Description

Two economists are walking down the street, looking for anomolies they hope to write about so they can be as famous as that Freakanomics guy. They see a stock certificate laying on the sidewalk.

Economist One. "Hey free stock, grab it, it's got to be worth something!"

Economist Two. "Don't bother. If it really existed, EMT dictates someone would have already picked it up."

Economist One. "Dummy, no-one believes in strongly efficient markets any more, pick it up."

So the second economist does, and reads it closely. "It's preferred stock," he says, "no voting rights."

"Oh, "says the second, "never mind." And they toss the certificate in a garbage can and head back on down the street.

It's not free, just at a huge discount. And in this case, the economists may be right that there is no free lunch, but I'm still going to recommend nibbling on Xcyte Therapies preferred shares. At 3.83 they are trading at less than 40% of their liquidation preference, while the company could redeem it in full ($34M in cash, $20.7M in liquidatin preference). And while you wait the company continues to pay quarterly dividends, yielding over 15% at todays prices. The no free lunch part is that depending upon what the board decides to do, the preferred could be worth either much more, or much less than current prices.

Xcyte Therapies was developing products based on "T cell activation" to treat certain infectious diseases. They canceled a clinical trial test in May after not being able to reach agreement with the FDA. In July they announced they were stopping all research and cutting operating expenses while they pursue strategic options. They have gone from 100 employees in March, to 21 employees in August. As I see it, they've got three potential options.

1) Liquidate.
2) Sell the company.
3) Buy another company using the remaining cash.

Scenario 1) requires redemption of the preferred. Here's my math on a liquidation scenario. Note the "derivitive" line from the balance sheet, this is just a liability for features of the preferred (dividend make whole feature). Since it's not a cash expense I added it back.

Best Worse
Equity $31,299 $31,299

Burn () $(4,500) $(7,500) // rough guess for three quarters
Severence $(796) $(796)
Leases $(1,899) $(3,797) // $7.5M to 2010, assumes
Contracts $(1,743) // Off balance sheet equip.leases
Derivative $2,483 $2,483
Prepaids $(1,399) $(1,399)
Prop/Equip $(3,210) $(6,420)

Net $21,979 $12,127
Preferred Shares 2,046 2,046
Preference $20,673 $20,673
Per Share $10.74 $5.93

So my worst case liquidation scenario is 50% above current prices, and the best case scenario is full redemption (+250%). The question is, how likely is a liquidation? The company's position is they are not contemplating liquidation. I've spoken to the CEO, Robert Kirkland, and he's said same. My belief is this means is they are going to explore all options before liquidation. I also belief their other options are slim, so that liquidation is still a likely outcome.

So what happens in scenario 2), sell the company? Well reading the offering for the preferred, it appears that in a sale the preferred is protected. I.e. a sale of common shares at $1, provides for a conversion price slightly less than that, ensuring preferred gets full redemption plus dividends. The language in the prospectus is, however, torturous at best, so don't rely entirely on my somewhat shaky interpretation. But I think it's reasonable that a worst case scenario would ensure the preferred gets paid out somewhere between todays prices and full redemption price.

Scenario 3), purchase of another company is the real risky scenario. As it stands now, common shares are really "options" on a huge turnaround in value, in a liquidation it's unlikely common would recieve anything. So from the common's perspective, a "reverse merger" into a viable company that needs a cash injection would be the best of all possible worlds to turn an underwater "option" into real value. But this kind of transaction could be highly destructive to the value of the preferred.

But I believe there is some downside protection in scenario 3. Currently the preferred is convertible into 4.22 shares of common at anytime. With the common at 50 cents that "right" is only worth a little over $2. But in the announcement of a deal favoring common over preferred should cause the common to trade up. So even if the preferred gets crushed you could have the chance to convert out, if common is at 90 cents you'll break even. Even if the common doesn't respond, my interpretation of the prospectus is that the conversion ratio in a low priced deal will be ratched down, so that preferred will convert into more common shares.

So what gives me confidence that the board of directors will do anything to protect the preferred? Two words, self interest. Three of the eight board members are VC's who invested early in the company, and also invested in the preferred offering. I believe (but haven't been able to confirm) that they still hold their preferred shares. Here is a table of what I believe their current holdings to be.

Common Preferred
Jean Deleage (Alta Partners) 1.142M 100k
Robert Nelson (Arch Venture Ptnrs) 2M 200k
Stephen Wertheimer (W Capital) 576k 103k

They control preferred with a liquidation preference of $4M, and common with a current market value of $1.75M. In any transaction, they will recieve just over 20% of the preferred's payout, and 18% of the common. Thin, but just enough I think for them to be incented to ensure preferred gets treated as fairly as possible. As evidence of this is the fact the dividend has not (yet) been discontinued.

So to summarize, there are three possible outcomes. One (liquidation) should show an outstanding profit. The second (sale) should show a profit, in fact it might be as good as liquidation. The third (purchase of another business) would probably show a loss, but conversion rights appear to be able to prevent a total loss and might actually salvage a small loss. The catalyst awaits the announcement of their strategic direction.

Disclaimer: This is the first preferred stock I've invested in, so I've learned quite a bit, and wouldn't be surprised if I'm missing something important. In fact, smarter people here may point out that I'm entirely wrong (which is why I posted this). I have a medium position in it right now, roughly 10% of my portfolio.

Risks
- Company can suspend dividend at any time.
- Conversion rights under water.
- If XCyte decides to re-invest it's cash into another venture, preferred can rapidly become worthless.
- Authoer might have misinterpreted conversion rights.

Catalyst

Resolution of strategic options, and board announcement of direction.