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Disclosure: Long 777 HK, long ISIG, long MOMENT 4.69% 2022, short MOMENT 11.5% 2016, short EXAS, no position in GCVRZ,
Happy new year! My apologies for the long hiatus from blogging. It’s been a busy couple months of holiday travel and a solid finish to 2014 thanks to the performance of several long positions in December. I’m looking forward to making a fuller report in a forthcoming quarterly letter. In the meantime, I felt some quick updates on ideas that have been discussed on the blog and elsewhere were overdue.
China trip and NetDragon (777 HK)
I will be visiting Hong Kong and parts of mainland China later this month. If I have any readers there and you would like to say hello, please drop me a line. If you are a fundamental investor with interest in joining any management meetings, I have a few opportunities for that as well.
The NetDragon thesis is largely unchanged following Q3 results, which were poorly received as expense growth for the education business ramps in advance of revenue generation. NetDragon now has more than half its R&D staff working on online education initiatives. Meanwhile, the core gaming franchise remains strong and has a potential new hit that has already recorded 240,000 PCU. The company repurchased 2.8% of shares outstanding in December.
Public commentary on Insignia Systems (ISIG)
ISIG remains a significant position for Cable Car despite an unusual activist situation in the marketplace. Given recent events, Cable Car has adopted a policy of not discussing the investment thesis publicly. However, I remain open to speaking one-on-one with other investors. If you are a shareholder and would like to discuss the company, please contact me directly.
Momentive Performance Materials reorganization
I was wrong about both the legal outcome and the potential downside for the 1.5 Lien notes, at least from a mark-to-market perspective. The plan of reorganization went effective in October and the former 1.5 Lien notes (now 4.69% second lien senior secured replacement notes) traded down to the low 80s context. At last trade, the replacement notes yielded 8.3% to maturity, much wider than other similarly capitalized industrial credits. I also failed to fully account for the impact of legal fees on the post-petition accrued interest, which remains in escrow pending a partial settlement (expected to be approximately 70% of billed fees, the same as the first lien notes). There is a further fee reserve against this amount to cover pending appeals. With the intercreditor action between the secured noteholders dismissed except for one narrow class of claims, cash recoveries under the plan as implemented are uncertain and appear limited.
That being said, I continue to find the risk/reward attractive, and arguably more so today. From a purely relative value standpoint, the replacement notes seem to be considerably cheaper than they should be. Interest rate risk and concern over high yield in general could negatively impact market values, but the notes are over-secured and the recapitalized Momentive is much more conservatively levered. Unfortunately, the ratings agencies are unlikely to rate the replacement notes unless someone pays them to do so, which may limit the number of natural buyers. The new notes should otherwise be investment grade. As mentioned before, comparable high yield issuers such as Berry Plastics have notes of similar coupon, duration and position in the capital structure that trade above par, despite what appears on the surface to be a worse financial position. I’m hard pressed to think of a good fundamental reason why second lien MOMENT notes should trade 300 bps wider than second lien BERRY notes, but perhaps there are technical reasons Berry is not comparable or greater concerns about Momentive’s underlying business than I have observed.
Furthermore, the terms of the replacement notes remain open to appellate review. At current levels, that certainly seems like a free call option. The Momentive bankruptcy raised some important questions regarding the proper determination of a market rate of interest for secured creditors. Both the coupon of the replacement notes and the original make-whole claims are the subject of an appeal currently before the district court. From a naïve, non-technical standpoint, the market outcome of the legal process to date—that senior secured creditors could recover anything less than par value while junior creditors received significant recoveries—is unusual enough to lead me to believe the appeals process has potential. From a legal standpoint, it is quite a bit more difficult to handicap the odds of success on appeal, but noteholders remain highly motivated to pursue the case. There remains an outside chance at a full recovery including the make-whole payment, which could result in nearly 50% returns from current trading levels. More likely in my view is an upward adjustment to the coupon on the replacement notes. Even if the court upholds Judge Drain’s reliance on Chapter 13 precedent for his basic methodology, in my opinion the small incremental increase to the interest rate already made at the end of the confirmation process belies the objectivity of the process. The chosen 4.69% coupon is essentially arbitrary and clearly did not reflect the full market value of the notes.
I expect the appeal to survive a motion to dismiss on equitable mootness grounds, since it would be relatively straightforward to adjust the coupon. I expect the senior unsecured notes, which I am still short, to fail to clear that hurdle.
Exact Sciences (EXAS) and Cologuard reimbursement
Despite my public comment, CMS retained its original crosswalk to codes 81275, 81315, and 82274 in its 2015 payment determination for code G0464. The ultimate payment rate was the subject of some drama over the past few weeks, as the rates document was initially published on December 19 with a lower reimbursement level before being retracted. The reimbursement rate in the document was approximately 74% of the crosswalked values, an adjustment that normally only applies to tests prior to 2001. This was corrected, but several localities in the revised document have significantly lower payment rates than the National Limitation Amount (NLA), which is itself slightly lower than the sum of the three crosswalked codes. For example, reimbursement in Jurisdiction K, which contains populous states such as New York, is 45% lower than the NLA. Medicare reimbursement is based on the lower of the amount billed, the NLA, or the local payment amount. Some market commentators and even Exact’s own press release seem to imply that the NLA is the only reimbursement amount for all Medicare patients, which is not the case. It is a maximum.
Expect a further post discussing this in more detail. I am still looking into the reasons for the lower local reimbursement amounts, and Cable Car has a pending FOIA request for the other public comments on the CLFS in order to respond to potential justifications for a higher reimbursement level. I still intend to submit a reconsideration request, which could potentially impact the 2016 reimbursement level.
As a reminder, Cable Car is short EXAS primarily on the basis of lower-than-expected uptake. I believe setting a lower reimbursement rate is a public health imperative that could actually encourage wider screening.
Lemtrada approval and GCVRZ
Sure enough, not long after discussing why I was unwilling to bet on Lemtrada approval, GCVRZ had one big day after the drug was approved. It didn’t quite triple, and it now trades about 50% above the price the day before approval. I stand by the reasoning in the post and increasingly suspect I may have dodged a bullet. The price reflects considerable uncertainty over the timing and success of the US launch. My post did not address in detail the risk that Lemtrada has a slow launch in the US. However, there is a distinct chance that Lemtrada fails to achieve the $400 million first-year sales milestone even with contribution from the US. Due to the number of alternative MS treatments on the market, Lemtrada’s status as a last-line therapy emphasized on the label, and the time required for physician acceptance, US sales might not be sufficient for the milestone in the first year even if the drug is ultimately a blockbuster. In the absence of US data so far, the picture of the pace of sales from Europe does not look encouraging.
Although bound by the terms of the CVR not to deliberately interfere with sales, Sanofi’s incentives are at odds with CVR holders as well. The company could conceivably justify a slower launch, focusing on building physician relationships over meeting near-term sales goals in order to maximize the long-term value of the product. That they might avoid a ten-figure payment to CVR holders would be a nice bonus. If the $2 milestone appears more likely once sales data begin to come in, I would expect Sanofi to buy back CVRs or conduct another tender offer. Unless and until they do so with the benefit of internal sales data, I view the likelihood of GCVRZ paying more than zero to be low.
Thank you for following along last year. I look forward to many interesting investment opportunities and conversations with you in 2015.