|Shares Out. (in M):||95||P/E||0||0|
|Market Cap (in M):||172||P/FCF||0||0|
|Net Debt (in M):||272||EBIT||0||0|
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BUY AEGR 2.0% senior convertible notes due ‘19. The merger between AEGR and QLT just closed on November 29th. AEGR’s busted convert trades in the mid to high 60s and offers a YTM in the high teens. Assuming pro forma year-end cash of $119mm, the convert creates the post-merger business, now called Novelion Therapeutics, at $153mm. Just to be conservative, if you zero out all the pro forma cash on the balance sheet, then the convert effectively creates Novelion at $272mm. While its not perfectly clear to me what Novelion will look like in 2019 when the bond matures, I believe that the spread will tighten over the next year offering an attractive total return opportunity. Assuming that the AEGR side of the business is successful in its goal of getting to (or even close to) cash flow breakeven by sometime in 2017, it would not be unreasonable to see this bond trade to a yield in the low teens, which puts the bond price in and around the mid 80s. It’s hard to say what the downside protection here is, particularly as a biotech tourist/generalist, but its worth noting that AEGR paid $325mm for its metreleptin drug in 2015 and is likely worth quite a bit today in a sale even after applying a distressed seller discount. Having said that, given the lack of protections (guarantees, liens, etc.) this bond can easily be layered between now and maturity, which would obviously lower the recovery value in the event of a restructuring.
In June 2016, AEGR announced that it entered into a definitive merger agreement with QLT, another biotechnology company based in Canada. Following the closing of the merger on November 29th, QLT as parent company changed its name to Novelion Therapeutics and be headquartered in Vancouver. AEGR will become a fully owned indirect subsidiary of Novelion and will continue to be based in Cambridge, MA. As part of the transaction, several existing and new shareholders provided a $22mm investment of new capital into QLT and voted in favor of the merger.
AEGR was well on its way to insolvency and needed this merger transaction to stay afloat. The company has faced a number of significant operational challenges, including declining revenue from its largest drug product, government investigations, litigation and employee departures, and a high debt load. This merger addresses AEGR’s short and mid-term capital needs and provides some potential growth drivers not currently available to the company. The cash on QLT’s balance sheet along with the new money cash investment of $22mm will capitalize Novelion with more than $100mm in unrestricted cash at closing. In addition to this, there should be $26mm in restricted cash on the balance sheet that may become available in the near future.
Management believes that Novelion’s portfolio of JUXTAPID, MYALEPT and if approved the Zuretinol asset carry the potential for up to $500mm in global peak sales annually, including up to an $100mm from JUXTAPID, $200 – 250mm from MYALEPT and $200mm from QLT091001/ Zuretinol.
AEGR is a biopharmaceutical company dedicated to the development and commercialization of innovative therapies for patients with debilitating rare diseases. It has only two commercial products, lomitapide and metreleptin.
Lomitapide was AEGR’s first product and it received marketing approval, under the brand name JUXTAPID, from the U.S. FDA in December 2012. JUXTAPID reduces low-density lipoprotein cholesterol, total cholesterol, apolipoprotein B, and non-high-density lipoprotein cholesterol in patients with homozygous familial hypercholesterolemia. JUXTAPID is intended for use in combination with a low fat diet and other lipid-lowering treatments. HoFH is a rare inherited condition that makes the body unable to remove LDL cholesterol, often called the “bad” cholesterol, from the blood, causing abnormally high levels of circulating LDL cholesterol. In the U.S., HoFH occurs in approximately one in one million individuals. For those with HoFH, heart attacks and death often occur before age 30. JUXTAPID works by impairing the creation of the lipid particles that ultimately give rise to LDL.
JUXTAPID has failed to gain a strong sales trajectory and has come under increasing pressure from rival drugs, namely the new class of PCSK9 inhibitors. Management has responded by keeping its drug on the market in the U.S. and pulling it out of the EU and other markets. The company will continue its marketing efforts in the U.S., Brazil and Japan, where it just gained approval. Withdrawal from these other markets made the most sense after seeing limited success on its significant time and investment to obtain pricing and reimbursement approvals in these regions.
In light of the competition and the exit from EU and other markets, management has reset revenue expectations for JUXTAPID. They now believe that this product can generate approximately $65 –75mm in the U.S. annually and $90 –100mm globally. With a lower revenue base going forward, the organization now needed to be right sized to cut and eliminate the cash burn. In July, the company announced a significant reduction in force with a goal to reduce the expense base by $25 – 30mm. On the recent merger closing call, the CFO suggested that the expense cut target is now $35mm. The company is well into this process and should start seeing results at the start of 2017 with the full benefit realized by 2H 2017.
AEGR acquired its second product, metreleptin, from Amylin Pharmaceuticals and AstraZeneca Pharmaceuticals for $325mm in January 2015. This product, which received approval from the FDA in February 2014, is currently marketed in the U.S. under the brand name MYALEPT for injection. MYALEPT treats the complications of leptin deficiency in patients with congenital generalized or acquired generalized lipodystrophy. Lipodystrophy is a group of rare syndromes characterized by loss of fat tissue. In some patients it is genetic, while in others it may be acquired for different pathophysiological, and in some cases unknown, reasons. Generalized lipodystrophy is characterized by widespread loss of fat tissue under the skin. This loss of fat tissue causes a deficit in the hormone leptin leading to multiple metabolic complications. Management estimates that the global opportunity for MYALEPT is $200 – 250mm in peak sales assuming that the product is approved in Europe.
QLT is a biotechnology company focused on the development of innovative ocular products. Currently, the core operations consist of clinical development programs focused on the synthetic retinoid, QLT091001/Zuretinol, for the treatment of certain age-related and inherited retinal diseases. Zuretinol is being developed to treat Leber Congenital Amaurosis and Retinitis Pigmentosa, severe inherited retinal degenerative diseases that cause progressive vision loss starting in childhood and ultimately lead to inevitable blindness. According to the company, there are currently no FDA or EMEA approved pharmacologic treatments for either of these conditions. The product is currently ready for a Phase 3 trial in patients with LCA and RP. Global peak sales for Zuretinol are estimated to be $200mm.
AEGR financials are not pretty. The top line has cratered because of the JUXTAPID competitive issues mentioned earlier and unfortunately MYALEPT is not big enough yet to make up the difference. As a result, over the last four years, operating cash burn has been over $100mm.
Here’s a quick look at the revenue breakdown by drug:
There’s not much to QLT since it doesn’t have any revenue generating products. The annual burn has been relatively consistent over the years.
The new post-merger capital structure for Novelion is as follows:
I estimate that Novelion will end the year with slightly less than $120mm in total cash on a consolidated basis. While the company has not provided guidance for cash, I believe that my estimates for the Q4 cash burn and merger related transaction costs are reasonable.
Total debt pro forma for the merger will be $390mm. At the secured part of the capital structure, there is the $25mm owed to Silicon Valley Bank. This loan is in technical default and due for full repayment but because AEGR has reserved $26mm as restricted cash for the full settlement of this obligation, SVB has entered into a forbearance agreement with the company and agreed not to take any action with regards to the default. The loan is secured by a first priority security interest in all of the Company’s personal property and a second priority interest in the intellectual property related to MYALEPT. The company is in discussions with SVB and its possible that a brand new facility could be negotiated, thereby freeing up the restricted cash.
Also at the secured level is an intercompany loan between AEGR and QLT. Concurrent with the execution of the merger agreement, QLT agreed to loan AEGR up to $15mm for working capital. AEGR has borrowed $3mm so far and may borrow up to $3mm per month in subsequent months in order for AEGR to maintain an unrestricted cash balance of $25mm. The interest rate on the loan is 8.0% per year and it matures on the earliest of July 1, 2019 and the maturity date of the 2.0% senior convertible notes. The loan is secured by a first priority security interest in the intellectual property related to MYALEPT and a second priority security interest in certain assets securing the SVB collateral package. Note that I’m leaving this debt out of the table above because its intercompany and therefore cancels out on a consolidated basis. Clearly, should Novelion end up in a bankruptcy situation, then this debt would eat into any recovery at AEGR.
At the unsecured level, there is the $325mm senior convertible bond issue. The interest rate on the notes is 2.0% per year and maturity is August 15, 2019. The notes are convertible into shares at a conversion price of $41.175/sh. The merger was structured so that it did not trigger a repayment obligation. The notes will remain the obligation of AEGR, now a wholly owned subsidiary of Novelion. Unfortunately, the convertible notes do not benefit from any guarantees from the parent Novelion or any other subsidiaries and therefore there is risk that they could get layered in the capital structure with more structurally senior debt. However, I believe this risk is low as the capital structure is already stretched and cannot support additional debt.
Also at the AEGR unsecured level is the $40mm obligation resulting from the agreement to settle the DOJ/SEC investigations relating to JUXTAPID sales practices. The company is working to finalize the settlement, however, the preliminary agreement provides for a consolidated monetary package of approximately $40mm, payable over five years as follows:
· $3mm upon finalization of the settlement with the DOJ and SEC
· $3.7mm per year, payable quarterly for three years following the finalization of the settlement, and
· $13mm per year, payable quarterly, in years four and five following finalization of the settlement.
Outstanding amounts on the fine will accrue interest from the date of the final agreement at a rate of 1.75% per annum, compounded quarterly. These settlement payments are subject to acceleration in the event of certain change of control transactions or sale of JUXTAPID or MYALEPT.
Thoughts on Cash Flow, Potential Restructuring and Recoveries
Obviously, for this idea to work, the key factor will be the management of the cash balance over the next 6 to 8 quarters. We know that there should be about $120mm in cash available to the company at the start of 2017 – for the moment, I think its reasonable to assume that they can figure out a way to deal with the SVB loan default without having to pay it off and losing $25mm of liquidity. We also know the QLT side of the business will burn around $25mm per year since there won’t be any revenues there for quite some time. On the AEGR side, we know expectations for the top line have been reset to levels that appear to be achievable in the near term (longer term, who knows?). We also know that core operating expenses at AEGR will be cut $35mm from 2015 levels but since we haven’t been provided with 2017 guidance yet, its still unclear how far they’re into the right sizing process. We know their goal is to be cash flow positive in 2017 at AEGR but most likely they’re thinking in terms of run rate at some point in 2017 and not for the full year. Therefore, it makes sense to assume there’s a burn at AEGR for the full year 2017. I estimate that AEGR will burn $10mm in the first half and another $5mm in the second half for a total of $15mm for the full year. Add to this the $25mm burn at QLT and total operating burn for Novelion would total $40mm for 2017. If you add to this another $7mm for DOJ/SEC related outflows then Novelion ends the year with a cash balance of $73mm. If AEGR is at least cash flow breakeven by the end of 2017, then there should be 3 years of liquidity available to fund research over at QLT, in theory.
The liquidity and debt levels clearly remain a priority for the company. On the November 30th merger closing call, here is what CFO Greg Perry had to say when asked about the convertible bond:
I don’t think anyone is particularly happy with the debt low that Novelion is carrying right now. And so I think it will be important to explore options in terms of the convertible debt.
I have no insight into what they’re planning to do but I view this comment as a positive to the thesis. It should be obvious that the company has an interest in extending the maturity beyond 2019. It seem unlikely that they would be interested in a paydown or tendering for bonds at a discount given their need to preserve liquidity to fund research. Therefore, its more likely they will approach the bondholders to restructure the debt and extend the maturity in return for better economics which could include a significant bump in the coupon, subsidiary and parent guarantees and maybe even liens. Most bondholders would have an interest in this as its unlikely that anybody wants to see this company end up in bankruptcy.
Finally, I wanted to briefly share what the company thinks about its longer-term prospects. Below is a forecast that the QLT prepared for the AEGR business during the merger process. It’s slightly dated but does provide some perspective. If this projection even comes close to being reality, then not only will the convert be money good but the stock price today will also prove to be a steal.
The QLT projections are almost meaningless as it relates to the convert thesis. The success or failure of Zuretinol will likely not be known by the time the convert approaches its maturity. Having said that, the prospects for the drug do matter and if they’re positive, then the equity markets will be open to the company should it require additional liquidity, which obviously would be a credit positive.