Debt Burden Makes Horizon Pharma An Attractive Short

| About: Horizon Pharma (HZNP)

Horizon Pharma (NASDAQ:HZNP) is on investors' radars, as the company launched DUEXIS in January 2012 and has an upcoming PDUFA date of July 26 for its second product, RAYOS, a modified-release low dose prednisone. The stock has enjoyed a ~100% run-up in its share price during the month of June on little news. Horizon has 33.7MM shares outstanding, cash of $80.4MM, debt of $60MM, and at a share price of $7.38, an enterprise value of $228MM. DUEXIS is a single-tablet combination of two generic products, ibuprofen and famotidine, that was fully launched in January 2012 with 80 sales reps. The DUEXIS launch has been slow, with only $0.9MM in sales in the first quarter of 2012. Accompanying these sales, was an SG&A expense of $16.2MM and a first quarter net loss of $23.7MM. In the first quarter of 2012, Horizon burned through $19MM in cash, which is substantially more than total revenue of $2.5MM, and unless sales ramp substantially, the company may be in trouble, as I will detail in this article.

Unprofitable BioPharma Companies With Large Amounts of Debt Typically Do Not Perform Well

Importantly, Horizon completed a $50.8MM private placement in March 2012 and entered into a $60MM senior secured loan in February, netting a total of $81.6MM after paying off $22.4MM of the previous Oxford and Kreos loans. I am particularly concerned with this new debt, which I will discuss in greater detail. I do not believe many shareholders are aware of the risk to equity associated with this debt.

Historically, unprofitable biopharmaceutical stocks with a considerable debt burden do not perform well. For example, MannKind (NASDAQ:MNKD) is currently trading at a market cap of $421MM, has an enterprise value of $822M, has a whopping $494MM in debt ($283.5MM from The Mann Group and $211 worth of notes due 2013 and 2015), and no revenue in 2012. Furthermore, as of 1Q12, MannKind had cash of $56MM, burned through $33MM in cash, and had a net loss of $38MM in 1Q12. At this rate, ManKind will be out of money by the end of this quarter. The stock is currently down greater than 75% since the accumulation of the debt. Most recently, MannKind completed a debt offering of $100MM aggregate principal amount of 5.75% senior convertible notes, which are due 2015.

Dendreon (NASDAQ:DNDN), which burned through $59MM in cash in 1Q12 and had a net loss of $104MM, also has $574MM of debt on the balance sheet and over the past year the stock has plummeted 85%, from a high of $39.53 to just over $6. Another example is Savient (OTC:SVNT), which burned $32MM in cash in 1Q12, recorded 1Q12 revenue of $3.5MM, and had a 1Q12 net loss of $34MM. Savient acquired $177MM of debt on February 4, 2011. Since the issuance of Savient's debt, the company's stock tanked almost 95%. These facts are hard to ignore. Horizon shareholders should heed the lessons learned from these experiences - if company product revenues don't grow sufficiently to repay the debt, then equity value is often wiped out when the creditors take control.

Horizon's $60MM Loan Agreement Includes Many Worrisome Covenants

Horizon's debt may cause Horizon's shareholders to lose, big time. First, the debt accrues interest at 17% annually, resulting in quarterly loan payments of $4.5MM. When one adds the $4.5MM to the $19MM in cash the company burned in 1Q12, the quarterly burn rate increases to $23.5MM, all else equal. With $80.4MM in cash at the end of the first quarter, the company does not have enough cash to last more than three quarters at this burn rate, or through 1Q13. To make the situation even worse, the debt holders have the option to ask for an additional quarterly $4MM payment of the loan principal starting April 2013. Unless sales of DUEXIS and RAYOS ramp significantly, the substantial burn will likely force the company to seek additional capital, if expenses are unchanged. As I will point out, I don't expect sales to ramp fast enough, however.

The most important covenants of Horizon's debt can be found in the fine print located in the company's latest quarterly SEC filing. The most disconcerting debt covenant, that investors should be aware of, requires that Horizon Pharma meet minimum trailing twelve month (TTM) revenues, as assessed on a quarterly basis (see Figure 1 below). Note that this covenant also includes "deferred revenue," which is typically inventory sales. This is typically an additional 2 months worth of revenue.

As one can see from the Figure 1, for the June 30 quarter, Horizon must meet a TTM revenue threshold of $10MM. I estimate that for this quarter, the total TTM revenue barely passed the minimum at $11.5MM. I calculated this number by adding the total revenue for the past 3 months, estimating $3.5MM in revenue for 2Q12, and accounting for two months in deferred revenue. Of course, we will know the exact number when the company reports second quarter earnings. I am most concerned, however, about the September 30 threshold of $20MM. I do not believe that Horizon will be able to meet this minimum revenue threshold and therefore be in default of the debt.

Figure 1 - TTM Minimum Revenue Requirements for Horizon's Loan

Quarter Ended TTM Revenue
30-Jun-12 $10,000,000
30-Sep-12 $20,000,000
31-Dec-12 $30,000,000
31-Mar-13 $40,000,000
30-Jun-13 $60,000,000
30-Sep-13 $70,000,000
31-Dec-13 $80,000,000
31-Mar-14 $90,000,000
June 30, 2014 and thereafter $100,000,000

Potential RAYOS/LODOTRA Sales Are Expected to Have Minimal Impact on Horizon's Ability to Meet TTM Revenue Thresholds

If approved on the July 26 PDUFA, Horizon's RAYOS (A.K.A. LODOTRA, marketed in the EU) is expected to be launched by the fourth quarter. Hence, I don't expect it to have much of an impact on Horizon's ability to meet the September 30 $20MM revenue requirement. Even if RAYOS is approved, I expect its sales to have minimal impact on the company's top line, as it has had a disappointing performance in the EU. The EU performance may be a good proxy for how it will do in the U.S. During 2009, 2010, and 2011, LODOTRA achieved sales of $6.6MM, $6.8MM, and $16.5MM, respectively.

DUEXIS Launch is Tracking Poorly and Not Generating Enough Revenue to Meet Debt Covenant Thresholds

Additionally, Horizon's newly launched DUEXIS has had a fairly anemic launch to date and is currently tracking at a $7MM annual run-rate. This launch is tracking almost identically to Somaxon's (NASDAQ:SOMX) SILENOR, which peaked at a $10MM run-rate. Based upon the current drug launch trajectory of DUEXIS and the LODOTRA's EU experience, I estimate that Horizon will record $15.8MM in total TTM revenue (3Q12 revenue estimate = $4MM) by the end of 3Q12. According to my calculation, Horizon will not meet the $20MM revenue threshold and subsequently trip the $60MM debt covenant.

Keep in mind that even if Horizon does somehow meet the September 30 threshold, the minimum revenue requirement increases by $10MM each consecutive quarter. The bar increases rapidly. Even if the DUEXIS launch mirrored VIMOVO's launch by AstraZeneca's (NYSE:AZN), Horizon would still fail to meet the revenue thresholds. Ultimately, I believe that DUEXIS, which is tracking poorly, and RAYOS, if approved, will need to wildly surpass expectations if Horizon is to meet the revenue thresholds of the debt.

Somaxon is a relatively good proxy for Horizon, in my opinion. Horizon's DUEXIS sales trajectory is comparable to Somaxon's SILENOR. Note that on August 25, 2010, Somaxon announced a co-promotion agreement with Proctor & Gamble. Since then, Somaxon shares are down over 90%. Similarly, Horizon entered into a DUEXIS co-promotion agreement with Mallinckrodt on June 18, 2011, and if the stock performs similarly to Somaxon's following the announcement, expect shareholders to lose.

Generic Paragraph IV Filings Have Begun for DUEXIS

Another factor that may impact expectation of DUEXIS and RAYOS, if approved, is possible Paragraph IV filings by generic drug manufacturers. Keep in mind that both DUEXIS and RAYOS are formulations of generic active drug ingredients, so it is possible for a generic manufacturer to file a Paragraph IV in anticipation of marketing a generic form of either drug. Once a Paragraph 4 is filled, the company, or Horizon in this case, has 45 days to sue the generic manufacturers for patent infringement. After the suit is filed, the FDA has to wait to approve or deny the filing until the generic manufacturer defends the suit or 30 months, whichever comes first.

In fact, Paragraph IV filings for DUEXIS have already begun. At the end of March, just two months after the DUEXIS launch, Horizon filed a patent infringement lawsuit in the United States District Court for the District of Delaware seeking to block Par Pharmaceutical Inc. from marketing a generic version of DUEXIS. AstraZeneca's (AZN) VIMOVO, as discussed above, is another drug that has been plagued by a slew of Paragraph IV filings. In March, June, and September 2011, Dr' Reddy's Laboratories (NYSE:RDY), Lupin Ltd. (LUPIN), and Anchen Pharmaceuticals have all filled Paragraph IV filings for VIMOVO. They are all currently in the discovery phase and are seeking to market a generic VIMOVO before its 2023 patent expiration. With the overhang of Paragraph IV filings, it is hard for investors to consider these products "long-lived" assets.

3.3 Million Warrants Become Exercisable August 22 and Will Surely Cause Stock Dilution

Many investors are eagerly awaiting the RAYOS PDUFA date. I, however, would like to point out another important date - August 22nd. As part of the February 2012 $60MM senior secured loan, Horizon issued warrants to the lenders to purchase up to an aggregate of approximately 3,277,191 shares. These warrants have an exercise price of $0.01 per share, netting the lenders a total of $24.1MM based upon the company's current share price of $7.38. These warrants become exercisable August 22, 2012. Given this windfall profit for the lenders, I would expect these warrants to be exercised and for the lenders to sell their shares, potentially putting pressure on the stock price.

The Bottom Line

For the reasons above, I believe investors should look at Horizon with a healthy amount of trepidation and heed the lessons learned from other unprofitable biopharma companies that have taken on debt. If Horizon Pharma is unable to meet the minimum revenue thresholds mentioned above, the company is expected to default on the $60MM loan agreement. The lenders will be able to demand accelerated repayment of all obligations under the terms of the loan. The loan is secured by a lien covering all of Horizon's assets, so if the company cannot meet the accelerated loan payments, then the lenders could claim these assets. Based upon my analysis above and the current company valuation, I believe that many equity holders are not aware of the risks associated with Horizon. There is a very reasonable likelihood that Horizon defaults on the $60MM loan, per the September 30 revenue threshold requirement.

Disclosure: I am short HZNP.

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