Has Theravance Just Given Away 40% Of Its Value?

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Summary

Today's $450 million private placement of 9% non-recourse notes somewhat changes the financial outlook for Theravance.

Investors that expected the soon-to-be-created Royalty Management to lever its reliable income stream need to understand the precise implications of this loan.

The loan is secured by 40% of the most important and predictable royalties the company will receive, so only 60% are left for shareholders.

However, a closer look at the structure of the loan reveals that the company is clearly betting on a bright future.

Theravance (THRX) today issued a press release about $450 million private placement of 9% non-recourse PhaRMA(SM) notes.

The notes are secured by a security interest in a segregated bank account established to receive 40% of royalties from global net sales of RELVAR®/BREO® ELLIPTA® (fluticasone furoate/vilanterol "FF/VI"), ANORO™ ELLIPTA™ (umeclidinium bromide/vilanterol, UMEC/VI) and, if developed, approved and commercialized, VI monotherapy, all of which are partnered with GSK, beginning with sales occurring on or after April 1, 2014 and ending upon the earlier of full repayment of principal or May 15, 2029. The notes are not convertible into Theravance equity and have no security interest in nor rights under any Theravance agreement with GSK. The notes may be redeemed at any time prior to maturity, in whole or in part, at the option of Theravance at specified redemption premiums.

At first sight, this seems to be a terrible move. The Royalty Management company, which shall be separated from Theravance Biopharma shortly, was supposed to increase shareholder value by leveraging the relatively safe stream of incoming royalties. And now, Theravance gives away 40% of this stream, leaving only 60% to play with?

In my recent article about the intrinsic value of this leveraging, I have made certain assumptions on presumable interest rates Royalty Management could pay for additional debt, which now seem to be totally unrealistic, as the company needs to offer a 9% interest rate and, most importantly, is required to give away the rights on 40% of its income at the same time to secure the loan.

But let's think more carefully about the structure of this loan:

The notes bear an annual interest rate of 9%, with interest and principal paid quarterly beginning November 15, 2014. Prior to May 15, 2016, in the event that the specified portion of royalties received in a quarter is less than the interest accrued for the quarter, the principal amount of the notes will increase by the interest shortfall amount for the period. Since the principal and interest payments on the notes are based on royalties from product sales, which will vary from quarter to quarter, the notes may be repaid prior to the final maturity date in 2029.

This means that, if the royalty stream is very strong, the company won't pay 9% until 2029, but will repay principal much earlier. Eg., if total royalties coming in for 2017 and 2018 are $500 million each (which is not unrealistic), the financiers will get $200 million in both years and, together with the payments made in prior years, Royalty Management could already be debt-free. On the other hand, if the royalty stream is zero, the company has to pay 9% on principal (adjusted for incomplete payments in the period up to May 15, 2016) out of its own coffers until 2029, when principal is due.

So it seems to be a bet on a higher-than-expected royalty stream on the side of THRX. On the side of the financiers, it seems to be a bet on a not-more-than-moderate flow of royalties that guarantees the payment of high interest rates for a long time, without reducing principal too fast.

As far as the presumable cost of capital for the future Royalty Management company is concerned, I would not read too much into the issuance of this loan, as it has a very special structure.

Furthermore, under current conditions, i.e. pre-spin-off, with still uncertain royalty streams, Theravance has, of course, a far higher cost of capital than afterwards.

A far more interesting question would be, what does Royalty Management need the money for? In the latest conference calls, management has always repeated that the company did not need a lot of money, which is why it intended to give almost all their cash to the split-off Biopharma company. So what will the proceeds be used for? If management feels sure about future royalty streams, a low valuation of the stock around the separation period could provide a great opportunity for buybacks, which would pay off nicely in the near future as soon as royalties start to flow, the loan is paid back and markets have more certainties when evaluating the stock. I don't think the company intends to use the money for special dividends at this point. It probably intends to safely bridge the period from now to the start of more robust income streams, and at the same time, get the flexibility to execute opportunistic buybacks.

This seems to be confirmed by this statement included in the press release:

The net proceeds from this transaction are currently planned to support the initiation of a capital return strategy to the stockholders of Theravance, Inc. in conjunction with the previously announced spin-off of Theravance Biopharma, Inc., for payment of remaining approval and launch milestones to GlaxoSmithKline plc (NYSE:GSK), and funding of the operations of Theravance, Inc. following the spin-off.

All in all, I see the loan issuance as a good move and would not change my basic investment thesis, as royalty streams would need to be far lower than estimated to keep this loan in life for a long time.

Disclosure: I am long THRX. 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.