In response to my November 12th article about why I thought Quest Diagnostics (DGX) might buy out Vermillion, Inc. (VRMLQ) and this much more comprehensive but wayyyy late to the game November 16th article on GenomeWeb, below is a letter emailed to me by a hedge fund manager as to why he is short 22,500 shares of VRMLQ and does NOT believe DGX will acquire VRMLQ.
Read it and see who you think is right..TIMalert subscribers and I already took profits of $20,000+ by buying the PREDICTABLE VRMLQ breakout so I really could care less now, it’s just interesting to see how these market guessing games play out (c’mon people, it’s fun entertainment, but those of us with accounts under $1 million SHOULD NEVER STICK AROUND TO SEE IF TAKEOVER TALK ACTUALLY PANS OUT):
Rebuttal to Quest Diagnostics buyout theory
Given currently available public information, we have substantial doubt that Quest Diagnostics
(DGX) will buy out Vermillion Inc. (VRMLQ) outside of the Chapter 11 process. Moreover, we
believe that DGX will take 100% control of VRMLQ’s post-reorganization equity as they are the
largest owner of VRMLQ debt as well as the provider of the debtor-in-possession (DIP)
financing. As lead creditors (via the notes position and DIP) and the lack of an existing
shareholder’s committee, it is highly doubtful they will make an offer to current VRMLQ equity
holders.
To provide a brief overview, under the typical Ch 11 reorganization process, a Plan of
Reorganization (POR) must be submitted by the creditor’s committee to establish a fair
enterprise value on the subject business. From that value, creditors are given the face amount of
the debt owing to them in the form of new debt or equity in the reorganized entity. If creditors
choose to accept equity in the reorganized entity, only when there is “excess” value remaining do
existing shareholders receive any of the new equity (after paying secured creditors, unsecured
creditors, and any preferred obligations outstanding).
Reverting to the rebuttal of a Quest buyout, our thesis comprises of three main points: the market
opportunity is limited; Quest controls the creditor’s committee through its holdings of VRMLQ
convertible notes; lastly, VRMLQ is not a “diagnostic testing company” as the opposing view
believes.
1. Market Opportunity
The US Food and Drug Administration (FDA) has only approved VRMLQ’s OVA1 test for a
limited application. Specifically, the test can only be used to guide as to what surgery should be
conducted on the patient’s ovaries.
“OVA1 (Vermillion Inc, Fremont, Calif), is not intended for ovarian cancer
screening or for establishing a definitive diagnosis of the disease, and should only
be considered an adjunctive test to complement, not replace, other diagnostic and
clinical procedures.”1
As such, the OVA1 test is not meant for general screening, which would necessitate an off-label
procedure that OVA1 is not approved for. There is at least one example of a competing product
being prohibited from off-label use. In October 2008, LabCorp was sanctioned by the FDA to
stop marketing their OvaSure test kit for off-label use without conducting clinical research and
receiving FDA approval.2 Therefore, VRMLQ will have to conduct a costly clinical trial in order
to market any potential off-label uses as a screening tool. To add to this obstacle, the National
Cancer Institute is already conducting a large clinical trial using an older test to address the need
for an ovarian cancer screening tool.3 The director of the reputable Memorial Sloan-Kettering
Cancer Center has stated this clinical trial is “incredibly important” as it has 200,000 women
enrolled versus only 500 that VRMLQ studied when applying for its limited-use FDA approval.4
2. Quest Diagnostics’ convertible bond holdings
There is no incentive for current bondholders (Quest being the largest) to convert their holdings
(convertible at $20.00/share) as they are in total control of the Ch 11 process, have liquidation
preference, and stand to gain control of 100% of the company post-Ch 11. Even if one assumes
they do convert to monetize their holdings, a total of 1.65 million shares will hit the market-
more than 18 times the average daily volume of 90,488 shares – and result in a significant price
correction.5 Furthermore, they are also within their rights as creditors to negotiate better
conversion terms to acquire more shares than the existing debentures allow and/or negotiate for
extended maturities.
In the event of any unlikely conversion of the notes, the company will still be in a cash bind as
they do not have much cash on hand (est. $3m after recent warrant exercises will only last till
approximately January 2010) to fund a clinical trial and general and administrative expenses
(they have fired all employees). No announcement has been made to-date regarding when
VRMLQ will start receiving royalties and how much those royalties would amount to. This is
rendered even more unlikely when one considers the time delay after approval that a newly
approved test could be produced and marketed in order to generate substantial revenues (and thus
royalties). Therefore, VRMLQ still needs an outside funding partner to finance its business plan
once it exits Ch 11. We do not see any candidates other than Quest that would play such a role.
Taking the above into account, we do not believe that Quest will relinquish its control over
Vermillion that it has gained through the Ch 11 process and convert its bond holdings resulting
in a much lesser control over the company. There is no incentive for anyone of power to protect
the existing common shareholders.
3. Vermillion is not a “diagnostic testing company”
A statement made in Quest’s recent bond registration filing (424B2 of November 16, 2009) is
being misinterpreted by proponents of the Quest-Vermillion “buyout” theory. In the filling,
Quest states: “…we are currently considering the potential cash acquisition of a diagnostics
testing business.”6 Proponents of this theory incorrectly assume that VRMLQ is a diagnostics
testing business. As a matter of fact, it is a biotechnology company in the business of developing
innovative products- not an actual testing (and the administering of such) company.
Moreover, it is Quest that is a diagnostic testing company. The correct interpretation of Quest’s
statement in the 424B2 filing would be that Quest is looking to acquire a larger or smaller
competitor in the same business line as itself (i.e., the administering of diagnostic tests and
provision of related services)- not a developer of testing kits! Buying VRMLQ would be a
dramatic change in Quest’s corporate strategy. In its latest 10Q, Quest says that “clinical testing
business accounted for greater than 90% of net revenues,” and a portion of the remaining 10%
was the business that “manufactures and markets diagnostic tests.” There is no mention of the
FDA in the entire 10Q and it does not break down R&D as a separate expense in its income
statement. Such statements would imply that it is involved in the biotechnology business,
specifically one that would require FDA oversight. Therefore, it is unlikely Quest would move
from its core testing and manufacturing business (with no FDA oversight) and get into the
biotechnology business that would necessitate managing scientists and research efforts.
Quest already possesses the rights to exclusively market VRMLQ’s tests in most major markets
of the world and a non-exclusive right on any new markets. In return for Quest’s marketing of
OVA1, VRMLQ will receive a 5% royalty. As such, Quest has already acquired what they
wanted from VRMLQ (the rights to OVA1) and have no further incentive in investing more
money into the company or buying out existing shareholders. The only reason one would
speculate that Quest is even remotely interested in acquire the existing shares of VRMLQ is that
the exclusive agreement is valid for only three years. However, given that they effectively
control VRMLQ at the moment, they are in a good position to renegotiate a longer term. Last but
not least, Quest has already entered into a partnership and licensing agreement with Correlogic
for a similar test that is currently being marketed.
Conclusion
Quest Diagnostics does not have the incentive to give up the control it exerts over Vermillion
and its Ch 11 reorganization process by buying out existing VRMLQ shareholders. Furthermore,
the OVA1 testing kit will very likely not be marketed in the near term for any uses other than to
guide doctors and patients as to what surgery is suitable to remove or treat the ovaries. Last, but
not least, it is incorrect to imply that Quest will be buying Vermillion as per its recent statement
in the November 16, 2009, bond registration filing.
Posted in Guessing Games