 2016 converts and the $1.50 warrants. In addition, he would hold the shares he already owns, which are 22 million. All in all, Klarman might own up to 227 million shares out of 625 million, i.e. ~36%. This is probably less than most investors would have imagined at first sight.

Furthermore, Baupost and its affiliates (which are treated as a single entity for the purposes of the second transaction) are entitled to designate two directors for so long as they hold at least 20% of Orexigen's outstanding common stock.

This is important as it totally invalidates Spencer Osborne's main thesis: Company directors and their affiliates won't be allowed to short the stock. It's just that simple.

Furthermore, it would be impossible to short the stock for another very simple reason: There won't be enough shares to borrow. In fact, of the 146 million shares that are currently outstanding, Klarman already holds 22 million. This leaves 124 million for borrowing. Neither the convertible notes nor the warrants have been exercised, so this is really the whole float available. How could Baupost short 220 million shares with a float of only 124 million? In fact, it's impossible.

Finally, shorting costs fees and the convert doesn't pay interests. So Baupost could never just take the converts, short the stock and essentially get a free option for the entire upside.

That said, I totally miss a fundamental discussion of the transaction. What Baupost certainly did not do here was to speculate on a short-term bounce. In fact, this would not even be possible, as (according to specific agreements with Orexigen) the group of investors won't be able to throw their shares on the market whenever they like. First, it would simply be too many shares and their sale would depress the price. Second, the shares obtained by Baupost won't be even registered immediately:

3.5 Transfer or Resale. The Purchaser understands that:

the Securities, the Note Shares and the Warrant Shares have not been and are not being registered under the Securities Act (other than as contemplated in the Investor Rights Agreement) or any applicable state securities laws and, consequently, the Purchaser may have to bear the risk of owning the Securities, the Note Shares and the Warrant Shares for an indefinite period of time because the Securities, the Note Shares and the Warrant Shares may not be transferred … ( Source)

It is pretty clear that Orexigen is a long-term bet for Baupost and its affiliates. Moreover, it is a long-term bet on Contrave's U.S. potential - as the company did not need any financing for its global distribution partnerships. Orexigen could have shut down its U.S. operations and would have become profitable within a short time thanks to almost riskless foreign sales agreements.

So, apparently, for Orexigen (and Baupost) the U.S. opportunity is worth the gamble. A gamble that was easily avoidable. They are putting $75 million on the table to buy back U.S. rights and invest ~$100 million per year in a new sales force and marketing. Plus, shareholders will have to swallow massive dilution. Remember that all executive officers and directors together held ~23 million shares, i.e. 16% of the company prior to the recent transaction. As they won't like the dilution either, there must be a chance - a very good chance probably - for a huge upside.

I will write another article over the next few weeks to explain the fundamental merits of the transaction in greater detail.

Disclosure: I am/we are long OREX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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