PDL Just Got Riskier

Because of setbacks in the company's pipeline, investors should exercise caution.
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PDL BioPharma's (PDLI) - Get Report investors were relieved that the company made its second-quarter profit numbers, but a surprising bit of bad news regarding its pipeline removed some of the glow.

As a result, despite possessing some nice qualities, PDL might not be worth the risk.

For the most recent quarter, royalties on drugs such as Avastin and Herceptin, which are sold by

Genentech

(DNA)

, were strong. Sales of its internal products edged down to $38.6 million from $39 million a year ago, but that figure included adjustments. The hypertension drug Cardene IV saw its sales rise 47%.

PDL earned 17 cents a share before certain items were factored in, handily beating the consensus estimate of 10 cents, but revenue of $104.3 million was below expectations of $107 million. Cash flow from operating activities was impressive at $43.6 million.

However, what has investors worried is the lack of execution in the company's pipeline. Along with reporting its financials, PDL disclosed that terlipressin, an experimental treatment for kidney disease, failed to meet its primary goals in phase III trials. PDL hasn't announced what further steps it will take regarding the drug.

Also, a phase II trial for Nuvion, an ulcerative colitis treatment, has been delayed due to slower enrollment, extending the time frame for when the company could market the drug, possibly to 2010. Additionally, phase II trials for the rheumatoid arthritis therapy HuZaf have been halted and the study of the compound has been discontinued.

Joel Emery, managing director of health care at TIAA-CREF, which owns PDL shares, said the numbers look fine, "but PDL continues to disappoint on its internal pipeline." Still, he says his fund will continue to hold PDL.

"The current valuation is appealing based on its royalty stream alone," he says. Emery adds that any positive developments in the company's pipeline would be a reason to lift the stock's valuation. Based strictly on PDL's royalty stream and internal products, he believes the shares should have a higher price.

PDL could get an added boost from royalties received from Tysabri, the multiple sclerosis drug developed by

Elan

(ELN)

and

Biogen Idec

(BIIB) - Get Report

. Tysabri was taken off the market in 2005 after it was linked to a potentially deadly infection of the brain called PML, but it was recently reapproved.

Most observers in the medical industry expect the reintroduction of Tysabri to progress slowly at first, but, considering the superior efficacy of the drug, if no more cases of PML are reported it could eventually become the blockbuster that was originally envisioned. PDL is certainly hoping for that scenario, considering it receives royalty payments on Tysabri.

PDL also could be poised for some upside owing to Genentech's Lucentis, a therapy for wet age-related macular degeneration, a disease that causes blindness. Currently, PDL hasn't been advised if it will indeed receive royalties on the drug, and Genentech has been known to play hardball when it comes to payments. Still, most industry watchers expect PDL to ultimately collect royalties on Lucentis, which isn't included in the company's guidance.

If you're looking for a pure royalty play, PDL isn't a bad one, considering its attachment to several blockbusters and the potential of Tysabri. However, the pipeline will likely be a drag on the stock's valuation for some time to come. Until Wall Street begins to see meaningful progress in bringing a robust drug to market, it's difficult to imagine PDL being rewarded with a higher valuation.

For investors who do want to take a chance, a more conservative strategy might be worth considering, says Elijah Cunningham of Valuepoint Partners. The Little Rock, Ark., asset manager owns the PDL convertible bonds that expire in 2023, in addition to the company's common stock.

The bonds convert to 49.66 common shares at the bondholder's request. The current price of the bond reflects a 22% premium to the stock price. In other words, investors would need PDL shares to trade at about $21.25 to break even. The stock closed at $17.44 Friday. What's attractive is that the bondholder receives a yield of 2.6% while waiting.

The convertible acts like a call option on the stock, but one that pays interest and doesn't expire for 17 years. The worst-case scenario -- assuming the company stays solvent -- is that the stock doesn't appreciate and the bond is repaid in 2023. At that point, you'd have earned a yield to maturity of 2.3%.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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