All about converts

MRX Analysis – May 18, 2005

Summary

There are currently a lot of moving parts for MRX. The company is not rated by S&P or Moodys but I estimate MRX to be a B- type credit with a 350 over Libor spread based on the following:

1)      MRX has $561M in cash and $453M in debt and will generate about $100M of free cash flow in 2005. The company should see strong growth with Restylane, Vanos, and Clin-RA while its cash cow acne franchise matures.

2)      On March 21, 2005, MRX agreed to acquire Inamed (IMDC) for 1.4205 common shares and $30 in cash for each share for a total of $2.8B. MRX plans to issue $650M in bonds to finance the deal. The acquisition of IMDC adds leverage to the company and introduces new risks such as the FDA review of silicone implants.

3)      MRX shareholders are likely to vote down the deal if the FDA approves silicone implants for MNT but not for IMDC. Most analysts believe that the FDA will reject both products in July. If the acquisition falls through, MRX’s credit will likely improve by 50-75 bps.

4)      The major risk is that MRX is placing all its eggs in the Restylane basket. If Restylane does not grow as quickly as the company’s expects and given the company’s added debt, this could lead to a widening of the credit.

5)      There is also risk that the FTC will ask MRX to divest some of its dermal filler products since the merger will give the combined company a near monopoly in that market.

Using 108.125 vs. 28.05 and 350 over, I get an implied vol. of 25 for the 2.5% converts.

Using 91.75 vs. 28.05 and 350 over, I get an implied vol. of 25 for the 1.5% converts.

MRX plans to issue $650M in debt to finance the deal but management has not indicated the type of debt it will issue. Given the company’s history, MRX may issue another convert to fund the acquisition which may affect the existing converts.

Also, if the merger falls through, MRX may become an acquisition target or may try to increase the dividend or buybacks to increase shareholder value. The converts are not takeover protected and only the 1.5% are protected for dividends over 5c per quarter (currently 3c).

Timeline

Summer 2005- Reloxin finishes phase III, files BLA for biologics

July 2005 – FDA rules on silicone implants for IMDC and MNT. The major risk is if MNT gets approval for silicone implants in theUSand IMDC does not.

December 2005 – Clin-Ra launch

December 2005 – Perlane launch

December 2005 – Expected completion date for IMDC acquisition

Summer 2006 – Juvederm launch

Summer 2006 – Reloxin launch

Business

Medicis is a specialty pharmaceutical company that specializes in prescription drugs for dermatology and aesthetic filler products. MRX’s future growth depends on Restylane and pipeline drugs (Vanos, Clin-Ra, and Perlane). Its older drugs including the acne related products and Loprox are maturing and starting to decline.

In March, MRX agreed to acquire Inamed to gain access to Reloxin, a phase 3 drug that is a potential competitor to Allegan’s Botox. MRX plans to combine Restylane with Reloxin to better compete with Botox.

Acne related dermatological products

The three products in this category are Dynacin (Molecule: minocycline), Plexion (sodium sulfacetamide), and Triaz (benzoyl perocide). These drugs are MRX’s oldest brands that contributed to MRX growth in the 1990s. These molecules are not patented so any company can produce them. MRX is able to stay ahead of the competition through effective brand building, distribution and developing new formulations including switching Dynacin capsules to easier to swallow tablets and adding Triaz pads to gels and cleansers.

As this segment has matured and competition has increased, MRX has switched its focus to Restylane. In the March quarter 2005, this group reported $24M in sales, below expectations of $34M due to increased competition for Dynacin.

Non-acne dermatological products

Restylane is an injectable, transparent dermal filler consisting of non-animal stabilized hyaluronic acid indicated for the temporary correction of moderate to severe facial wrinkles and folds. There are two families of hyaluronic acid fillers approved for use in theUS, with the other being Inamed’s Hylaform. Restylane is often considered to result in longer lasting corrections than Hylaform, although there has not been a clinical trial directly comparing the two products.

Prior to hyaluronic acid, the dermal filler market consisted of two types of collagen – bovine collagen (purified cow skin) and human collagen (purified human tissue). The most commonly used collagen products are Inamed’s Zyderm (Superficial lines) and Zyplast (wrinkles). The largest human collagen products are Inamed’s Cosmoderm (superficial lines) and Cosmoplst (wrinkles).

Of the dermal filler procedures, about 14% were done by Restylane or Hylaform in 2004 and 71% were done by collagen products (Zyplast, Zyderm, Cosmoderm, and Cosmeplast) although Restylane is expected to gain considerable market share due to its superiority. Restylane has a significant advantage due to minimal risk of allergic reactions and do not require lengthy skin testing prior to treatment.

Loprox is a broad-spectrum antifungal agent that is the leading branded antifungal among dermatologists and podiatrists. Script growth recently has been hurt by Altana’s generic ciclopirox launched in August 2004.

Omnicef is an oral antibiotic that treats uncomplicated skin and skin structure infections. MRX markets Omnicef to dermatologists and podiatrists through a license agreement with Abbott. MRX receives commission revenue from Abbott based on prescriptions generated b dermatologists and podiatrists. 

Vanos is a new drug introduced in February 2005 to treat plaque type psoriasis. This market is $329M in theUSand competes with CNCT’s Olux.

Non-dermatological products

MRX sold its rights to Orapres and its pediatric sales force to BioMarin in May 2004 in exchange for $93M license payments in order to focus on Restylane. By 2006, sales from this category will be nearly insignificant.

Pipeline

MRX is very tight-lipped with their pipeline drugs. Sometimes analysts do not even know about a drug until after it has been launched. MRX guided analysts to 2 major launches by 2006 with the first one being Vanos. Analysts speculate that the second pipeline drug is Clin-RA, a topical combination drug to treat acne. The drug could reach the market by the end of 2005 and is expected to reach $50M in sales in 2006. MRX has a patent challenge with CNCT which has a similar drug coming out called Velac. Another important pipeline drug is Perlane, a derivative of Restylane. Perlane is expected to launch in 2005 and deliver $15M sales in 2006.

Sales force

MRX markets its products with two dedicated sales forces consisting of 140 reps. The company’s dermatology and podiatric sales force of 100 employees calls on 5,000 high subscribing dermatologists and 3,000 podiatrists. MRX has 40 reps detailing Restylane to plastic surgeons and aesthetic dermatologists.

Acquisition of Inamed (IMDC)

On March 21, 2005, MRX agreed to acquire IMDC for 1.4205 common shares and $30 in cash for each share for a total of $2.8B. MRX plans to issue $600M in bonds to finance the deal. The rationale for the deal is to get IMDC’s Reloxin drug, a potential competitor to Allegan’s Botox.

Restylane is used to treat wrinkles below the nose while Botox is used to treat wrinkles above the nose. Restylane is often used together with Botox to get the best results. MRX’s strategy is to acquire Reloxin and package it together with Restylane to form a formidable competitor to Botox. MRX also makes a case for the merger by arguing that the combined company will have a complete line of products for plastic surgeons.

Inamed’s business

Inamed has 3 groups of products for the plastic surgeon’s office consisting of breast implants, facial treatment and obesity procedures. In breast implants, IMDC is the leader in saline implants in theUSand silicone implants inEurope. About 66% of breast implants sales come from theUS. This market is a duopoly with Mentor (MNT). In facial aesthetics, IMDC has a mature line of Collagen products, a hyaluronic acid dermal filler (Hylaform) and two new products (Juvederm and Reloxin). The obesity intervention treatment is a procedure to use gastic banding as a replacement for stomach stapling to reduce obesity 

Capital Structure and Credit Spread

MRX has $561M in cash and $453M in debt and will generate about $100M of free cash flow in 2005. To pay for the merger, MRX plans to issue $650M in new debt (possibly converts). MRX is not currently rated by the agencies but based on the credit metrics of the new MRX and company fundamentals, I estimate a B- type credit or a spread of about 350 over Libor.

 MRX is unlikely to increase its dividend from its current 3c per quarter. Assuming the completion of the merger, MRX will need to use its free cash flow to pay down the debt from the acquisition.

It is possible the MRX could be taken over although there have been no rumors or speculation that it would. Some logical buyers are the big pharmaceutical companies but none have been specifically mentioned. MRX’s acquisition of IMDC makes it less  likely that the combined company will be taken out.

Risks

FDA ruling on silicone breast implants in the US.

On April 13, 2005, the FDC panel voted 7-2 for approval ofMentor’s silicone gel-filled breast implants after voting against the approval of IMDC’s silicone gel-filled breast implants the day before. Most analysts believe that the FDA is not ready to approve either solution when it makes its ruling around July 2005. Both silicone products are currently sold in Europe but not in theUS.

About 66% of IMDC’s breast implant revenues come from theUSin the form of Saline implants. However, inEurope, 90% of implants are silicone. If the FDA approvesMentor’s silicone product but not IMDC’s silicone product, it is likely that MRX shareholder will vote down the merger since IMDC’s breast implants in theUSwill likely go to zero.

MRX is forced to divest some products

The acquisition of IMDC is expected to close by year end 2005. There is a possibility that the FTC could require MRX to divest some products in the dermal filler segment as a condition to complete the merger. In this case, MRX may have to divest some products, which could reduce the benefits of the merger. However, MRX is confident that the FTC will not have an issue because MRX believes the market for dermal fillers should include the entire facial aesthetics market where there are plenty of competitors.

Acquisition of IMDC could get delayed or terminated

MRX shareholders need to approve the acquisition of IMDC expected at year end. Between now and then, there could be events for IMDC that could cause shareholders to vote down the deal such as the FTC’s rejection of IMDC’s silicone implants or negative

The Restylane franchise is not as strong as expected.

MRX is focusing on growing the Restylane by investing in sales, marketing and acquiring Inamed for its complementary Reloxin product. In the process, MRX is adding $650M in debt to fund the purchase. If Restylane is weaker than expected, MRX’s other products will have to take on a bigger load to finance the increase debt. However, even with the increased debt, MRX should be able to manage through a slowdown.

Faster than expected decline of mature products

MRX has several mature products such as Dynacin and Loprox that are slowly declining as more competition enters their markets. If these declines are faster then expected, cash flows to the company may be lower than planned. We saw this in the March quarter where Dynacin and Lopprox declined faster than expected. However, even with the increased debt, MRX should be able to manage through a slowdown.