Buy or Hold Mannkind

Mannkind (NASDAQ: MNKD) is an inhalable drug company developing a fast acting, inhalable insulin (branded Afrezza) that is superior to any other insulin in the market today and a likely blockbuster drug.  They have completed phase III clinical trials and received no drug efficacy related pushback from the FDA, but have received two CRLs recently.  They are currently conducting two clinical trials to prove that the inhaler they intend to go to market with is equivalent to the inhaler with which they used for most of their clinical trials.

Afrezza is inhalable (through a whistle like inhaler) as compared to Eli Lilly’s (NYSE: LLY) and Novo Nordisk’s (NYSE: NVO) injectible insulins.  Inhaling is simply easier to take than sticking yourself with a needle, no matter how advanced today’s insulin pens have become.  Inhaling is also likely to improve patient compliance (ie. people will be more likely to take their insulin on time).  Further, it is much more forgiving (take it at the beginning of your meal, no calorie counting, etc) compared to the injectibles. Afrezza is also likely to be the only inhalable option for Type I & II diabetics if approved.  The only other one that has been approved is Exubera by Pfizer (NYSE: PFE) and Nektar Therapeutics(NASDAQ: NKTR) which was a mega-flop in 2006 and subsequently withdrawn from the market.  Afrezza and Exubera couldn’t be more different.  Exubera’s inhaler was the size of a bong and quite complicated to use and Exubera didn’t provide any incremental benefits as compared to injectibles unlike Afrezza which could actually help prevent weight gain.

Mannkind’s founder is a multi-billionaire who has invested about $1 billion of his own money into the company and maintains approximately a 31.3% stake (no other Insulin company has a funder with such a large equity stake).

The current trials are delayed and still enrolling patients.  Mannkind expects to submit the results to the FDA in Q3, 2013 and thus will not get an approval before Q2-2014!  They currently only have approximately $59 million in funding ($32 million in cash and $27 in available debt financing) which will fund them through most of Q4 (they used $57 million of cash in the first half of 2012 but expect increased expenses related to the clinical trials in the remaining part of the year). Taking a very pessimistic view, they would require at least an infusion of $171 million ($57 / 6 months for 1.5 years) to get through approval.

While Mannkind has been in very long-running negotiations with partners, no agreement seems to be close to final (despite management’s statements to the contrary on several occasions).  They have not been successful in their raising additional debt financing and are hoping to raise non-dilutive financing as promised by the management team for the last two quarters.  While delivering on this promise will be a positive surprise (given their history of making optimistic statements which they have yet to deliver on), it is more likely that shareholders are going to get diluted once again and soon.

While I believe that there is a likelihood of further dilution, we also know that Al Mann is trying very hard to not get diluted himself—at the last offering, he converted some of Mannkind’s debt to him into equity simply so that he could maintain his ownership position in Mannkind.  In the off-chance that management is able to deliver on their promise (either through partnership or raising funding through a non-dilutive means), the stock price could easily go above $10 per share.

Thus, I recommend that current share holders grit their teeth and sit on their shares.  For those looking to build a position, I would recommend taking small bite-sized positions and growing them over time.

Bull Case for MNKD

Jockey CEO

Al Mann is a billionaire with a series of startups that he has successfully exited from including Minimed which made insulin pumps. He also owns something akin to 40% of the company and has a line of debt open to the company as well.

FDA 

• Clinical Trials: They have completed Phase III clinical trials and have not had any CRLs where the FDA pushed back on Afrezza (the actual drug). 2 more Phase III clinical trials under way (catalyst 3)
• CRLS: this is where the company has fallen short to date. The last CRL was a result of MNKD management making a decision to switch inhalers from Gen 1 to Gen 2 (a big mistake in my mind). The Gen 2 inhaler is much superior (less drug required, better design) but got roadblocked due to an inter-departmental issue at the FDA...and hence, the current Phase III trails are aimed at proving that the amount of Afrezza delivered between the two inhalers are equivalent (and this essentially has nothing to do with the efficacy of the drug)! Interesting note on this...as a side note: an FDA insider  got caught on insider trading had traded with the expectation that MNKD to be approved at the last submission...

Partnership

Al has a reputation of being an extremely hard-nosed at negotiations...so where others would have partnered earlier, I expect the partnership for Afrezza to come closer to FDA approval. (catalyst 2a)

Pipeline

They have a few cancer drugs in the pipeline. No one (including me) give this any value because if Affrezza doesn't come to market, the company will go under.

Funding

A huge question mark as to how this will happen. They currently have funding through the end of 2012 (combination of cash on hand and the $38M remaining on Al Mann's line of credit). The next round of funding, if equity or debt will likely see Al Mann also adding more money as he has in each past round of equity based funding. (This catalyst can go either way depending on whether the additional funds are equity or debt or partnership).

Product

• AFREZZA - is an inhalable insulin. The FDA has had no issues with this drug at all through clinical trials and has recommended a study on kids as young as 4 years old. This addresses the Type 1 & 2 diabetes market and has shown amazing results..ie blood glucose response similar to normal insulin produced in non-diabetic people and fast acting response (approx 15 minutes or less). It also has shown an ability to blunt weight gain ( a common problem with diabetics). The inhaler is the size of a whistle (unlike Pfizer's which was the size of a tennis ball can).
• Technosphere - this is the wildcard. It is the excipient used to deliver AFREZZA but could be used with a large number of other drugs. No one gives this any value (just like the cancer drugs in the pipeline). However, this technology provides MNKD interesting non-Afrezza related partnership opportunities. (Catalyst 2b)

Competition

All competitors for inhalable insulin have essentially dropped out of the race. Competition is now only with pills, below-tongue dissolving tablets, skin patches and needles. The under-tongue tablets and skin patches are still early in their developmental cycle.

Thoughts on Leverage in Personal Investing

With the financial meltdown; personal leverage in investing has gotten a bad wrap.  Lets examine the types of leverage and than discuss the types of behaviors that led many to get burned.

There are several types of leverage:
1. Overspending on your credit cards---ie financial leverage to drive personal consumption
2. Maxing the amount of your mortgage to get the biggest house for your current salary
3. Borrowing money to invest in real-estate
4. Borrowing money to invest in a business
5. Borrowing money to invest in liquid investments (ie. stock markets)
6. Using your "buying power" to invest in equities
7. Lending your shares out for a fee to others who would like to short them.

There are probably others, but these types of leverage cover ones that most people will encounter.

#1 & #2 are about personal consumption.  The first is just a bad idea.  Buying an item that starts losing money the moment you buy it and paying 18+% per annum for the privilege is just plain bad.  If you need to do this to put food on the table than that is another story.  Unfortunately, for most people in the US, this is about consumption of non-necessity type of goods (ie. non-food items).  There are plenty of articles on why this is bad, do a google search for "credit card debt stories". 

#2 -- is a common misnomer.  Buying a house is also personal consumption although it is commonly thought of as buying an "asset".  If you look at financial accounting rules, the house is an asset -- for your bank (the one that provides your mortgage).  A house is not an asset!  It is a "home".  The building depreciates and looses value.  The land may gain value.  But, does it gain sufficient value to not only cover the building depreciation but also any improvements you may make as well as the interest you pay on it?  In today's environment, this is not an easy answer.  We can look at financial calculators or build fancy excel sheets to prove this--but at the end of the day, don't think of your house as an "asset" unless you are willing to sell it at a moment's notice and move if the market makes your asset profitable or if your asset looses value just like you would for any equity investments you may have.

#3-#6 are truely about investing.  #3-#5 involve borrowing money at a (typically) variable interest rate and investing it in something that will hopefully provide a return above that interest rate.  The pros and cons on these will be discussed later.

#6 is a very different type of leverage--and something that you will find in your brokerage accounts if you try to buy/sell options.  Brokerage companies will compute the "risk" of your cash & equity holdings in terms of the loss of value based on volatility and call it "Initial Maintenance Margin" or something of this type.  They will also calculate an "Available Margin" which is the additional value that your positions have today beyond the "Initial Maintenance Margin".  What these mean is that basically, if you have $X of equity, they will allow you to borrow $Y against $X as long as you maintain a minimum of $Z of value in your account where $Z is often less than $X. 

But, what makes this different from #6 is that you can use this value to sell options which impact "borrowing power" but do not require you to actually borrow any money.  When you sell an option, depending on the type of option, you are telling the person you sold the option to that you will be the other end of the trade if/when they wish to exercise their option.  For this privilege, they will pay you a fee upfront and your brokerage company will calculate the risk on the option being exercised and add that to your "Initial Maintenance Margin" and reduce that amount from your "Available Margin". 

#7 is another very different type of leverage...one that the average investor rarely sees and one that institutional investors take advantage of all the time to either juice their returns or increase their own profits.  It involves lending shares (that are owned by the lender) to others.  The buyers will typically use these shares to create short positions and in return will pay a fee to the lender and also give the lender cash collateral equivalent to the value of shares lent.  Only in very rare cases does the lender not get back their stock (ie. their brokerage company goes out of business)--as the brokerage company acts as an intermediary and is the counter-party (not the actual borrower).  If you have a brokerage company (like Interactive Brokers) that is transparent about this--they will give you a percent of the fee for borrowing.  If you don't (most brokerage companies), than you will not ever be told about this--but they will lend your stock and keep 100% of the fees.  If you have an equity account and positions that have any sort of short interest, this is the most risk-free way of leveraging your returns.

Mannkind Financing Summary (February 6, 2012)

Al Mann's Investment
Summary: Al Mann gets 31,250,000 shares of Mnkd in exchange for $77.2m debt cancellation (and potentially reducing the revolving debt line by $77.2m). 

In short, he is protecting himself from some of the dilution but he remains a debt holder for Mannkind.  This debt-to-equity conversion was probably required by the investors as a way for Al Mann to show that he has skin in the game for this round of fund-raising but provides Mannkind with no incremental cash.

External Investment
Underwriters: Jefferies & Company, Inc., Piper Jaffray & Co. and Cowen and Company, LLC
Issuance: 31,250,000 units = 31,250,000 stock + 18,750,000 call options (strike = $2.40, expiry = ~2/2016)
Price: $2.4 / unit

Cash raised net of underwriting expenses: $70,500,000 (@$2.256 / unit that the underwriters are paying to Mannkind)

What is the valuation of stock & warrant in each unit?

1 unit (@$2.4) = 1 stock + .6 of a call option (strike price: $2.40, expiry ~2/2016)

There are no publicly trading options with 4 year expiry dates...without reverting to Black Scholes, the
$2.5 option expiring in 1/2014 is valued at $0.60 (2 years to expiry).  Same option expiring in 1/2013 is valued at $0.39.

Using a volatility calculator and daily closing prices for Feb 7, 2011 - Feb 7, 2012 we get a range of volatility values (16%-71%) using 4 different volatility calculations.  Than using a Black-Scholes calculator (Inputs: high & low end of volatility, 1004 trading days, stock & strike price of $2.4, risk free rate of 2%),  we get the price of the warrant to be in the range of $0.328 - $1.1029.

Value of 1 warrant: $0.328 - $1.1029 (ie. value of .6 warrants = $0.1968 - $0.66174)

Value of 1 stock: $2.20 - $1.73826 (8.2% - 27.6% discount to the $2.4 value of the stock)

Additional: 
Underwriters have an option, exercisable for 30 days, to purchase up to an additional 4,687,500 shares of common stock and warrants to purchase 2,812,500 shares of common stock to cover any over-allotments.

Dilution
Current Shares Outstanding: 122.34M
New shares added as a result of this deal: 81.25M (assuming the warrants are eventually exercised.  If they are never exercised, chances are that Mannkind is out of business and this discussion is moot).
Total Shares Outstanding after Offering: 203.59M
Dilution: 33.5%


Other Fund Raising
Separate private offering of convertible senior secured notes  not considered a part of this offering.  No details are provided on what these are or to whom.

Conclusion
This deal sounds like it was negotiated with Warren Buffet in terms of extracting an ounce of flesh for financing. While I have confidence in Al Mann it looks like the investors that the underwriters shopped this deal to do not--hence the failure of the original private debt placement and the current valuation for the equity placement.  On the other hand, they could just be negotiating from a position of power vis-a-vis Al Mann and thus able to extract these generous terms.   

References
http://biz.yahoo.com/e/120206/mnkd8-k.html
http://finance.yahoo.com/news/MannKind-Announces-Proposed-bw-1380749394.html?x=0
http://finance.yahoo.com/news/MannKind-Receives-Commitment-bw-2160821953.html?x=0

Note: I am long MNKD