ArbitrOption's Best Idea in the Universe for September: Shire PLC (SHPG)

This information is provided for educational purposes only, and is intended to be an example. It does not constitute investment advice. As with all investments, there are associated risks and you could lose money investing. Prior to making any investment, a prospective investor should consult with her or his own investment, accounting, legal and tax advisers to evaluate independently the risks, consequences and suitability of that investment to their personal financial circumstances.

Published 9/9/14

Current Favorite: Shire, PLC (SHPG)

- the pending corporate event must be disclosed by the company's management or Board of Directors (no rumortrage) - the pending corporate event must have an estimable process duration and terminal value, and - the company must have exchange-listed options with suitable expiration dates and strike prices

SHPG is the best investment opportunity in ArbitrOption’s universe because the following investment process is expected to produce returns more than NINE TIMES better than ArbitrOption’s equity-trading peers.ArbitrOption’s investment process can be broken down to five stages:

1.Idea Generation 2. Investment Research 3. Trading 4. Portfolio Management 5. Exits

The following describes how this investment process is being applied to the investment opportunity in Shire.

1. Idea Generation

On 6/19/14, press rumors revealed that SHPG had been approached by ABBV about a potential acquisition. The next day, as required by the UK Takeovers Panel, ABBV issued an announcement confirming that it had made three acquisition proposals, all of which were rejected. ABBV’s announcement triggered the start of a 28-day period under the UK Takeover Code. If ABBV could not reach an agreement to acquire SHPG within 28 days, it would be precluded for six months.

2. Investment Research

Of particular interest is the discussion of the transaction’s regulatory conditions on page 27 of the press release. Paragraph (k) says the transaction’s completion is conditional upon regulatory authorities not obstructing the deal, with the exception of “any change or potential change […] in tax law […] that would or might cause New AbbVie to be treated as a United States domestic corporation for United States federal income tax purposes”. In other words, a change in tax law that prevents ABBV from reincorporating in the UK to lower its tax bill is not sufficient grounds for ABBV to cancel the deal.

In addition, ABBV and SHPG filed a Co-Operation Agreement at the SEC on 7/18/14. The Co-Operation Agreement and the Plan of Merger that is its Exhibit A contain a Specific Performance clause, such that ABBV and SHPG are both entitled to seek completion of the merger if the other party breaches the agreement. A substantial amount of journalistic ink (or pixels, for digital media) has been expended discussing tax inversions, in which a US company relocates its corporate domicile to a lower-tax jurisdiction. The agreement between SHPG and ABBV categorizes a claim by ABBV that a change in US tax law constitutes a materially adverse change as a breach of the contract. As described above, if ABBV breaches the contract, SHPG is entitled to seek a court order that compels ABBV to complete the agreement. Given the lack of precedent for actually enforcement of a specific performance clause, a more likely outcome would be a renegotiated acquisition price or a deal termination that is coupled with the £320 million termination fee in the agreement plus additional reimbursement for expenses.

Financing Risk

The Takeover Announcement also discloses that ABBV will finance the cash portion of the transaction’s consideration with existing cash balances and a £13.5 billion bridge facility from JP Morgan, as outlined in this credit agreement. In the event that JP Morgan is unable to syndicate the debt, it will be obligated under the bridge facility to make the loan itself. On 8/21/14 ABBV entered into a term loan credit agreement that reduced the amount of the bridge facility by £3.2 billion and arevolving credit agreement that reduced the bridge loan by a further $4 billion.

Regulatory Risk

SHPG and ABBV have minimal overlaps in their product areas. The following graphic was part of the companies’ presentation of the transaction.

After reviewing the description of the treatments in the companies’ 10-K filings, it appears the only possible area of antitrust concern is ulcerative colitis, which is treated by ABBV’s Humira and SHPG’s Pentasa and Lialda. According to data from IMS Health’s National Prescription Audit in December 2013, Lialda and Pentasa had respectively 28% and 14% of the ulcerative colitis market. Figures for Humira’s share of the ulcerative colitis treatment market are not available because Humira’s sales are not broken out by the condition being treated. A 2012 article from the National Institute of Health specified that Pentasa and Lialda are a “first-line treatment for patients with mild-to-moderate” ulcerative colitis, while this NIH article from 2013 specifies that Humira is “for use in treating adult patients with moderate-to-severe, active ulcerative colitis”. The 2013 article goes on to say (emphasis added):

The main treatment goals for ulcerative colitis are the induction and maintenance of clinical and endoscopic remission. As far as mild-to-moderate disease is concerned, the oral and topical aminosalicylates (such as Pentasa and Lialda)represent the standard therapy for achieving this outcome. In the event of inadequate response to aminosalicylates and in patients with moderate-to-severe disease, systemic corticosteroids are the best option for inducing remission. Patients with active ulcerative colitis who do not have significant clinical improvement after 2–4 weeks of an appropriate course of corticosteroids are classified as “corticosteroid-refractory.” Anti-tumor necrosis factor-alpha (TNFα) monoclonal antibodies (such as Humira) represent the best available option for this group of patients, achieving clinical and endoscopic remission without prolonged steroid exposure.

If antitrust authorities conclude that joint control of these three drugs creates sufficient market power that New AbbVie could raise prices for ulcerative colitis treatments without losing customers, it is possible that a divestiture could be required. It is important to note here that clause 1.8 of the Co-Operation Agreement is clear that “[n]othing in Clauses 1.1 to 1.6 inclusive shall require the Parties to offer to any Regulatory Authority, accept or agree any undertakings, commitments, conditions, modifications or remedies, whether involving divestments or disposals or constraints on prices or other behaviour or otherwise, in order to obtain the satisfaction of the Regulatory Conditions.”

After researching the respective product markets, ArbitrOption concluded that a divestiture will probably not be required, though the US or EU antitrust authorities might extend their respective reviews to have sufficient time to delve into each product market. Because SHPG’s treatments are used as first-line treatments and Humira is only prescribed if earlier treatments are ineffective, the products are not substitutes. In addition, in a combined market of first-line and second-line treatments, there exists substantial competition from Janssen’s Remicade and Simponi, as well as Warner-Chilcott’s Asacol, Salix’s Apriso, Dr. Falk’s Salolfalk, and Recordati’s Claversal. Lastly, the pre-deal high price associated with Humira (estimated by NIH to exceed $18,000 per year) indicates that ABBV already has substantial pricing power, and that the merger with SHPG is unlikely to increase it.

ArbitrOption initially estimated the transaction would be completed by the end of December 2014. SHPG and ABBV will have to gain antitrust and shareholders’ approval before the transaction is completed. On 8/21/14 ABBV filed the S-4 that will serve as a preliminary proxy document for ABBV shareholders. In this document, ABBV reveals that the US antitrust filings were made the same day. In the unlikely event that the antitrust period is allowed to expire without an extension, it will end on or before 9/22/14.

ArbitrOption’s timing guideline for shareholder votes is 90 days, comprised of 30 days from the deal’s announcement for a preliminary proxy, 30 days from the preliminary proxy for a definitive proxy, and 30 days from the preliminary proxy for a shareholder vote. As above, the preliminary proxy was filed on 8/21/14, roughly 30 days after the transaction’s 7/18/14 announcement, in line with ArbitrOption’s expectation. If this prediction holds true, ABBV shareholders will vote in late October.

The Takeover Announcement said that “[i]t is expected the Scheme Circular will be published in autumn 2014”. SHPG’s Board of Directors has committed to hold its shareholders’ meeting 22 days after the Scheme Circular is published (the UK Takeover Code prohibits holding a shareholders’ meeting less than 21 days after the Circular’s publication). ArbitrOption anticipates that SHPG shareholders will see their Scheme Circular around the end of September and will vote on the merger with ABBV in later October, as well.

If the acquisition is completed successfully, ABBV will acquire shares of SHPG for £24.44 in cash and 0.8960 ABBV shares. ArbitrOption only trades in securities listed on US exchanges, such as SHPG’s American Depositary Receipts. As explained here, each ADR is equal to three Shire shares. A review of the technical characteristics of trading in ABBV shares and the GBP-USD exchange rate over the past 12 months suggested that SHPG is likely to be worth over $235 per ADR at the transaction’s completion.

3. Trading

In order to achieve an annualized return greater than 10% and a risk/reward ratio for the option trade that is superior to that of the stock, the maximum price that ArbitrOption could buy a January ’15 $230 / $235 call spread would be a debit of $4.09. That price is found by taking the lesser of a) the maximum price that would allow a 10% annualized return, or b) the price that matches the current risk/reward ratio of the stock.

Annualized Return

In order to generate a 10% annualized return, an event that lasts 114 days (the number of days between September 8th and December 31st) would have to produce a 3.12% gross return. The maximum price at which this call spread could be purchased and still allow for a 10% return is $4.85.

Underlying Math

10% / (365 / 114) = 3.12% $5 option spread / 1.0312 = $4.85 maximum price to achieve 10% annualized return.

Risk/Reward

In a transaction with consideration that’s made up of cash and stock, as is the case here, an equity investor would buy the target, or SHPG, and sell the acquirer, or ABBV. Given the 0.8960 stock exchange ratio, and the 3:1 ADR ratio, an investor should sell 2,688 ABBV shares for every 1,000 SHPG ADR she purchases. At $248.70, with a success value of $267.46, a downside failure value of $172.46 per SHPG ADR, and an upside failure value of $58.35 per ABBV share (downside and upside failure values are calculated based on the pre-deal prices, adjusted for change in value of a basket of peers) the risk/reward ratio in the stock is 83.71/18.76, or 4.46x. The maximum price that could be paid and still produce a superior risk/reward ratio is $4.09.

Underlying Math

4.09 risk / 0.91 reward = 4.49x

Since August 1st, 2014, ArbitrOption has bought January expiration $230 / $235 call spreads that risk 2.75% of the portfolio’s value at prices that will produce a 47.83% return on investment if the deal consideration or SHPG shares are worth more than $235 when the options expire. On an annualized basis, the return will be 153%.

4. Portfolio Management