Last year PDL BioPharma (Née Protein Design Labs back in the 90s) spun-out its drug development operations from its royalty-bearing patent estate. The drug development operations became Facet Biotech (Nasdaq: FACT) while the royalty-bearing patent estate (the Queen patents) covering all humanized biologics in development remained with PDL BioPharma (Nasdaq: PDLI).

PDL BioPharma has thus become a pure play on the Carey Queen patent estate and the humanized biologics on the market and in development. These humanized biologics are the drugs with generic names ending in “zumab” such as Roche’s bevacizumab (trade name: Avastin) and Biogen Idec’s natalizumab (trade name: Tysabri)

THE INVESTMENT THESIS

PDL’s stock is currently trading at a $6.96 per share. PDL May 2010 $7.50 call options* (symbol: PDIEUX) currently have a bid/ask of $1.15/$1.35 and if the options expire in the money they also require the option seller to come up with $1.67 per share ($167 per option contract) in addition to the standard option terms. (click on the underlined to see the terms of the existing PDL options contracts)

If you buy PDL shares, sell a May 2010 call, and wait for the option to expire here are the possible gain/loss scenarios from this covered call selling scenario:

IF PDL SHARES ARE AT OR ABOVE $7.50 AT THE END OF MAY 21, 2010

Your returns would be:

$7.49-6.96= $0.53 in share price appreciation that accrues to you (the call strike price is $7.50)

plus

$1.15 per share in premium for the calls you sold

plus

one of two regular dividends unannounced at this date but likely at least $0.20 total (was $0.50 in 2009 but monetization of assets will highly likely reduce this amount in 2010)

minus

$1.67 per share that must be included as part of the executed call option sale

equals

a return of at least $0.21 per share (depending on the size of the dividend payments), which is a 3.01% return over approximately six months if you close out this trade at the time of options expiration.

BREAK-EVEN ON THE DOWNSIDE

PDL shares would have to fall approximately $1.15+0.20= $1.35 per share to $5.61 a share from your $6.69 a share purchase price for your six month investment in PDL to be result in a return of 0%. Even though PDL’s patent estate is a wasting asset and the dividend is likely to be reduced a large amount in 2010 due to the 2009 monetization of 60% of its royalty stream, PDL shares falling to $5.59 a share appears unlikely based on the discounted net present value of its royalty stream.

BEST CASE SCENARIO ON THE UPSIDE

This trade performs best if PDL shares are trading at $7.49 at the close of May 21, 2010. If this occurs and PDL pays out $0.20 a share in dividend payments in the first half of 2010 then this trade nets a gain of:

$0.53 (share price appreciation)

plus

$1.15 in option premium

plus

$0.20 in dividend payments

equals a return of $1.88 a share on your $6.96 a share cost basis. This best case scenario results in a 27% return (ignoring tax and frictional trade costs).

RISKS TO THIS TRADE

This is obviously not a riskless trade and there are several variables that could cause this trade to turn south pretty quickly

1. Interest rate risk: If interest rates jump then PDL shares are heading south

2. Drug risk: If Avastin, Herceptin, or any other of the key drugs that PDL receives royalties on experiences sales declines then this will   adversely affect PDL shares. On the flip side, if Roche changes the geographic mix of its Avastin and Herceptin production, PDL shares stand to gain from a flat 3% royalty rate on the portion of drug produced outside the U.S. versus the tiered royalty rate it receives on production of these drugs in the U.S.

3. Changes to the tax code: If most PDL shares are held in taxable accounts and taxes on dividends are increased, this will adversely affect high-yield dividend stocks like PDL.

4. Patent litigation risk: There are several challenges to PDL’s patents going through the courts right now. Any one of them could have a severe effect on PDL’s abilities to collect royalties on its patents.

It’s worth repeating and remembering that PDL’s patents are a wasting asset. PDL’s shares are not going to be worth what they are today when 2014 rolls around. PDL’s shares should slowly decline to account for the lessened remaining patent life. Our bet is that the decline is slow enough (and that PDL’s shares are undervalued enough) that this trade will pay off.

CONCLUDING THOUGHTS

To be clear, PDL BioPharma’s patent estate is a wasting asset with the patents set to expire in 2014 and thus also PDL’s key source of revenue. There is a slight possibility for PDL to continue receiving royalty income beyond that time period but we are completely discounting that possibility right now. Therefore the discounted net present value of PDL’s royalty income that gets returned to investors through 2014 needs to exceed PDL’s current share price for PDL to be considered a good investment.

It’s worth repeating and remembering that PDL’s patents are a wasting asset. PDL’s shares are not going to be worth what they are today when 2014 rolls around. PDL’s shares should slowly decline to account for the lessened remaining patent life. Our bet is that the decline is slow enough (and that PDL’s shares are undervalued enough) that this trade will pay off.