PDL BioPharma — Update 3 March 2016

This dividend reduction, although large on a relative scale, still allows the company to preserve a respectable yield of 6.8%, while providing cash flow to support its immediate obligations through early 2018, as well as investment in future royalty streams. This will provide the company with an additional $16.4m per quarter in cash if the rate is maintained. We previously projected a cash shortfall of $77m by the end of 2018, so the new dividend should be more than sufficient to meet its obligations and provide liquidity for new transactions.

The reduction in the dividend was essential to meet a series of obligations, the largest of which is the company’s $246m in outstanding convertible debt, due in February 2018. The company was also scheduled to pay $25m to complete repayment of its term loan from RBC in Q116. Outside debt, the company is committed to providing $50m in financing to Ariad and potentially $20m to CareView if it can meet certain milestone conditions. As a reminder, the Ariad deal provided an initial $50m in financing in July 2015, with the obligation for PDI to provide an additional $50m one year later. Additionally, Ariad has the option to request $100m in additional financing during the six months before the final payment. Collectively, PDL’s obligations are associated with $433m ($533m with the Ariad option) in payments by Q118 (Exhibit 1).

Although the majority of positive cash flows are associated with the Queen patents and will be ending in Q116, many note agreements are scheduled to begin principal repayment in the next two years (Exhibit 2). The principal payments and existing licensing revenue should provide sufficient capital to service the debt and other obligations with the new dividend structure. However, PDL may seek short-term financing in the future, enabling it to do more deals or to finance the Ariad option.

Like many other companies, PDL has been a victim of the downturn in biotech, but it is in a unique position to profit from the situation as the need for alternative financing increases. For instance, Halozyme recently entered into a $150m debt agreement backed by royalties for its Enhanze technology. The last financial downturn in 2008 was also characterized by an increase in healthcare royalty deals and the founding of a number of funds associated with royalty-backed instruments.1

However, worsening financial market conditions could increase the rate of corporate defaults if clients are unable to obtain other financing to maintain operations and service their debt or royalty agreements to PDL. There is relatively little risk of interruption of revenue streams from royalty contracts, as they are by and large with well-established companies, but the debt agreements do pose a potential risk. Having said that, recent experience with LENSAR has shown that even these issues can be resolved in a manner favorable to PDL.

PDL recently presented their Q415 and year-end earnings reporting a revenue of $178m for the quarter and $590m for the year. This revenue exceeded our expectations (by $32m) due to a larger than expected royalty revenue of $34m outside of the Queen, et al., patents. The company explained on the earnings call that this was predominantly from the Glumetza royalty stream. There was previously a degree of uncertainty surrounding the royalty considering difficulties receiving payment from Valeant (see our update note published on 18 November 2015). Glumetza and the associated royalty agreement were acquired by Valeant during its acquisition of Salix, which had been stuffing channels with the drug. More recently, Valeant failed to report any revenue for the purposes of royalty calculation to PDL for Q315 filings due to inventory backlogs and late payments. PDL recently initiated royalty auditing proceedings, as the true sales of the drug remain somewhat unclear. The problem seems to be resolving because the company reported $18.9m in payments for Q315 sales and increasing royalty payments over Q415 ($5.3 million, $7.7 million, and $13.1 million for October, November, and December, respectively; December payments to be recognized in Q116). There will likely be some erosion of Glumetza sales over the coming year because of three generics entering the market (one launched in February, the remainder in Q3), but the runway for the royalty stream extends to 2023, and approximately 67% of the principal of the deal has been recovered since signing in 2013. Altogether, non-Queen revenue increased from $94m to $105m between 2014 and 2015 (12% increase).

The royalty payments for Queen, et al., patents was $121m for the quarter and $485m for the year. The Queen royalties are booked on a one quarter lag. Royalties from products sold by Genentech and Roche ended in December 2015, and therefore, the largest remaining portion of the payments will appear on Q116 reports. However, there might be some tail to the revenues because the remaining agreements cover products manufactured before patent expiration in December 2014, and some of these inventories may remain.

In news relating to PDL’s other investments, last October Sanofi issued a voluntary recall of its Auvi-Q epinephrine autoinjector devices due to inaccuracies in the quantity of drug delivered. Auvi-Q was licensed by Kaleo Inc., who has a $145m outstanding note due to PDL. It was announced on the PDL Q415 earnings call that Sanofi has returned the rights of the Auvi-Q injector to Kaleo. Although these developments put the future of Auvi-Q in question, this does not necessarily mean Kaleo will struggle with their loan repayments. First, the terms of the loan stipulated that Kaleo maintain a $20m reserve account to satisfy interest payments in the event of a shortfall, and PDL reported that this account alone should be sufficient to satisfy interest obligations through Q216. Also, Kaleo has an established commercial operation and sells the Evzio naloxone autoinjector in the US. They will not necessarily need to find another partner to relaunch Auvi-Q. This being said, it is unclear at this time the severity of the issues that lead to the recall or how long Auvi-Q will be off the market, although they intend to continue making payments through the interim.

Operational expenses for the year increased $5m and were largely due to legal costs associated with the LENSAR restructuring and the expenses associated with Wellstat Diagnostics. The company has initiated liquidation proceedings with regard to the assets secured against the Wellstat notes and reiterated its stance that the value of the assets exceeds the note principle. Wellstat sold a priority review voucher to AstraZeneca in September 2015 for an undisclosed amount, but previous priority review vouchers have fetched prices in the hundreds of millions, with the most recent public deal between United Therapeutics and AbbVie valued at $350m. PDL has filed for summary judgements in New York against Wellstat’s voucher and other assets. The company records a book value for the Wellstat notes of $50.2m, but the exact terms of the loan have not been made public.

We are slightly decreasing our valuation to $1,033m from $1,034m, corresponding to a reduction to $6.29 per basic share ($6.28 per diluted share) compared to $6.30 per basic share ($6.27 per diluted share) in Q315. Different effects balanced in our model such that the valuation did significantly change. Net debt decreased from $101.7 to $38.9 over the quarter (due to planned drawdowns on the term loan and an increase in convertible note buybacks), but this effect was offset by changes in our calculated NPVs as we roll over our valuation to 2016. The change in NPVs was dominated by the reduction in value for the Queen, et al patents as they approach extinguishment in early 2016. It is worth noting that the current EV of the company ($523m) is less than the book value of PDL’s assets from Q415 filings ($766m), a discount of 32%.

Revenue for Q415 exceeded our expectations at $590m compared to our estimate of $558m. The difference between the values is largely due to a difference in the change in fair value of royalty rights. We are currently maintaining our forecasts. PDL ended Q415 with $219 in cash, compared to the $227.5 reported in Q315. This was lower than our previous estimates of $243m primarily due to an increase in cash used to repurchase convertible notes. We are currently modelling a stable $0.05 quarterly dividend though 2018. Under these conditions, PDL will not need to refinance existing debt, but may seek short-term financing to take advantage of the favorable market or to fund the $100m Ariad option before the increase in cash flows associated with principle repayments in 2017 onwards. Additionally, if Kaleo is unable to successfully relaunch Auvi-Q, its $145m loan agreement with the company may be at risk.