It's been a rough year for Peregrine Pharmaceuticals Inc. (NASDAQ:PPHM) shareholders. PPHM crashed on 2/26/2016 when the company's Phase III trial for Bavituximab (an experimental anti-cancer drug) was halted. However, things were not all doom and gloom. A new bio-manufacturing facility was commisioned on 3/17/2016. While Bavituximab may have hit a dead end, the Avid Bioservices division is booming. The new plant more than doubled Avid's manufacturing capacity.
The good news for the Avid Bioservices division continued with fiscal Q4 2016 results. Avid reported a $68 million revenue backlog. Manufacturing revenues of $50 - $55 million were projected for the 2017 fiscal year ending on 4/30/2017. Biopharmaceutical manufacturing is a high margin business with significant barriers to entry. The growing cash flow from Avid is particularly important to holders of the PPHMP preferred shares.
What is PPHMP?
PPHMP is a par $25 cumulative preferred convertible issue. It has a generous 10.5% coupon and dividends are paid quarterly. PPHMP now yields 11.9% at a recent price of $22.88. PPHMP is optionally convertible to PPHM at $3 per share. The conversion option is far out of the money with PPHM trading at just 37 cents and should be ignored. See prospectus for additional details. A reverse split of PPHM is likely and would have no impact on PPHMP. As of 4/30/2016 there were 1.58 million shares ($40 million par value) of PPHMP outstanding.
1. Path to profitability
Peregrine has experienced decades of losses in the drug development business. These losses have been funded primarily by selling common stock. Fortunately for preferred stock holders, the company has decided to shift focus to its growing Avid Bioservices unit. Expertise acquired through the in-house manufacturing of Bavituximab is now being applied to manufacture pharmaceuticals for others. The company expects to become profitable as the high margin Avid unit grows enough to cover greatly reduced spending on Bavituximab. As noted in the fiscal Q4 earnings report:
"On June 2, 2016, the company announced the goal of achieving overall future sustained profitability in 24 months."
2. Strong liquidity
Liquidity is always an important consideration for preferred stock holders. Does the company have the cash to pay the preferred dividend? Peregrine reported balance sheet cash and restricted cash of $62 million as of 4/30/2016.
3. PPHM is debt free
Peregrine is a debt free company. It's very unusual to find an 11.9% yield from a cash rich company with no balance sheet leverage.
4. PPHM is restricted from incurring debt
Debt is senior to preferred stock. Preferred holders should be concerned about eventually becoming subordinated to a large amount of debt. Fortunately, PPHMP has a unique protective covenant that prohibits the company from incurring more than $10 million in debt. As per page S-20 of the PPHMP prospectus:
"...so long as Series E Preferred Stock has at least an aggregate of $10,000,000 in liquidation amount outstanding, to incur additional Indebtedness after the date the first share of Series E Preferred Stock is issued in an amount greater than the lesser of A. $10,000,000 ..."
5. Avid Bioservices is worth about $100 million
Avid Bioservices is a great niche business. Gross operating margins are close to 50%. They have a $68 million revenue backlog and revenue growth has been very strong. There are also significant barriers to entry. New manufacturing plants must undergo a rigorous licensing and regulatory process to ensure high quality. Peregrine developed the required expertise through in-house manufacturing of Bavituximab.
Even though the company's second manufacturing plant was just completed in March, a 3rd plant has already been planned. As noted in the fiscal Q4 earnings report:
- "In response to demand for manufacturing services, the company is now designing a third manufacturing facility dedicated to clinical manufacturing that is anticipated to significantly increase Avid's manufacturing capacity. The new clinical suite is expected to be complete and ready for clinical manufacturing activities by mid-2017.
How much is Avid Bioservices worth? The company has projected fiscal 2017 revenues of $50 - $55 million. A premium valuation is justified due to the desirable combination of rapid growth, high margins and significant barriers to entry. A 2X revenue multiple is reasonable. The estimated value of Avid Biosciences is therefore $100 - $110 million.
President and CEO Steve King remarked about the growth and value of Avid on the fiscal Q4 conference call (see page #1):
"We believe Avid should be highly valued from a shareholder perspective based on the current consistent year-over-year growth almost the 40% compounded annual growth rate over the past five years with the remarkable 66% growth this past year, all coming from one facility."
6. Preferred stock is well covered by assets
If we value Avid Bioservices at $100 million and add the $62 million in cash, then there are $162 million in assets. There is no debt. To be conservative, I will value Bavituximab at zero. It may yet have considerable value despite the recent failure of a Phase III study. Less expensive smaller scale studies are planned. To be conservative, I will also value their early stage project to develop a blood test for cancer at zero. There is $40 million par value of PPHMP outstanding and it is senior to PPHM. Asset coverage of PPHMP is therefore $162 million / $40 million = 4X.
7. PPHMP is senior to $92 million of PPHM
In item #6 above I showed that PPHMP is well covered by assets. This is also evident from looking at the $90 million equity market capitalization of PPHM. PPHMP is senior to PPHM. There is $40 million par value outstanding of PPHMP. If we assume that the $90 million market capitalization of PPHM is "correct" then the asset coverage of PPHMP is (90 + 40) / 40 = 3.3X.
8. Research & development costs will be cut in half
Peregrine is still spending some money on Bavituximab and other research projects, but spending will be much lower. As CFO Paul Lytle states on the fiscal Q4 2016 conference call (see page #5):
Right now for R&D our goal is to basically take R&D spending from fiscal year '16 and reduce that by 50%.
9. Low cost effort to develop a blood test for cancer
The company recently acquired a novel PS-exosome technology with the potential to detect and monitor cancer at an early stage through a simple blood test. This is an extremely exciting project and has the potential to create a huge payoff. However there is also concern that is could be costly. Fortunately, management made it clear that this is a low cost project. It won't interfere with company's drive to profitability. As stated in the fiscal Q3 earnings report:
"The company believes that, for a modest capital investment, it can quickly reach proof of concept with a goal of partnering the technology with an established diagnostics company. Overall, Peregrine believes this strategy will allow the company to continue its research and development activities with significant upside coming from partnering as it moves toward profitability."
10. Tax Advantages
PPHMP dividends are classified as Return Of Capital distributions. ROC distributions lower your cost basis, but are not taxable as income. Many of my Panick Value Research Report subscribers favor these tax advantaged ROC issues. As of 4/30/2016, Peregrine has built up an accumulated deficit of $509 million. Dividends are likely to remain ROC for many years, even after the company becomes profitable.
What are the risks?
After decades of losses, management has changed strategy and plans to live within the growing cash flow from their Avid contract manufacturing business. Although I think it's unlikely, its possible that they could change strategy again and revert to a more aggressive focus on drug development.
The $68 million revenue backlog reduces the risk for Avid, but there are still some risks. This is a highly regulated business. Any unexpected quality control problems or regulatory issues would be costly. Avid is dependent on a small number of key customers.
Even though PPHMP has strong protective covenants (see item #4) it is not a debt issue. Preferred holders are always dependent on the good will of management to declare expected preferred dividends. Preferred holders generally expect that a company with strong liquidity, no debt and growing cash flow from Avid will continue to pay the preferred dividend. While the $62 million cash balance is impressive, its still possible that the company will want to raise additional capital as they transition towards profitability. They are not permitted to sell debt and selling a depressed common stock is not a good option. Additional "at the market" sales of PPHMP are probable. I believe a dividend deferral is unlikely, since PPHMP is an important potential source of capital.
Peregrine is a great example of how preferred stocks can sometimes outperform common stocks. Unfortunately, the apparent failure of Bavituximab destroyed much of the value of the common stock. The PPHMP preferred stock has fared far better. Asset coverage of the preferred is in the 3X - 4X range using the methodology shown in items #6 and #7. With the rapid growth of the Avid division, the company is now on a path to profitability. This is very good news for PPHMP holders.
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Disclosure: I am/we are long PPHMP.
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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