All about converts

Trade idea

I like the ONXX 4% converts and would set it up on a 70 delta and sell 30 of the 7/21/12 44 strike call options at $4.3 to get to a 78 total delta.

Using 450 credit spread I get 38 implied vol compared with Jan 2014 options implied vol in the low 40s and implied delta is 79, although Citi says they trade it on a 69 delta. The converts also seem attractive given the wide equity valuation range for the stock based on upcoming catalysts and the wide range of estimates for the company’s Carfilzomb drug.

There is a significant event coming up that could accelerate approval for Carfilzomb to 2012 from 2014, which could move the stock -4 or +6. On June 18, documents that will guide FDA panel discussions will come out. These documents usually paint a negative picture for the drug because of the tough questions that it raises but are typically harsh for any FDA panel review. The FDA panel will vote on recommending approval on June 20. The actual FDA approval would take place on July 27. Although the FDA will usually go along with the panel, I think there will be some uncertainty in the case where it is a close vote in favor of approval. This is because the FDA has maintained a stance that it does not like to approve drugs based on phase 2 trials unless it fills an unmet need. It is debatable whether Carfilzomb fill an unmet need because there are other options for multiple myeloma patients.

In the last 5 years, there have been 5 drugs applying for accelerated approval with 3 getting approved (SGEN’s Advertris for Hodgkin’s lymphoma in 8/2011, ALTH’s Folotyn for lymphoma in 9/2009, CELG’s Istodax for lymphoma in 11/2009) and 2 being rejected (Roche’s T-DM1 for breast cancer and Genzyme’s Clolar for AML).

ISI’s survey reveals that 72% of buy-side analysts believed that the drug would not be approved. Sell-side analysts think the probabilities are about 60% non-approval.

I exchanged emails with Sammy Oh, who said he saw a -6/+8 scenario but that if the drug does not get approved, he sees the stock moving back up because in the end, the drug is effective and even though it will be approved 2 years later, it is still a valuable drug. It will also remove an overhang for the stock.

If ONXX does not get approval, the options will likely expire worthless, providing 1.5 points of 1.3 points of profit. My thesis is that the stock trades down to $41 and then gradually trades back up so being on a 70 delta would not hurt much if at all. To the upside, we are effectively selling stock at 48.30 to get to a theo delta

Company description

Onyx Pharmaceuticals (ONXX) is a biotech company with three main drugs:

1)      Nexavar – approved and marketed drug for liver and renal cancer

2)      Carfilzomb (Kyprolis) – Phase II drug filed for early approval in multiple myeloma (bone marrow cancer)

3)      Regorafenib – expected to be filed for approval in colorectal cancer and GIST in 2012.

Catalysts

The biggest catalyst for ONXX in the near term is whether Carfilzomib will get accelerated approval, which according to analysts could cause the stock to drop as much as $4 in an adverse decision or rise by $6 if it gets accelerated approval. Sammy Oh thinks -6/+8 and the options market is pricing in

I believe that this event has been a bit of an overhang for the stock. If the drug gets accelerated approval, the stock could initially be up $6 but could continue to move up another $5 to $6 in following weeks. This is because there would be more clarity and confidence around estimates and we could also see takeout speculation. A takeout given an accelerated approval should be about $70.

If ONXX does not get approval, the stock will likely rebound after the initial hit because Carfilzomib will still likely get approval but in 2014 instead of 2012.

June 18, 2012 –  documents for the FDA panel come out

June 20, 2012 – FDA panel meet to decide whether to accelerate approval for Carfilzomib

July 27, 2012 – PDUFA date for Carfilzomib approval

Equity valuation

ONXX has about $6 in net cash but I am not giving the company credit for this because of cash burn in the next couple of years. ONXX also has some potential drugs in the pipeline but since none are close to development, I am excluding this value as well. The most likely scenario is somewhere between the base case and bull case valuations, as the data that has come put so far from the Regorafenib and Carfilzomib is very good.

Nexavar is valued by most analysts at about $20 per share. Onyx is partners with Bayer on Nexavar and receives 50% profit share. The drug was approved for renal cancer in 2005 and liver cancer in 2007. About 75% of Nexavar sales and 100% of profits comes from liver cancer treatments. Nexavar’s growth is beginning to plateau out with analysts projecting ONXX’s profit share to grow from $287m in 2011 to $350m in 2019, the last full year before patent expiration. With associated R&D and sales costs declining, Nexavar should be a large cash contributor to the company in coming years.

Nexavar has filed to treat other diseases including thyroid cancer (DECISION trial), kidney cancer (SORCE trial), breast cancer (RESILENCE trial), Adjuvant liver cancer (STORM trial), and first line liver cancer (SEARCH). If approved, each one of these could account for an additional $1 per share in value. The bear case is

Regorafenib is valued by most analysts at $5 per share although some see as much as $20 per share if all goes right. This drug is positioned as a replacement and expansion for Nexavar with patents extended to 2024. Regoradenib presented phase 3 data in colorectal which should be good enough to get approval. Unlike Nexavar, ONXX will not bear any development or commercialization costs. ONXX will get 20% of net worldwide sales. According to Bernstein, the base case is for Regorafenib to reach $476m in sales by 2020, which equates to $5 per share. However, if Regorafenib were to achieve the sales levels of Nexavar ($1B revenues), the value could be $8 per share. If it reaches the levels of Erbitux ($2B), the value could reach $20 per share.

Carfilzomib (brand name Kyprolis) is valued by most analysts at $25 (range as low as $11 per share at Goldman and as high as $39 at Bernstein) in the base case scenario and an additional $8-$9 if the drug gets accelerated approval. This drug will be the biggest value driver of ONXX stock in coming years. Carfilzomib, fully owned by ONXX, targets Multiple Myleloma, a type of bone marrow cancer. The drug completed phase 2 trials with good results. Because the drug treats an unmet need for Multiple Myleloma patients who do not respond to Takeda/Millenium’s Velcade, the FDA panel will meet and decide on June 20, 2012 whether or not to recommend an accelerated approval for the drug.  If Carfilzomib gets accelerated approval, ONXX can launch the drug in 2012 instead of the expected 2014, which would add $8-$9 per share in value. Otherwise, the drug will conduct phase 3 trials (ASPIRE) with expected approval in 2014.

Credit

I see ONXX as a BB rated credit and use 400 as the credit spread for the 4 year converts due to several positives offset by some negatives. The average BB spread is 500 for 5 year maturity.

Positives – The company has $622m in cash with the converts $230m as the only debt. ONXX has a $3B market cap compared to only $230m in debt. The company has a proven drug on the market that is generating significant profits ($300m in 2012).

Negatives – ONXX will burn about $150m in cash in each of 2012 and 2013 before turning FCF positive in 2014 under the base case scenario. There is no assurance of approval for the company’s Regorafenib and Carilzomib drugs although in this scenario, ONXX can cut back on sales and marketing launch costs.