Cephalon setback positive for hedged players; Lucent strengthens on merger talks; BioMarin starts strong

By Kenneth Lim

Boston, March 24 - Cephalon Corp. was a boon for hedge investors on Friday after the stock crashed on the pharmaceutical company's failure to get regulatory approval for its key drug Sparlon, but outright convertible bond investors were stung as the company's credit widened.

Meanwhile, merger talks between Lucent Technologies Inc. and France's Alcatel sent Lucent stock skyrocketing, and onlookers said a successful deal could improve Lucent's credit story.

Fresh from the oven, BioMarin Pharmaceutical Inc.'s new convertibles had a strong debut, trading about 2.5 points higher on a neutral basis as investors took note of a deal seen as cheap during price talk. King Pharmaceuticals Inc.'s new convertible senior notes did not do as well, staying around par during trading. Investors panned the low coupon on the convertibles, while King Pharmaceuticals' bid to gain a six-month extension on its Altace hypertension drug was dealt a setback by the Food and Drug Administration, which said pediatric trial data was lacking.

Cephalon weakens on FDA setback

The credit spreads on Cephalon's bonds were seen widening Friday after its drug Sparlon failed to get FDA approval for treating attention deficit hypertension disorder, but the sharper drop in the company's stock was good news for hedged investors.

Cephalon's B tranche of zero-coupon convertibles due 2033 were seen trading more than 10 points lower on an outright basis at 119.5 versus $64, while the 2% convertibles due 2015 lost almost 20 points on an outright basis at 150.25 versus the same stock price. A major convertible shop marked the A tranche of zero-coupon convertibles due 2033 lower by 12 points outright at 117.08 bid, 117.58 offered versus the closing stock price of $63.80.

But a sell-side convertible analyst said that on a hedged basis the zero-coupon convertibles were better by almost a full point while the 2% convertibles improved by about one-third point.

Cephalon stock (Nasdaq: CEPH) ended Friday down $9.51 or 12.97%.

Trading in Cephalon stock was halted on Thursday as the FDA considered the company's request. News that the FDA had rejected Sparlon, which is currently sold as a sleep-disorder drug under the brand Provigil, as a treatment for ADHD emerged after the close. Although the FDA panel of experts had unanimously agreed that the drug was effective against ADHD, the panel was concerned about the drug's potential to cause a serious skin rash in children.

Analysts had been expecting the FDA to approve the drug for ADHD, albeit with a "black box" warning label.

Frazer, Pa.-based Cephalon lowered its sales estimate for the year by $100 million to between $1.4 billion and $1.5 billion, but still guides for earnings per share of $3.80 to $4.00. Merrill Lynch equity analyst Gregg Gilbert wrote in a report that he has removed Sparlon from his models, cutting his 2007 earnings per share estimate by 16% to $3.83 from $4.57. He maintained a neutral recommendation on the stock.

Like Gilbert, the sell-side convertible analyst said he was taking Sparlon out of the picture for Cephalon.

"The question now is, what will happen to the drug?" the sell-side convertible analyst said. "I think it will probably cause a 15 to 18 month delay. What will happen is that the $450 million to $500 million sales people are expecting [from Sparlon] by 2010 previously, now it will be delayed by at least 18 months. And could be other safety concerns that could lead to a black box warning on the drug, which would lead to less than the $500 million of sales expected?"

He said the full impact of the setback will not be reflected in 2006, but estimate cuts for 2007 and beyond were "significant" because that was when analysts were expecting the drug to take off. He said the FDA rejection was not all negative for Cephalon. The consensus on Sparlon's effectiveness against ADHD leaves a window of hope that it is "probably going to be a decent enough drug, maybe not as big as Cephalon thought it would be, but still decent."

In terms of the company's credit risk, "it's not a disaster because this is an EBITDA-positive company even today, and today's EBITDA doesn't depend on Sparlon at all," the analyst said.

Nevertheless, he is widening Cephalon's credit spread by 25 basis points for all three convertibles, to Libor plus 150 bps for the A tranche zero-coupons, Libor plus 275 bps for the B tranche zero-coupons and Libor plus 350 bps for the 2% convertibles.

Lucent, Alcatel in merger talks

Lucent convertibles gained on an outright basis on Friday after the telecommunications equipment supplier said it was in fresh merger talks with its larger French rival Alcatel.

Lucent's 2.75% convertible due 2025 changed hands at 114 versus a stock price of $3.10 on Friday, while the 7.75% convertible due 2017 traded at 994 against a stock price of $2.95, said a sell-side source. Another trading desk marked the company's 2.75% convertible due 2023 about four points higher at 107.38 against the closing stock price of $3.06. Lucent stock (NYSE: LU) closed 24 cents or 8.51% higher.

Murray Hill, N.J.-based Lucent and Paris-based Alcatel said Friday that they are discussing a deal that would be valued at current market prices, and market speculation was that Lucent chief executive Patricia Russo would also helm a new combined company.

The sell-side source said there was still a lot of speculation in the market over whether the merger will actually happen, but "if it does, there's not question that it will be a big plus for the credit" of Lucent.

A buy-side convertible analyst said the benefit of such a merger was actually the topic of a discussion at a telecommunications trade show earlier in the week. He saw a deal as "a really good idea."

The companies will have to work out cross-border labor and regulatory practices and overcome legacy problems from each side. Lucent's Bell Labs, which does national security work, may also have to be entirely or partially spun off to address security concerns, but on the whole the companies would be a good fit, the analyst said.

"They have good portfolios to balance each other, and there needs to be consolidation in the space," the analyst said.

The analyst said Lucent's 7.75% convertibles would become more attractive if the deal goes through: "We liked them before and we think this could be even better."

There are three possible outcomes for the convertibles, the analyst said. The merger could be structured so that the larger Alcatel acquires Lucent, in which case the convertible could climb closer to par on prospects of a change-of-control redemption. Lucent could also tender for the 7.75% convertibles.

Alcatel is also currently better rated by credit agencies, which would be positive for Lucent debt when the two companies' credit ratings are combined if the convertibles remain outstanding.

"The devil's going to be in the details," the analyst said.

Moody's Investors Service on Friday affirmed Lucent's B1 corporate family rating and changed the outlook to developing from positive. The credit rating agency said Lucent's credit profit would benefit from a merger, but the company would continue to face challenges if the merger falls through.

BioMarin's new issue starts strong

BioMarin Pharmaceutical's upsized $150 million offering of seven-year convertible senior subordinated notes were priced at the rich end of talk on Thursday but still had a strong start on Friday.

The new 2.5% notes due 2013, which were priced at par, were seen changing hands at 105 versus a stock price of $13.125, up about 2.5 points on a neutral basis, said a buy-side trader. BioMarin stock (Nasdaq: BMRN) rose 19 cents or 1.45% to close at $13.32 on Friday.

Price talk was for a coupon of 2.5% to 3% with an initial conversion premium between 22.5% and 27.5%. The original size of the deal was $125 million with a greenshoe of $18.75 million. The greenshoe option is now $22.5 million.

Merrill Lynch was the bookrunner for the off-the-shelf offering.

The deal was seen by several analysts as cheap during price talk, and the convertibles were bid 1.25 points up in the gray market on Thursday.

"They were well bid for in the gray market," said the buysider.

A syndicate source said there was broad interest from outright and hedge fund investors, and because BioMarin shares had gotten a boost recently by news of positive drug trial results, some hedge investors gave indications that "they were going to play it on an outright basis," the source said.

Novato, Calif.-based BioMarin plans to use the proceeds of the two offerings to fund the commercialization of its products, additional clinical trials of products that include metabolic disorder drug Phenoptin, and potential acquisitions. The company may also use some of the proceeds to buy back some or all of the $125 million outstanding of its 3.5% convertible bonds due 2008, which become callable on June 20 this year.

The company last week reported positive results from Phase 3 trials of Phenoptin, increasing the likelihood that the drug will hit the market.

"I would not be surprised to see them expand a little bit more," said the buysider of the new convertible bonds.

King Pharmaceuticals gets rocky start

King Pharmaceuticals priced its $400 million offer of 20-year convertible senior notes on Friday at the cheap end of talk with a coupon of 1.25% and an initial conversion premium of 20%.

The notes, which mature on April 1, 2026, were talked at a coupon between 0.75% and 1.25% with an initial conversion premium between 20% and 25%, market sources confirmed.

Citigroup, UBS Investment Bank and Banc of America Securities were the bookrunners for the Rule 144A deal. They have a greenshoe option to purchase a further $60 million of notes.

The notes were trading at par against a $17.15 stock on Friday, said a sell-side source. King Pharmaceuticals stock (NYSE: KG) closed at $17.20 on Friday, down 16 cents or 0.92%.

"The Kings didn't look all that great," said a buy-side portfolio manager. "The terms didn't look good, and at the mids they were like 1%, up 22%. I'm trying to stay away from one percents. Two years ago they could bring something like this, but now it's just not enough."

King Pharmaceuticals stock also retreated early in the day after the company said the FDA found that its tests on children using its Altace hypertension drug were insufficient, and the company may have to conduct more drug trials to get a six-month patent extension on the drug.

A sell-side analyst said the impact of the Altace setback is probably insignificant, mainly because the patent will expire only after late 2008. "Those are the outlying years," the analyst said.

A bigger concern for the Bristol, Tenn.-based pharmaceutical company is pending generic competition for its drugs, most of which have patents that are expiring soon. Earnings estimates for the company are lower in the next two years than in 2005, the analyst said.

But the company continues to generate cash, and could become a more attractive play if it maintains a strong balance sheet and improves its product mix, he said.

Moody's on Friday affirmed King Pharmaceuticals' Ba3 corporate family rating, as well as the Ba2 rating for its senior secured revolver due 2007 and the Ba3 rating for its 2.75% convertible due 2021.

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