Wednesday, May 23, 2012

Capital Structure Arbitrage Note: KV Pharmaceutical

KV Pharmaceutical Company is a pharmaceutical company that is currently marketing two approved products: Makena and Evamist, and expects to launch two previously approved products, Gynazole and Clindesse, in 2012.

There are two classes of common stock. The A class has a higher dividend but much smaller voting rights than the B class. The fully dilluted A+B share count is ~90 million, giving the company a $90 million market capitalization. Meanwhile, there are $225 million of senior secured notes due 2015 trading at 60 (market value $135mm) and $200 million of convertible notes due 2033 trading at 16 (market value $32mm). [In addition to various other obligations including payments owed to the previous owner of Makena.]

Importantly, the 2033 notes are putable next May (less than a year) at par. The specifics are that "holders may require us to repurchase all or a portion of their 2033 Notes on May 16, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the 2033 Notes, at 100% of the principal amount of the 2033 Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash."

Obviously, these notes which are trading at 16 and due next year are both the fulcrum and most exciting security. According to a recent holders list, ~25% of the issue is owned by Susquehanna, 15% by Lazard, 15% by SAC, 13% by Whitebox, and the rest by a variety of other distressed debt and convert arb funds.

They gave an investor presentation on Apr 12 which has the longest safe harbor statement I've ever seen. Besides the notes, their material financial obligations are $95 million in milestone payments to Hologic for Makena, and $35 million in various government settlements. They had roughly $60 million cash at the end of March.

Makena is a once a week injection (given for approximately 15 weeks) for women who have already had a prior pre‐term pregnancy and are once again pregnant. It was shown to reduce the chance of the mother having a preterm birth. In optimistic sell side research that shows substantial enterprise value, almost all of the value is in Makena.

The problem with Makena is that it is an "orphan drug" and doctors had been using the active ingredient in Makena (a progesterone called 17p) for years, made by compounding pharmacies. Apparently the cost of 17p from a compounding pharmacy was in the $10/shot range. However, KV initially priced the drug at $1,500 per injection. Doctors and health care payers like insurance companies were not impressed, and as a result many potential customers have continued to use compounded product rather than Makena.KV needed the FDA to prevent the compounding pharmacies from undercutting them on price by a factor of 100x. Unfortunately for KV, the FDA did not exactly come to the rescue with this statement:

"FDA approved Makena (hydroxyprogesterone caproate) in February 2011 for the reduction of the risk of certain preterm births in women who have had at least one prior preterm birth. For many years before Makena was approved, a version of the active ingredient of Makena has been available to patients whose physicians requested the drug from a pharmacist who compounded the drug. In March 2011, after learning that the owner of Makena, K-V Pharmaceuticals, had sent letters to pharmacists indicating that FDA will no longer exercise enforcement discretion with regard to compounded versions of Makena, FDA issued a statement about compounded hydroxyprogesterone caproate to clarify the agency's enforcement priorities. In the March 2011 statement, FDA explained that the agency prioritizes enforcement actions related to compounded drugs using a risk-based approach, giving the highest enforcement priority to pharmacies that compound products that are causing harm or that amount to health fraud. The agency also stated: 'In order to support access to this important drug, at this time and under this unique situation, FDA does not intend to take enforcement action against pharmacies that compound hydroxyprogesterone caproate based on a valid prescription for an individually identified patient unless the compounded products are unsafe, of substandard quality, or are not being compounded in accordance with appropriate standards for compounding sterile products."
Essentially meaning that the FDA is not going to stop the compounding pharmacies from undercutting KV on their wildly overpriced drug. The American Congress of Obstetricians and Gynecologists (ACOG), which was not pleased with the pricing of Makena, had previously said,
"[While]… there are clear benefits to having an FDA-approved version of 17P, there is no evidence that Makena is more effective or safer than the currently used compounded version. In fact, the evidence used to obtain FDA approval for Makena relied primarily on data obtained using the compounded product."
I found a UnitedHealthcare document describing their reimbursement policies for 17p/Makena:
"UnitedHealthcare requires prior authorization for Makena, whether administered in the office or by a home health service, for the following Commercial plans and products..."
It seemed as though they would prefer that people use/doctors prescribe the cheaper compounded version (surprise).

Anyway, the bonds are cheap enough that there is a pretty clear long bonds / short stock opportunity here. And it is helpful to know that the company's assets are probably insufficient to cover the bonds, meaning that the stock is most likely worthless.


Robin said...

thanks for the write up - wanted to ask what ratio you would put this trade on? long how much of the convert vs short how much of the common?

thanks again

CP said...

Depends on how bearish you are on the Makena valuation.

But the nice thing about bonds trading at 17 is it gives you some leeway to short more.