Case Study 41 - Mogen Inc

Mogen, Inc. Patrick Cunningham M03619570 Professor John Phelps, Ph.D. April 1, 2014

Executive Summary: This case study analyzed the challenge to structure a convertible debt offering to make it attractive to issuing company (MoGen, Inc.) in terms of its cost of capital, while at the same time selling it for full price in the market. By analyzing the capital market data, MoGen’s sto ck prices, conversion premiums, and coupon rates I was able to

determine the positives and negatives of each of these alternatives. The alternatives were a 15%, 20%, 25%, 30%, 35% conversion premium and a 1.17%, 1.56%, 1.95%, 2.34%, 2.73% coupon rate, respectively. The recommendation provided for MoGen, Inc. is to have a 30% conversion premium and a 2.34% coupon rate for their convertible debt offering. The main factors in deciding on this alternative were the higher conversion premium and the adequate coupon rate. The higher conversion premium showed investors that management were confident in the upside potential of this stock. In addition, the previous successful convertible bond offering had a high conversion premium. Also, the coupon rate is acceptable because it is still lower than the previous offering and the likelihood of reaching the conversion premium is low.

Table of Contents: Executive Summary – Page 1 Situational Analysis – Page 4 Alternatives – Page 6 Recommendation – Page 10 Appendices – Page 13

Situational Analysis: Founded in 1985, MoGen Inc. (Molecular Genetics) had rapidly become a leading biotech firm in the industry. This company was among the firsts to deliver products through emerging sciences focusing on advances in molecular biology and recombinant DNA. But, like any other biotech firm, the keys to success were finding new drugs through research and then having the drugs approved by the Food and Drug Administration (FDA). This approval process required extensive trials that would take a massive amount of time and can cost hundreds of millions of dollars to the firm. Therefore, MoGen needed to have a consistent supply of cash to fund R&D and to maintain financial flexibility for future challenges and opportunities. This is where the company turned to previous business partner, Merrill Lynch, to assist in raising the needed funds. MoGen had worked with Merrill Lynch in the past and had previously raised $10 billion for the company. MoGen estimated that they would need roughly $10 billion in capital for the fiscal year of 2006. Approximately $5 billion had been generated internally which they had on hand, while the other $5 billion would need to be raised externally. Dan Maanavi, the managing director of Merrill Lynch’s Equity -Linked Capital

Market Group, prepared a proposal for a convertible debt offering by MoGen, Inc. The proceeds from the convertible debt offering were to be allotted for the funding of research and development (R&D) expenses, working capital needs, capital expenditures, as well as a share repurchase program. With so much funding needs Merrill Lynch and MoGen had to decide on how to price such a significant and important financing. The $5 billion offering represented the largest such single offering in history, therefore, it is critical the pricing be set at a level that generates sufficient demand

without giving away too much. Thus, the problem was to find the right combination of coupon rate and conversion premium that would be acceptable to MoGen management as well as suitable to investors.

Alternatives: 1. 15% Conversion Premium; 1.17% Coupon Rate The first alternative for MoGen is to have a convertible debt offering with 15% conversion premium and a coupon rate of 1.17% (Appendix 2). This alternative has pros and cons for both the issuing company and the investors. The pro for MoGen would be the low coupon rate, which would mean a smaller coupon payment, and less money paid out. The con for MoGen would be the very low conversion premium. Management may think they are sending a bad signal to the market with such a low conversion premium because it could be interpreted as lack of confidence in upside potential of stock. Now, the pros for the investors in this alternative are that it is a very low conversion premium. Investors want the lowest conversion premium so they can have a better chance of reaching it. The con of this alternative is that it is a low coupon rate so the payment would be pretty low. 2. 20% Conversion Premium; 1.56% Coupon Rate The second alternative for MoGen is to have a convertible debt offering with 20% conversion premium and a coupon rate of 1.56% (Appendix 3). This alternative has pros and cons for both the issuing company and the investors. The pro for MoGen would be a still pretty low coupon rate. This coupon rate isn’t as low as the first alternative but this

option has a higher conversion premium, which would entice even more investors. The con for MoGen is not a very high conversion premium. Issuing companies want a high conversion premium and MoGen’s management believes their stock is already selling at

a depressed price, which represents an excellent buy for investors. Now, the pro for investors is once again the lower conversion premium. Most convertible debt offerings have a conversion premium between 10%-40%. This is still relatively low compared to that range. The con for investors is still a lower coupon rate. Investors want higher coupon rates to make more money. 3. 25% Conversion Premium; 1.95% Coupon Rate The third alternative for MoGen is to have a convertible debt offering with 25% conversion premium and a coupon rate of 1.95% (Appendix 4). This alternative has pros and cons for both the issuing company and the investors. The pro for Investors is a coupon rate much lower than the year-to-maturity (YTM) yield, which is at 5.75%. Maanavi, knows the convertible should carry a coupon rate much lower than the 5.75% and this alternative accomplishes. The con for MoGen is the conversion premium is not as high as it could be. The management will still believe they can have a higher conversion premium with how the stock is selling right now. Now, the pro for the investors is the conversion premium. It is still well below the 40% it could be which makes it a good investment. The con for investors is they will always want a higher coupon rate to make more money in their investment.

4. 30% Conversion Premium; 2.34% Coupon Rate The fourth alternative for MoGen is to have a convertible debt offering with 30% conversion premium and a coupon rate of 2.34% (Appendix 5). This alternative has pros

and cons for both the issuing company and the investors. The pro for MoGen is the fact that conversion premium is higher than the average of normal convertible debt offerings. They are usually between 10%-40%, which would make the average be 25%. This alternative is higher than that average making the management happy with this conversion premium. This can also be a con for MoGen though because the conversion premium is higher than the previous alternatives and that this may make the demand decline. With this offering being worth $5 billion, MoGen has to make sure the demand will be high enough to where investors will want to buy and they can make the full amount. Now, the pro for investors is the higher coupon rate compared to previous alternatives. This higher coupon rate will help increase their investment if it reaches the conversion premium. But, the con is that the conversion premium is higher than average convertibles and it will be harder to reach it. 5. 35% Conversion Premium 2.73% Coupon Rate The last alternative for MoGen is to have a convertible debt offering with 35% conversion premium and a coupon rate of 2.73% (Appendix 6). This alternative has pros and cons for both the issuing company and the investors. The pro for MoGen is the high conversion premium. With a conversion premium this high it will be much less likely for the stock to reach it making it a better offering for MoGen. The con is that with a conversion premium closer to the ceiling of most offerings it makes the demand shrink and will make it more difficult to reach the $5 billion needed. The pro for the investors is the higher coupon rate. Having the largest coupon rate of all the alternatives makes it for a better investment if the conversion premium is reached. Investors may believe the

higher conversion premium is worth the risk and make more money. The con for investors is the highest conversion premium of all alternatives. The chances of reaching this conversion premium is much lower than any other alternative, which could scare away many of the investors, they want. Fundamental investors don’t like to invest in

anything 40% or higher and at 35% this alternative may be to close for comfort for many of these investors.

Recommendation: Based on the alternatives analyzed I believe the best alternative is the 30% conversion premium with a 2.34% coupon rate. The previous convertible offering MoGen had was in 2003 when the stock price was $61 and the conversion price was $90. By looking at appendix 1, I calculated the conversion premium for this offering was 47.5% and the coupon rate was 2.9%. This gave me a good basis on what would work for MoGen in this convertible debt offering. I knew that convertible debt offerings carried conversion premiums in the range of 10%-40%. In 2003, they had an offering of 47.5%, which made me realize they could have a higher conversion premium and still get the demanded needed. Now, this was a much larger offering at $5 billion and I knew it should be lower if they were going to make sure that demand was met. But, I knew it could be higher than the average based on how well the stock was doing and management’s feelings based on the stock price. Therefore, I believe 30% conversion

premium would still generate demand and be able to show investors management has confidence in the upside potential of the stock. Next, the decision to have the coupon rate at 2.34% was based on equaling the face value of $1,000 per bond. With a 30% conversion premium, to equal the face value the coupon rate would have to be 2.34%. This coupon rate would work well because for the previous convertible debt offering in 2003 the coupon rate was higher and it still never reached the conversion premium. In addition, MoGen stock price had a five-year appreciation from 2001 to 2005 of 12.2%. If this trend continued for the next 5 years of this bond then the conversion price would have to be $87.49, which is much less than the conversion price for this offering. The conversion price for this alternative is $101.37, which is much less than $87.49.

Therefore, the chances of reaching the conversion premium are very small. In conclusion, those are the reasons why I believe alternative 5 would be the best choice for MoGen Inc.

Appendices

Appendices Appendix 1: 2003 Seven-Year Convertible Notes Current Stock Price Conversion Premium Face Value of Bonds Conversion Ratio Conversion Price Straight Bond Value Coupon Payment (Annually) Coupon Payment (Semi-Annually) Coupon Rate (%)

$61 0.475 $1,000 11.11 $90 $677.71 $29 $14.50 2.90%

Appendix 2: 15% Conversion Premium Current Stock Price Conversion Premium Face Value of Bonds Conversion Ratio Conversion Price Straight Bond Value YTM Number of Years Coupon Payment (Annually) Coupon Payment (Semi-Annually) Coupon Rate (%)

$77.98 0.15 $1,000 11.15 $89.68 $869.48 5.75% 5 $11.70 $5.85 1.17%


$77.98 0.2 $1,000 10.69 $93.58 $834 5.75% 5 $15.60 $7.80 1.56%


$77.98 0.25 $1,000 10.26 $97.48 $800 5.75% $5.00 $19.50 $9.75 1.95%


$77.98 0.3 $1,000 9.86 $101.37 $769 5.75% 5 $23.39 $11.70 2.34%


$77.98 0.35 $1,000 9.5 $105.27 $741 5.75% 5 $27.29 $13.65 2.73%

Case Study 41 - Mogen Inc

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