Rogue Missives Friday, June 06, 1997

Imagine you're part owner of a company with hot prospects but not enough cash to really take advantage of the opportunities in sight. Out of the blue, you receive an epistle from the guys managing the operations saying they've got a bright idea. They've decided to go to Atlantic City, cash in part of your ownership stake for chips, and try their hand on the roulette wheel. Before your heart medicine has had a chance to kick in, you hear that these guys are already at the cashier's window waiting for the chips. Question is, are they just taking a reasonable risk to attain much needed capital for the business or are they stealing from you on the off chance that a wild gamble will pay off?

Though this analogy overstates the case somewhat, shareholders of CEPHALON <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CEPH)") else Response.Write("(Nasdaq: CEPH)") end if %>, a seasoned though still development stage biotech company, were recently confronted with a not-so-different situation. And so far, the house is winning.

On April 9, with Cephalon shares trading in the mid-teens, the company announced it had struck an innovative, first-of-its-kind deal with SBC Warburg, Inc., part of SWISS BANK CORPORATION (OTC: SWBZY). Management said it planned to issue 490,000 new shares to acquire call options representing the right to acquire 2.5 million Cephalon shares. As detailed in subsequent public filings, the European-style options would have a strike price of $21 1/2 per share and expire on October 31, 1997. The options would be capped at $39 1/2. This meant that if Cephalon stock at least doubled in price, the company could pocket up to $18 a share, or $45 million.

With Cephalon last quoted at $20 a share when the deal became effective on May 8, management was essentially betting $10 million worth of stock that sometime in the ensuing six months, Cephalon shares would rise, preferably above the $25 break-even level. If not, the deal would dilute the shareholders' equity and produce nothing in return. The options could simply expire worthless, as roughly 90% of options do. Indeed, roulette players generally do much better.

The company's management, though, clearly thought this was a smart bet. That's because the same day the options deal became effective, an advisory panel of the Food and Drug Administration (FDA) was scheduled to discuss Myotrophin, a drug used to treat patients suffering from amyotrophic lateral sclerosis (ALS), a degenerative and ultimately deadly neurological disease better known as Lou Gehrig's disease. Myotrophin is one of two key Cephalon drugs being reviewed by the FDA for commercial approval (the other is a drug to treat narcolepsy). Back in June of 1996, the same FDA panel had granted Myotrophin investigational new drug (IND) status. This status allowed the drug to be offered on a compassionate use basis. Since the FDA usually follows the recommendation of its advisory panels, a thumbs up from the panel was expected to send Cephalon shares higher.

Yet in June, the panel had clearly been unimpressed by Cephalon's data. In fact, some panel members requested that Cephalon and its partner CHIRON CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CHIR)") else Response.Write("(Nasdaq: CHIR)") end if %> conduct an additional Phase III study of the drug. A double-blind North American study had found a statistically significant clinical benefit in patients taking the drug. But a follow-up European study failed to corroborate the earlier results, though that study ultimately had too few patients for the data to have statistical significance. Indeed, death rates for those on the drug in the European study were higher than for patients in the control group. Yet the company argued that the higher mortality level had nothing to do with its drug but with the normal progression of the disease. Some independent commentators agreed, insisting that a close look at the data revealed that the European study was improperly controlled since patients assigned to Cephalon's drug were generally sicker at the start of the study. The FDA, at least, seemed to agree that safety wasn't a concern. Efficacy, however, was.

In large part, then, Cephalon's options deal was a bet that the FDA would soon give the company the go-ahead to market Myotrophin. But given that the company had not launched an additional trial and did not provide detailed follow-up data on the earlier patients studied, it's hard to determine precisely why the company's management was so confident aside from the fact that doctors and patients battling ALS generally favor the drug's approval since, at this point, there's only one other treatment available.

But when the panel met again in May, it proved disastrous. By a 6 to 3 vote, the committee determined that the data presented for review did not constitute "substantial evidence" that the drug was effective in treating ALS. As the panel's chair, Dr. Sid Gilman of the University of Michigan Medical Center, told Dow Jones News, "The data does not look robust." Dr. David A. Drachman, professor of neurology at the University of Massachusetts Medical School, said, "My sense is we have seen cosmetic changes in the data, nothing substantial. We find ourselves where we were last June -- we want more data."

With most investors assuming this vote was tantamount to an FDA rejection, even though the FDA has until August to make a final decision on the matter, Cephalon shares immediately lost 40% of their value, dropping to around $12 a share, where they remain. Though the contracts don't expire for another five months, Cephalon's options play so far looks like a complete failure.

Yet regardless of the outcome, the case should raise concerns for investors, in part because it's apparently the first time a public company has tried such an essentially speculative use of options as a way of raising capital. Other companies may follow its lead. INTERNEURON PHARMACEUTICAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IPIC)") else Response.Write("(Nasdaq: IPIC)") end if %> recently announced a similar agreement with SBC Warburg, which is said to be proposing more such deals. Given the smashing success so far of their Cephalon agreement, who can blame SBC Warburg? Even at Cephalon's currently depressed levels, SBC Warburg appears to have walked away with a least $6 million in stock alone. Not bad for a few days work.

Typically, though, companies use options as a means of managing risk. As The Wall Street Journal reported last week, some of America's largest corporations, including INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> and IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, have ventured into the options market. Indeed, a February report from Salomon Brothers indicated that at least 100 firms in recent years have used options to bet on their stock price. In most instances, these companies are selling put options as part of a stock buyback program.

A put gives an investor the right to sell a stock at an agreed upon price. Someone buying a put, then, is trying to lock in a price, and thus is usually betting the stock will fall. Someone selling or writing a put contract is making the opposite bet, locking in a purchase price now rather than risking a price increase down the road. Selling puts makes sense if a company is committed to buying back shares sometime in the next few months and is comfortable with the current price. The advantage over simply buying the shares is that the put writer gets paid a premium to do so, and that premium can effectively reduce the purchase price the company is otherwise ready to pay.

The market can always move against the put writer. A company might sell $50 put contracts, pocket $2 a share in premiums from the buyer, but then find the shares have dropped to $40 two weeks later. The firm will then end up paying $48 for shares that could now be had for just $40. Without writing the options, though, the company might have paid $50 a share and be further in the hole. According to the Journal, companies engaged in this practice rarely lose money. In the past six years, Intel has made $423 million writing puts on its stock, and has rarely had to pay off. Microsoft also has done smashingly well, pocketing $300 million without being forced to pay off. Currently, Intel has a $1 billion put exposure and Microsoft $2 billion. Both companies are involved in huge stock buy-back programs, in part to support employee stock option plans.

The Cephalon deal differs from most other corporate trading of options in that it goes beyond financial risk management to something closer to active speculating. Risk is inherent in the biotech industry, and potential investors should be well aware of the potential for volatility and, sometimes, disaster. Still, these companies are not hedge funds. It's worth asking whether Cephalon shareholders have gotten the shaft.

Company officials say no. In public filings, Cephalon's management explained that part of any funds received from the exercise of the call options would be used to buy out a limited partnership formed in 1992 to support development of Myotrophin. The company will have to make substantial milestone and royalty payments to the partners if the FDA approves the drug for marketing. As Cephalon spokesperson Jason Rubin explained, "We were probably looking at somewhere on the order of a $120 million investment, potentially, to acquire the rights to this partnership and forego the milestone payments and not have that royalty drag on earnings."

Rubin said the company then got together with SBC Warburg and devised the options agreement as one of a series of ways for the company to raise money. Rubin said that Cephalon CFO Kevin Buchi and CEO Frank Baldino, Jr. saw the plan as a way to raise a fair amount of money with minimal dilution to shareholders. "The issue was, how could you put a minimum amount of capital at risk and potentially raise a substantial amount of money. In hindsight, you could look at the program differently than we did at the time. But I think it's fair to say that we entered into this particular transaction as one of a series of possible transactions that would help secure the company's financial position.... This struck us as an innovative way to potentially raise $45 million."

The company was clearly surprised and disappointed by the FDA panel 's decision. But the company is not conceding defeat yet. "We're still in discussions with the agency, and we believe there's still a strong case to be made. I can't handicap the prospects at this point.... I will also say that I think the FDA would like to find a way to approve the drug given the seriousness of the disease." Rubin added that the options are good for another five months and that, given that the FDA hasn't made a final decision and that the FDA is also still reviewing Cephalon's narcolepsy drug, "there is time. I think it's premature to reach the conclusion that this was not a successful offering."

He also noted that since the firm has about 25 million shares outstanding, the 490,000 shares used to pay for the options represents just 2% dilution. "For a company of our type and size, [that dilution] is not unreasonable, given the risky nature of this industry. I think we viewed it as a reasonable risk to take."

Cephalon shareholders are obviously disappointed with recent events, but Rubin said the initial reaction to the options deal was mixed. "Among institutional investors, I think it was seen as a pretty savvy opportunity. Among individual investors, particularly a lot of brokers who have clients in the stock, there was a lot of head scratching over this." He said there's mainly been confusion over precisely what the agreement amounts to. "Some people have thought that we were out $10 million in cash, and that's not the case."

But Sarah Gordon, a well-known biotech investor who manages money for Amerindo Investment Partners, a firm with a 10.3% stake in Cephalon, offered a more critical view of Cephalon's management. "I don't think I've ever described them as 'savvy,'" she said, laughing. "I'm always nervous because I think they're always going to zap me with some dilutive financing." She said that on many occasions, she's expressed to CEO Baldino her preference for "plain vanilla equity financing." But she said Cephalon has persistently showed a preference for the unusual. "They tend to do much more exotic financing, probably the most exotic financing in the industry, right now. Somebody's obviously sitting there at the company thinking these things up all the time."

Gordon admits that Baldino's initial explanation of the scheme left even institutional investors befuddled. "None of us really knew what the hell he was talking about." But once the details sunk in, she found it not to her liking. "If Frank Baldino wants to be an options trader," she said, "why doesn't he come to Wall Street and run a fund?"

Gordon said that the 490,000-share dilution makes her cranky, though it's "not going to kill the company." The real problem is that Cephalon needs money and the options deal has failed to deliver any. "You go and pay these bankers all this money and all the lawyers all this money, and you think you're being really savvy. But guess what? No money gets into the coffers of the company. You've got egg on your face and you haven't actually added any value to the company."

She said that after she learned of the call options, she contacted Baldino to say that as a means of expressing dissatisfaction with management, Amerindo was reversing its vote on an option package for employees. Still, in her view, there's little shareholders can or should do to head off such deals. "Even if you're a large shareholder, which we are, the actual control you have over a company is marginal at best." She said that Cephalon doesn't usually consult even institutional shareholders before implementing these financing arrangements, "though they make sure they do tell us" generally what's happening.

"As shareholders, you really have remarkably little impact on these things. You really have to trust the CEO and the board of directors to make those hopefully rational business decisions. You can't have your senior shareholders making those decisions because then they become insiders."

What investors should do, Gordon said, is "bitch and moan afterwards. If there's enough discussion about, 'hey, this half a million shares are basically being given away,' then I think CEOs will be a little more circumspect next time around when they think of doing these things."

Indeed, Gordon wonders why Cephalon didn't simply wait to see if the panel review went well and then make a secondary offering. "You know, you show tangible progress, and you go out and do a secondary offering. And shareholders buy stock because they want to invest in the company."

The reaction from Cephalon investors in Fooldom has been surprisingly muted. Perhaps owing to the already speculative nature of biotech investing, Foolish posters to the Cephalon folder have been less dismayed by the options play than by the fact it didn't succeed. In one exchange, a poster named "Braio" suggested that Cephalon should have used a straddle, an options strategy involving taking offsetting positions to hedge against an unexpected market move against a single position. But a poster using the screen name "WeirdPro" responded that "a pure call option will beat the tar out a straddle any day of the week if the stock goes up." Based on the circumstances at the time, WeirdPro said, "I think CEPH made a smart and knowledgeable move."

Given the fact that share purchases by a company's insiders are often interpreted as a buy signal for investors, since these are the folks who presumably best understand the company's prospects, it's somewhat surprising that a Wall Street firm would be willing to accept a wager like the one SBC Warburg struck with Cephalon's management. Gordon pointed out, though, that most CEOs tend to think their stocks are undervalued. Management's opinion of its own progress, she said, is sometimes out of step with reality. And she said the key to whether investors see more deals like Cephalon's call option agreement is the willingness of banks to take the other side of the bet.

Still, in this case, Gordon suspects the option play was doubly dangerous for Cephalon stockholders because in addition to the risk, it may have "pissed off" the FDA. The doctors on the panel well could have been annoyed by management's assumption that it knew what the panel was going to decide. Other knowledgeable observers believe there may be something to that assessement, raising questions of just how detrimental the company's gamble really was.

Dr. Harry M. Tracy, of the well-regarded NeuroInvestment newsletter, has followed the Cephalon story for quite some time, frequently posting to the Fool folder. He said he didn't like the call options from the beginning, calling them "provocative." While not a critical factor in the panel's vote, he said he does think the options deal showed the company was not willing to compromise, a strategy that may have led the FDA panel to treat the company more roughly than expected. Cephalon's actions were "sort of like running with the bulls in Pamplona while wearing red."

On the other hand, Tracy is one of those who remains optimistic that the FDA will approve Myotrophin rather than risk an embarrassing political fall-out from a parade of ALS patients charging the FDA with obstructionism. This would never do, he said, given that Congress is looking for the agency to process new drug applications more quickly and with a focus commensurate with its federal charter to concern itself with safety, not efficacy. And he pointed out that twice in the past six months alone, the FDA has ruled contrary to advice of its expert panels. When asked to handicap Myotrophin's chances, he put the odds at 2-to-1 for approval.

Cephalon's Rubin also highlighted the fact that the panel was never formally asked to vote on approval, only to vote on whether the current data was "substantial." He said that at least one of the panelists who voted against the company on this issue later said she would have voted for approval had she been asked. The fact the FDA did not ask this ultimate question suggests to Tracy and others that the agency was looking to preserve it options.

Though Gordon still likes the company, particularly at $12 a share, and with nearly $5 a share in cash on hand, she doesn't believe the FDA will greenlight Myotrophin. But she does have hopes for the company gaining European approval, and she said she's always liked the narcolepsy drug more than Myotrophin. As for the call options, she said that "unless manna falls from heaven, I suspect that they will expire worthless."

Though Gordon and other Cephalon investors may not be pleased by the company's venture into options trading, they seem ultimately resigned to the idea that, at least in the biotech arena, investing involves risks. And if shareholders themselves aren't annoyed enough to take meaningful action against such swashbuckling managers, it's likely more companies will commit to similar options deals in the future. No doubt short-sellers will be keeping a list of those that do.

--Louis Corrigan (RgeSeymour)

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