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CEPH Analysis – May 10, 2005

Summary

I would use 300 credit spread over Libor for CEPH. The credit metrics of the company suggest a tighter spread but CEPH faces some challenges in 2006-2007 that require a higher spread to compensate for the added risk. Overall, I believe the credit is good with the positives balancing out the negatives. However, both the equity and the credit may face volatility as the good and bad news may not be released evenly.

1) The biggest challenge for CEPH is to manage the transition from the decline of its 2 main drugs (Provigil and Actiq) to the launch of 4 new drugs that are in the pipeline. This transition will begin in the second half of 2006. The timing of the launch of the new drugs vs. generic competition is important to watch.

2) CEPH has a full pipeline of drugs with 4 potential drugs launches in 2006 and 2007. According to analysts, each of these drugs has a high probability of approval and success.

2) CEPH faces 2 generic challenges to its franchise (Provigil and Actiq) drugs in 2006. CEPH plans to replace Provigil (with Nuvigil) and Actiq (with OraVescent) but this transition could be tricky especially with generics challenging the original drugs.

3) CEPH has good liquidity with $800M in cash, $1.2B in debt, and expects to generate over $200M of free cash flow in 2005.

4) Management has paid down debt in recent months but is also looking for acquisitions to add to their growth from 2007 to 2009.

Products

 Timeline

May 2005 – American Psychiatric Association annual meeting – Provigil ADHD data

June 2005 – Meetings on sleep disorder – Nuvigil Phase III

October 2005 – Provigil ADHD in children PDUFA

January 2006 – Provigil court proceedings begin

June 2006 – Analysts expect Provigil to go generic.

Provigil/Nuvigil (Sleep disorder)

Provigil is the only drug that treats patients suffering from excessive daytime sleepiness (EDS) associated with narcolepsy. Provigil has patent protection through 2014 but may face generic competition in late 2006. Six companies led by Teva and Mylan challenged the patent claiming that one of the key Provigil patents (particle size modafinil patent) is either invalid or not infringed by their generic versions. In May 2005, one of those companies- Sandoz – dropped out of the challenge but analysts do not think it means much.

CEPH believes that they will prevail due to legal precedent for particle size patents. Also, the company believes that generic companies will find it difficult to produce a bioequivalent version of Provigil without infringing the particle-size patent. CEPH plans to replace Provigil with a new improved version called Nuvigil.

Nuvigil is a single isomer version of Provigil, which may improve safety and efficacy. So far, all the data on Nuvigil has been very positive.

TheDisctict Courtproceedings on the patent challenge will begin in early 2006. Allowing at least 6 months for the judge to deliver his verdict, and time consumed in the appeals process, these court cases could stretch into 2007. CEPH says most analysts expect a June 2006 generic launch but is more likely to be 2007 before generics launch.

Actiq/OraVescent (Cancer pain)

Actiq treats breakthrough cancer pain in patients who have not achieved adequate pain relief from other opioid analgesics. Actiq has patent protection until 9/5/06 with a chance for a six month extension for pediatric exclusivity. Barr Labs is ready to enter with a generic. CEPH plans to replace Actiq with a new improved version called OraVescent Fentanyl (OVF). CEPH plans to file an NDA for OVF by 3Q05 with approval and launch in 3Q 2006.

Attenace (Attention deficit)

Attenace is being developed to treat Attention Deficit Hyperactivity Disorder (ADHD) in children. If approved, Attenace will compete against established treatments such as Adderall XR (Shire), Concerta (J&J) and Strattera (Eli Lilly). However, safety concerns for Strattera and Adderall bode well for Attenace. The 10 month PDUFA date is 10/21/05 with a mid-2006 launch expected. Analysts believe this drug has a high probability of success.

Gabitril (Epilepsy/Anxiety)

Gabitril treats seizures in patients suffering from epilepsy, a brain disorder. Gabitril has a small 1% share of the market that is dominated by Pfizer’s Neurotin. Gabitril sales have slowed in 2005 following a new warning label. CEPH plans to launch new Gabitril indications for general anxiety disorder (GAD) and insomnia that could help 2008 and beyond.

Sales Force

CEPH as a 500 person sales force that markets products to a broad group of doctors. Of that, 240 people promote Provigil and Gabitril to neurologists, psychiatrists and sleep specialists. A second team of 90 people market Actiq to pain specialists and oncologists. CEPH plans to add a 250 person team to promote Attenace to pediatricians. In 2007, CEPH may add another 200 people in preparation for the launch of Gabitril for generalized anxiety disorder. The company is clearly building for growth but could cut back on these expenses if the drug launches do not go as planned.

Capital Structure/Credit

CEPH’s strategy is to issue converts, hope for the stock price to go up, force holders to convert into stock and then start the cycle again with new convert debt.

Management has bought back some 2.5% converts in private transactions when a large holder goes to them with a proposal. Management is open to buybacks because they realize that their debt level (60% debt to equity) is a bit high and is willing to reduce debt given the right opportunity.

CEPH has $791M in cash, $1.3B in debt and expects to generate over $200M FCF in 2005. Management is looking for acquisitions in the $200 to $300M range in areas that can 1) leverage their existing specialty sales forces in psychiatrics, pediatrics or neurology or 2) create a new specialty sales force such as cancer.

CEPH’s strong interest coverage suggests that the company should trade at tighter spread. However, it’s debt levels and business risk suggests a spread of about 300 over Libor. S&P rates CEPH a B+ and the subordinated convertible debt two notches lower at B-.

Equity valuation

At $45, the stock trades at 16x 2005 EPS estimates of $2.89. Analysts and management both believe the stock price reflects the generic competition to prevail against Provigil with a mid-2005 launch. CEPH equity will likely be volatile over the next 2 years given the timeline of news that will come out during that time.

Risks

Generic erosion of Provigil occurs sooner and faster than expected

If the Courts rule in favor of the generics and allow them to launch prior to CEPH launching Nuvigil, there could be a period of time where CEPH faces a gap in its revenues. A poorly executed transition could make it hard for Nuvigil to gain back market share lost to generics.

New drugs face delays

CEPH would not be able to replace revenues lost to generics if any of its 4 pipeline drugs have delayed launches or get pulled from the market. So far all the data related to the 4 pipeline drugs have been very positive.

New launches fall below expectations

After the new drugs launch, there is still risk that they are not accepted by the market, However, given the efficacy profiles of the drugs, they will likely meet a need of the market.

Makes a bad acquisition

Management may use a good part of their cash for an acquisition. If the acquisition does not turn out well, it could place stress on their balance sheet. However, management has a history of making good acquisitions.

Unexpected departure of a senior executive

According to analysts, the loss of their CEO, CEO, President and R&D manager would be a significant loss for the company.