PDL BioPharma: Take the LEAPS

As I pen this newsletter, I'm already seeing the Dow Industrials Index dropping by 160 points, despite the fact that oil is actually down over $1.00 per barrel today.

Markets seem to be detaching from the recent predictable cause-and-effect of higher oil prices = lower stock prices and vice versa.  The focus is shifting...but the big question is:  To what is that focus going to be on next?  PIMCO's Bill Gross had an interesting June Newsletter opining on the "real" rate of global inflation vs. what the US Domestic CPI and PPI measures are showing.  His very interesting observation was the US Government, which reports the statistics of CPI and PPI has been monkeying with how those indexes are measured for so long, and in such measure, that they really don't reliably report the actual "real" rate of inflation any more.  Bill's group has a gigantic vested interest in knowing what the real rate of inflation is on a global scale, and the fact that the rest of the world is reporting 6+% inflation rates while we in the US still are being fed data that show benign rates - well, let's just say that what we're being fed is pretty good fertilizer.

We still like the late May put spreads we recommended on the overnight transport industry biggies:  FedEx (FDX) and UPS (UPS).  Higher fuel prices, even above the $125 level and notwithstanding today's little pullback, are going to hurt those companies' profitability, and there's no ifs, ands or buts about it.  We like the longer-term expirations in those names, too.

 

Today's pick is in the biotech field, and also has a "sum-of-the-parts" play to it.  Protein Design Labs (PDLI), or "PDL, Inc.", as they are known now, is actively divesting itself of pieces of its drug portfolio, spinning off royalty streams and intellectual property into a small collection of income-producing vehicles.  We think, after reading an excellent recap of this company written by the "Motley Fool" people over the weekend, that this is a great place for a LEAP investment.

 

We also intend on making a few more picks in the near future, probably in the "inter-week" variety, so stand by for those.  We're looking at some call spreads in online retailing again, and in the oil tanker sector as well, however we're not going to go into the teeth of a market that seems determined to sell off (did you notice that it was only May 19 when we were last at 13,000+ on the Dow, and now, two weeks later, we're off by 500 points).  So, we'll wait for the right moment on those, and buy those spreads on the cheap.

Technical Analysis

The chart above shows PDLI for the last six months. The stock had a massive U-turn at the $6 level, and then has actively risen as management has pursued its break-up into various pieces.  The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are moving into the positive.  We think the sum-of-the-parts here is worth more than $10, so we'd like to own LEAPS on the name.       
   
Fundamental Data

• Current Price:  $10.17
• Shares Outstanding: 119.3 million
• Market Cap: $1.2 billion
• Forward Price / Earnings (avg. Est): 9.2x
• PEG Ratio (5 Year Expected):  0.74x
• Price / Book:  2.5x

 
PDL, Inc - what a dry name!  It's the old Protein Design Labs, which we think had a lot more pizzazz to it.  In case you've forgotten, Protein Design Labs was responsible for creating "Avastin", amongst many other engineered drugs, which has proven to be one of the most useful anti-cancer drugs on the market.  PDLI recently (late 2007) decided to basically split itself up into several pieces and sell itself, thus realizing what its directors and shareholders believed would be a significant premium to its then-prevalent share price.  As a result of the sales of a few of its patented drugs, the company paid the first special dividend of over $4 per share to holders last month.  There are more spin-offs and special dividends to come here as the company completes this effort.

The Motley Fool article referenced above reviews the discounted value of PDLI's royalty streams that they are packaging up and selling.  In their estimation, the value of the future drug payments from various companies is going to be over $1.4 billion. 
 
What's happening with those royalties to realize their value today?  Specifically in April, PDLi announced that it would distribute royalty revenue that the firm receives on drugs from companies like Genentech (NYSE: DNA), AstraZeneca (NYSE: AZN), and Wyeth (NYSE: WYE), in that process, create a new publicly traded stock for PDLI Stockholders.  The Company also revealed that it would distribute almost all of the revenue it receives from these royalties as dividends to shareholders of the new spinoff.
 
The Fool article notes that these royalties aren't infinite; they are going to come to an end within the next five to six years, around 2013 or 2014, when PDL's existing patents on the manufacture of humanized monoclonal antibodies expire.
 
There may be concern for the value of that $1.4 billion mentioned above, as some of the company's royalties are coming in lower than expected, however most of the royalty-generating drugs are still growing quite nicely -- Genentech's Avastin experienced year-over-year sales growth of 13% in the first quarter, and the relaunch of Biogen Idec's (Nasdaq: BIIB) and Elan's (NYSE: ELN) Tysabri seems to be successful.  New compounds in PDLI's pipeline ike Cimzia, a treatment for Crohn's disease have also recently been approved by the FDA, and they'll soon add to PDL's royalty revenue as well.
 
Overall, In 2008's first quarter, PDLI's royalty revenue grew at a rate of just under 3% Y-O-Y, and for next year PDLI management believes they will exceed an 8% growth rate. 
 
Adding to the "sum of the parts" play here, when PDLI further breaks itself apart later this year, investors will also get a stake in PDLI's remaining drug pipeline assets.  Although many of these drugs are in the early stages of formulation and approval, you are effectively getting a collection of drug candidates that may or may not pay off for free. 
 
Important note:  The usual 100 shares of stock of PDLI represented by one option contract has been adjusted for the purposes of that $4.25 per share special dividend mentioned above.  Accordingly, what you are buying in the recommendation below is the right to buy 100 shares of PDLI, plus you will receive a $425 cash payment representing that special dividend.

Investment Recommendation

We recommend that investors buy PDLI's LEAPS, specifically the January 2010 expiration $10 strike price LEAP, which includes the $425 dividend.  The symbol is "YOJAB".  Current bid / ask for those LEAPs is $4.50 at $5.20, so we might look to be at the $5 level today, June 2, 2008.  We would look to hold this trade to expiration - as PDLI's various spin-offs occur, holders of these LEAPS will benefit, and the value represented by the $425 special dividend, although not paid .
 
Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in PDLI stock or PDLI options.

Comments

[Daniel Jones]

The final sentence looks like it got cut off: it should read "We would look to hold this trade to expiration - as PDLI's various spin-offs occur, holders of these LEAPS will benefit, and the value represented by the $425 special dividend, although not paid until expiration, gives us a comfort level on the current value at $5.00.

[andyn]

Options holders don't get dividends...only shareholders do... so how are you assuming the LEAPS holder will get the $425 special?
Am i missing something here?

[Daniel Jones]

The CBOE website "Contract Adjustments" page has an update back in early May for the PDLI contracts that includes this $425 special dividend....so as the article said, you get the right to buy 100 shares at $10, (for the $10 strike) and also receive that $425 dividend as a cash payment. It's included and kind of a "special wrinkle" to this trade.

[andyn]

The CBOE article merely states and I quote:
"On Tuesday, May 6, 2008, each PDL BioPharma, Inc. contract will require the receipt or delivery of 100 shares of PDLI Common Stock, plus $425.00 cash."
Notice that all option symbols have been changed after that date, with the 2010 LEAPS going from YAV to YOJ.
What that means in your particular case is that if someone had the YAV options bought before that date, then they would have recd $425 on May 6th and AFTER that date, the option symbol would have changed to YOJ (which does NOT have the dividend). At least, that's my interpretation, so to everyone, caveat emptor.

[Daniel Jones]

Here is that link to the contract adjustments:

search.cboe.com/cgi-bi...


Please read that memo under the section "Contract adjustment for the special cash dividend" - it makes the statement that each contract will require the "receipt or delivery of 100 shares of PDLI Common Stock, plus $425 cash".

That's the dividend, and it IS INCLUDED in the YOJAB options that I recommended. On settlement date, you will enjoy the ability to get 100 shares of PDLI at $10, plus $425 cash. There is a series of options under the label of "YAV" that do not include that cash payment. Those options have a difference in price of the NPV of that $425 cash payment.


Hope this helps clear things up.
Best regards,
Daniel

[coachtd]

Daniel,

what happens to the YOJAB $10 contract if PDLI gets bought out by another company?

Thanks

[Daniel Jones]

Hi Coach - sorry to be late in answering this question.

These options would convert to equivalent number of acquiring company's shares - just like any other takeover. Plus the $425..

HOpe this helps. New picks coming all the time on the website - the FDX and UPS put spreads have been nice hedges in the latest downturn. Gotta toot the horn on those...see my list of historical picks.