FACT: Facet Biotech - A Rewarding Spinoff

Analyst name: William DiJohnson Date: 2/6/09 PDL BioPharm, Inc.'s Facet Biotech Corporation Spin-off Company Name: Facet Biotech Corporation Ticker Symbol: FACT Market: NASDAQ Price: $6.42 Shares Outstanding: 23,901,368 Est. Market Cap: $193,362,067 Insider Ownership: 8% Institutional Ownership: 37% 52 Week Range: $5.86 - $18 First day of Trading: December 10th, 2008 Situation and Company Overview Spin-off Rationale: According to SEC filings, PDL BioPharm's management decided to spin-off Facet Biotech to: enhancing the market's recognition of the independent companies, enabling each company to focus efforts on their own respective goals, and increasing attractiveness to prospective employees and current employees with equity compensation more tied to the performance of the respective company. According to news reports, shareholders have grown increasingly agitated with lack of results so they launched a revolt, of sorts, putting pressure on management to better serve the company's shareholder base. As a response, the company (PDL BioPharm, Inc.) fired their CEO, sold off some compounds and arranged the spin-off of their drug-development operations into Facet Biotech Corporation. Spin-off Terms: December 5th, 2008, a 5 for 1 trade will occur: for every 5 PDL shares a shareholder owns, they will receive 1 share of Facet. The first day of trading on the NASDAQ stock exchange would be December 10th, 2008. Facet will get a new CEO, the CFO from PDL, employees from PDL, and the old headquarters (PDL will move its headquarters). PDL will give Facet $405 million for working capital and expenses, as well as, any and all of the company's clinical drugs, including Phase I multiple myeloma drug, a deal with Bristol-Myers Squibb. Also, PDL will pay for all operating expenses and related liabilities prior to the spin-off of Facet, with Facet assuming the current liabilities after the spin-off date, but PDL will send funds to cover those liabilities within 25 days of the spin-off date, estimating about a $7.5 million contribution. PDL will hold royalty rights for all current and future licensed products from Facet. Facet Biotech's Business: Facet Biotech Corporation is comprised of PDL's drug-development operations. Facet is paid by pharmaceutical companies to develop drugs usually after preset "milestones" are reached. Pharmaceutical companies can also elect to collaborate with Facet, in which case expenses are shared and profits divided (royalties are paid to Facet), where the pharmaceutical company does the selling (Facet has no sales force). Totaling seven drugs, with six in various clinical phases and one of those passing the second phase, Facet is a research-and-development based company focused on immunology and oncology but with greater emphasis on the latter. Five of the drugs in various clinical phases are in collaboration with either Biogen Idec, or Bristol-Myers Squibb (BMS), with a sixth drug in a preclinical phase that BMS has the option to collaborate on. In various forms, these collaborations make for the sharing of development costs, commercialization costs, and final profits. PDL BioPharma's (New) Business: PDL's "new" business focus will be on licensing and royalty fee revenues. Prior to the spin-off, substantial amounts of revenue were generated from this line of business (in excess of 50% annually). The company's patents expire in December 2014. Their three biggest revenue generators are Avastin, Herceptin and Synagis, but they have five other products in their portfolio for licensing as well. As part of the spin-off, PDL holds royalty rights for current and future products developed at Facet. Investment Rationale - Evaluating Spin-off Opportunities Why the Opportunity Exists - The Problem with Spin-offs: A spin-off is a notoriously inefficient method of unloading a division of a company. Rather than selling the division, which would prompt the seller to try to get the best price, a spin-off is essentially the formation and forced distribution of shares of a side company (which, in many cases, could not be sold) onto uninterested, indifferent shareholders of the parent company. Most of these shareholders are institutions who, for various reasons, cannot hold the spin-off's shares even if they wanted to. This results in mass selling pressure due to a supply-side imbalance; and whenever indiscriminate (regardless of price or investment merit) selling takes place opportunities for value investors may materialize. Evaluating Facet as an Investment Opportunity: Spin-offs, in many cases, require different tools to value than "textbook" companies, and the biotechnology/pharmaceutical fields need their own considerations as well. This is generally because of limited historical data for the business and unproven management. To compensate for this lack of information investors need to understand three main things surrounding the spin-off's situation: 1) Mass selling, regardless of fundamentals, took place; 2) insiders have a vested interest in the company's success; 3) a hidden investment opportunity has been revealed. 1.) The presence of a supply-side imbalance is probable due to several factors surrounding institutional holders. When PDL decided to spin-off Facet, it had roughly 94% of its shares held by institutions and mutual funds, had a total of over 119,000,000 shares outstanding, was a member of the S&P MidCap 400 Index, and had a market cap of about $1.5 billion. Institutional holders and mutual fund managers ("Institutions") are restricted in many ways when investing, due to both regulation and size of their portfolios. Of the many legal restrictions imposed on these institutions, ones that are likely to have affected Facet's case are: liquidity considerations - Facet had less than 24,000,000 shares outstanding; market cap size - Facet had a market cap of under $450 million and immediately fell lower to where it is now, about $200,000,000; Facet is not a member of an index - many of the institutions holding PDL's shares either were meant to mirror the S&P MidCap 400 index or could only pick companies that are in that index or could only hold shares of companies in a(n) (certain) index; size of portfolio - the terms of the spin-off gave one Facet to share for every five PDL shares an investor held, for a multibillion dollar portfolio with a 4% stake in PDL, a 4% stake in a company less than 1/3 the size will have little effect on the overall performance of the portfolio and therefore isn't worth analyzing. All these reasons may have contributed, in varying amounts, to the large sell-off of Facet's newly printed shares. 2.) Evidence that insiders have a vested interest in the success of the new company can be found in the circumstances of the spin-off, terms of the spin-off, and compensation arrangement of the new management. In this case, it is especially important to look at the circumstances surrounding the spin-off: an angry shareholder revolt forced PDL to take steps to appease them, to which, among other things, they decided to spin-off a less profitable, but very important division of their company. When PDL was whole, it was Facet's responsibility to make sellable drugs which PDL then licensed out and received royalties for, that was and is PDL's main source of revenue and without that division they are in trouble come 2014 when their patents expire. This brings us to the next point, the terms of the spin-off. The terms explicitly state that PDL will have the rights to royalties from current and future products that Facet makes, so essentially, this is still their source of future revenue producing royalties. That is the most compelling reason to believe the insiders have a very great incentive to make sure the company does well. However, there are also several other instances that support this, too: giving Facet PDL's headquarters buildings, the $405 million in cash and cash equivalents given to the new company for working capital needs and expenses (estimated to last the company for 3 years), and the lack of debt on the new company's balance sheet (usually in a spin-off, even with the best intentions of the parent company, the spin-off is loaded up with all or a lot of the debt of the parent, but in this case, the spin-off's long-term liabilities equal a tenth of just the parent company's long-term debt. This is probably because, as mentioned in the SEC filings, Facet will not have as high a credit rating as PDL, so they would have to pay more on the debt. And since PDL wants Facet to succeed (as the thesis goes), they have elected not to burden it with debt. The fact that PDL gave Facet such little debt is strong evidence of the importance of Facet to them - PDL's debt decision is very uncommon in the spin-off world.) Finally, it is always important to make note of the new management's compensation structure, and also where their employees and management are coming from. Options, restricted stock, etc. all lend to the alignment of management and shareholders' interests. Facet's new CEO, as well as other employees, are being heavily incentivized with equity. Their new CEO was hired from Biogen Idec, one of their collaborative partners, their CFO is PDL's old CFO, and their employees are substantially all from PDL. 3.) Facet's stock price's descent from $18 to now $6.42 has revealed an obvious investment opportunity as the company now trades significantly below the cash on their balance sheet and hence below liquidation value. Valuation: The biotech industry is known for its massive research and development costs, its companies' heavy dependence on their drug test's results, government approvals, and financing needs. In fact many (or even most) biotech companies of Facet's size, but other sizes, too, are either heavily in debt or suffer long periods of being unprofitable, or both. Yet because the success of one or two drugs is so fiscally rewarding, pharmaceutical companies, and other financiers, etc. are willing to partner up or help bankroll these companies' expensive endeavors. This is the environment Facet works in, and under most cases I try to stay far away from it. The dynamic nature of this industry makes it incredibly difficult to follow and value, as a company's cash flow one day can disappear the next with the introduction of a superior version, or any number of fast past changes. And, as so, does not lend itself well to traditional techniques of valuing a company. Fortunately, this industry stuff only plays a minor role in Facet's investment case. According to Facet's pro-forma balance sheet, an estimated balance sheet of what the company looks like if it were separate from PDL as of September 30th, 2008 including the terms of the spin-off like the $405 million cash infusion and assumption of current liabilities, the company is currently valued at less than its liquidation value. I calculate liquidation value the same way as Benjamin Graham did, with his Net Working Capital formula: Current Assets - Total liabilities. If this calculation, divided by the shares outstanding, is greater than the market price of a share of the company, then it is believed to be trading below liquidation value. The potential snag in this calculation is that Accounts Receivable and Inventory will most likely not get full market price if sold under a bankruptcy filing, but, fortunately, but over 95% of Facet's current assets is cash. Here's the calculation using Facet's Sept 30th, 2008 pro-forma balance sheet: (Current Assets = $420,000,000) - (Total Liabilities = $102,218,000) = $317,782,000/(Shares Outstanding = 24,000,000) = $13.24. $13.24 represents the approximate per share liquidation value of Facet, this does not include the $124,500,000 in plant, property and equipment, net, or other long-term assets, and $405 of that $420 million is cash. The approximate margin of safety of an investment in Facet Biotech at $8.09 is $13.24/$6.42 = 51.5%. Even after the company's estimated $110 million is used over the course of 2009, assuming that A) the company incurs no more liabilities, and B) the company's stock does not budge more than a couple pennies, an investor who bought in at $6.42 would still hold shares priced approximately 25% above the company's liquidation value. However, this calculation does not take into account the qualitative side of the investment. As explained earlier, the insiders have set up this spin-off company to succeed. As Facet has several drugs in the pipeline, are collaborating with some big name pharmaceutical companies, now have compensation for their employees better aligned with the success of their research and development company, and have a pristine balance sheet with enough funding to survive an estimated three years before needing to find other financing (hopefully the credit markets will be up and running fully by then), it would seem that their intrinsic value is at least somewhat higher than their liquidation value. The bottom line is that there is reason to believe that there is at least some upside and a limited downside.