1/14/19

Idiosyncratic, 21-33% over nine-month IRR opportunity in an uncertain market:  Buy Celgene on the likely closing of the Bristol-Myers Squibb acquisition of the Company (and buy Bristol-Myers for a high longer-term IRR opportunity)

Bristol-Myers Squibb (“Bristol” or “BMY”) and Celgene launched 2019 with a bang with the announcement of their definitive merger agreement on January 3.  The deal represents the second largest pharma M&A deal of all-time (only behind Pfizer’s 2000 purchase of Warner-Lambert).  The combined value of the companies is more than all the pharma deals announced in 2018 combined.  And what harkens back to the old school days of M&A, this is the first mega merger in recent memory that is anticipated to be substantially EPS accretive on day one after closing as a) Celgene’s valuation was thoroughly washed out (~6x 2019 IBES consensus on the day before announcement) and b) the companies are projecting $2.5bn of synergies in the deal.

This report recommends two ways to capitalize on the deal:

Primary recommendation:  Buy Celgene(~$87.50) on the assumed takeout by BMY at anywhere between the current implied takeout price (~$100) and ~$107 per share (I believe that there’s a reasonable likelihood that BMY’s stock increases to the mid-$50s by the time of close of the deal).

Secondary recommendation:  Buy Bristol-Myersa) opportunistically taking advantage of the dislocation that this deal has created in BMY’s share price and b) as a hedge in the low likelihood event that an interloper makes a successful approach to BMY and scuttles the deal.

Discussion on the opportunity in Celgene shares:

Consideration for Celgene’s shares comes in three components:

1.  $50 cash per share (fully committed financing by Morgan Stanley and MitsubishiUFJ)
2.  One Bristol share (currently priced at $48 per share)
3.  One CVR that will pay out $9 if three Celgene drugs receive FDA approval for specific indications within two years following close of the deal.

The attractive IRR opportunity on a purchase of Celgene comes down to four key determinants:

•   Where does BMY’s stock trade at the time of close?
•   How should the CVR be valued?
•   When does the deal close?
•   What price are the Celgene shares purchased at?

Further, when evaluating the opportunity in Celgene shares one must take a view on the likelihood of the deal closing.  I will conclude this section with some thoughts submitting that there is a strong likelihood that the deal closes.

Forecasting BMY’s stock price at time of close

The biggest swing factor in the IRR calculation for the Celgene takeout is where does BMY’s stock price fall at the time of the close of the transaction.  With approximately 50% of the value of the deal coming in Bristol shares and the bulk of the rest coming in cash, having a view on the range of likely share prices for BMY at closing is critical.

Some things to consider:

1)   Over the last 52 weeks Bristol’s share price has ranged between $44.30 (hit upon announcement of the Celgene deal) and $77.05.  At its current $48 per share, Bristol is trading at a 31% discount to its 52-week high and only an 8% premium to its 52 week low.

2)   In conjunction with the announcement of the transaction, Bristol provided 2019 EPS guidance of $4.15 per share (exclusive of completion of the Celgene purchase).  Not only was Bristol’s guidance 10 cents above consensus at the time of the announcement, it arguably helps de-risk a purchase of Bristol (or Celgene) by providing further confidence in 2019’s earnings outlook.

3)   Given Bristol’s updated guidance, the company trades at <12x 2019 earnings and somewhere between <8x (assuming the Celgene deal closes) and <11x (assuming that Celgene doesn’t close and using IBES consensus) 2020 earnings.  Assuming no deal close, these multiples put Bristol at a ~20% discount to the comparable group (see end of report) in terms of P/E multiples.  Assuming that the deal closes, at Bristol’s current stock price it will be one of the cheapest stocks in the S&P 500 and a 2020 P/E multiple 45% below its peer group.

4)   The sell-side research community is fairly evenly divided between Buy ratings and Neutral ratings on BMY’s stock.  Most have not updated their ratings/forecasts since announcement of the deal (probably because many are now restricted as their bankers are pursuing financing or advising business on the deal).  The median target price on Bristol amongst the nine firms I surveyed is $58.50.

5)   Bristol intends to spend $5bn on some form of accelerated share repurchase program immediately post close of the Celgene acquisition (presumably using cash on Celgene’s balance sheet to fund the program).  This program should a) provide a significant bid for Celgene shareholders who wish to flip their BMY shares upon close of the deal and b) make the arb community think seriously about how short they want to be BMY shares going into the close of the transaction.

6)   The IRR that can be locked-in on buying Celgene and shorting BMY at this juncture is attractive enough that a significant short interest position is likely to develop in BMY shares. As of 2018 year-end, short interest in BMY was less than 1% of shares outstanding.

7)   According to the most recent quarterly 13-F filings, approximately 27% of BMY’s shares outstanding are held by retail (a high percentage vs. the average stock in the S&P) and ~30% of the stock is held by just five fund complexes:  Wellington (8.7%), Vanguard (7.9%), Blackrock (7%), State Street (3.1%) and Dodge & Cox (2%).

8)   Bristol and Celgene’s management teams as well as their advisors will be actively selling this deal to the investment community.  In addition, any major pharma sell-side analyst who’s firm isn’t in the deal is likely to be publishing research on the combination.  While there are undoubtedly some concerns with the combination by certain voices in the sell-side community (namely that BMY is going to now shoulder Revlimid patent expiration risk as well as Celgene’s late stage emerging drug portfolio approval risk), on paper this deal looks massively accretive (as highlighted by how BMY’s forward P/E multiple falls assuming completion of the deal).  The deal is also a great way for both companies to diversify their existing drug and emerging drug portfolios as well as strip out synergies that are worth ~$25bn? (10x 2.5bn of expected synergies) on a capitalized basis.  On balance, it should be expected that the sell-side community is constructive on the deal

Upshot is this, I think it a high likelihood that BMY’s share price will migrate higher between now and close of the deal due to its abject low valuation and the likelihood that as investors fully vet the deal that they will buy into the value creation potential of the combination. I believe that there’s a 70% likelihood that BMY ’s stock price gravitates to somewhere between the low and high $50s by the time the deal closes.  I think there’s a 20% likelihood that the shares are flat with their current price and that there’s only a 10% chance that they close lower than current by the time of close.  On balance, there are too many things working in the favor of Bristol’s shares.

I’m providing a sensitivity below that highlights the range of potential IRR’s in Celgene’s shares given a range for BMY’s stock price.  In short, I believe the likely outcome is somewhere between a 21%-33% IRR assuming the deal closes on September 30, 2019.

Valuation on the Contingent Value Rights (CVRs)

CVRs are something that one rarely sees outside the pharma world and something to understand in the context of this deal. Keeping it high level, BMY will be providing one CVR for each Celgene share.  If three of Celgene’s specific late-stage drug candidates gain FDA approval for specific indications agreed to in the deal, then the CVR will pay out $9 in cash.  All three approvals must be achieved within specified time frames for each drug, but overall within approximately two years of the anticipated closing date of the deal.

What’s important to recognize is these CVRs will trade on the open market post close of the deal.  SoSo,while one could wait around to see if these three drugs jump all the hurdles necessary to obtain the windfall $9 payout, investors should be able to sell the CVR’s at a significant discount to the $9 potential payout post close of the deal.

I’ve seen estimates of anywhere from 70-90% likelihood that each drug receives its indicated approval within the time frame specified for the CVR.  SoSo,when multiplying 80%x80%x80% and then discounting back to the expected close date for the transaction, the value of the CVR’s could be as high as $4 at the time of close.  Barron’s is out this weekend estimating that the value of the CVR would be closer $2.

I would take a more conservative tack.  I would assume a 50% likelihood in each scenario and then discount back arriving at an estimated value of the CVR’s of $1. Triangulating between the three estimates, I think the CVR’s could easily trade in a range of $2-$2.50 per (the market has a tendency to overpay for lottery tickets).

Estimated time to close

The companies have announced that they expect to close the transaction in Q3 2019.  For the purposes of my IRR analysis, I’ve assumed a September 30, 2019 close date.  There are a number of elements of this deal that should facilitate a closing within the expected time frame.

1)   This is not like a large managed care deal where there are multiple state insurance regulators that need to sign-off.  Further this is not a cross border transaction.  This is one big domestic pharma company buying another big domestic pharma company.  Between them, the two companies total US revenues represent less than 5% of the money spent on pharmaceuticals in the US in 2018.  There is minimal overlap in the drug portfolios so regulatory hold up risk should be minimal.

2)   There will have to be shareholder votes for both companies. A positive shareholder vote by Celgene shareholders is all but guaranteed.  In terms of Bristol, based on the current composition of the shareholder base (27% retail and 30% in just the top five holders all of which I expect, to be positively inclined) I believe it highly likely a positive vote comes through.

3)   With committed financing already signed up, the biggest other wildcard comes down to whether another buyer comes forward for either Bristol or Celgene or whether an activist comes in with an effort to bump up the consideration for Celgene’s shares (“bumpitrage” – wouldn’t put it past the likes of Icahn (who has been very active in the space in the past) or Elliott).

4)   By way of reference, there are only two comparably sized, non-cross border mega pharma deals this century to look at as reference points in terms of time between announcement and close of the transaction.  Pfizer’s purchase of Warner-Lambert (an $80+ billion transaction) took only four months to close in 2000.  Pfizer’s ~$70bn acquisition of Wyeth in 2009 took nine months to close.

I will discuss the potential for item 3 later in this report, but big picture there’s certainly a fluidity in term of when this deal potentially closes.  It is very close to the largest pharma deal of all-time. I, conservatively I believe, have estimated a September 30 closing, but it could just as easily close a month or two sooner.

Here’s a sensitivity table highlighting how different closing dates impact the IRR opportunity on Celgene shares.

Likelihood of deal closing:

As alluded to in various points throughout this report, I believe that it is highly likely that this deal closes.  But why or how this deal doesn’t close, if in a way that would be detrimental to Celgene shareholders, must be understood.

Interloper comes in to break up the deal by making a successful approach to Bristol

As alluded to in a Credit Suisse research report published soon after the deal announcement, this is the number one question on investors’ minds.  Might another major biopharma make a bid for Bristol. First up, there are really only, maybe, five big biopharmas with the horsepower (and potential pharma logic) to do it:  J&J, Pfizer, Novartis, Amgen and Abbvie (leaving Merck out because BMY’s biggest drug Opdivo is a direct competitor to Merck’s Keytruda and Roche has a similar overlap in its drug portfolio).  While each of the aforementioned big biopharmas certainly have the financial flexibility to make a run at Bristol, I would submit that the only way a deal gets done to buy Bristol is a) on a hostile basis or b) at a price of at least $86 per share on a friendly basis (why $86?  Because I believe that BMY should be able to credibly argue that they are worth at least $86 (peer median 13.9x estimated 2020 eps provided that the Celgene deal closes – further they are likely to want a premium valuation to their 52-week high of $70)).

SoSo,assuming that very few of these major pharmas would be willing to pay $86 on a friendly basis (which would represent 19.4x IBES consensus BMY 2020 forecasts before synergies), then that begs the question which of them would be willing to assert a hostile offer for BMY?  Of the five aforementioned potential acquirers, I believe (based on having spent a number of years, personally, in healthcare investment banking and knowing the historical dispositions of some of these companies reasonably well) that there’s little likelihood that J&J or Novartis would make a hostile offer.  I’m also going to lump Amgen in that camp.  That leaves Pfizer and Abbvie as companies that may consider a hostile approach to Bristol.  Pfizer has had mixed success in the past with a hostile approach to Warner-Lambert succeeding while an attempt on Astra Zeneca failed.  Abbvie has a strong potential motivation given how reliant the company is on its dominant drug Humira (the biggest seller in the world), but Abbvie already has significant indebtedness on its balance sheet and Abbvie trades at a lower P/E multiple than BMY.

Ultimately, I believe Bristol’s corporate sensibility has to be considered when weighing the likelihood of Bristol’s willingness to sell out as a company.  Bristol traces its routesrootsback to 1858 making the company 160 years old. Bristol views itself as one of most established, bluest of blue chip US corporate entities and has fiercely defended its independence at every turn in the past.  I believe that a huge reason that Bristol has committed to this deal with Celgene is it further secures the company’s independence.  Given that as a backdrop, I believe that Bristol is not for sale. Further, given that the complexity of doing any hostile deal, let alone a hostile deal the size of a Bristol, is high I think the likelihood of a either a hostile or friendly takeout of Bristol at this juncture is low (less than 20%).

Possible shareholder vote against the deal

The other potential driver of the deal not closing would be if Bristol’s shareholders voted against the deal.  The biggest reason for this to happen would be if Bristol’s shares fell even further (due principally to concerns about the deal or new information learned about Celgene that turned the market sour on the deal). So long as Bristol’s shares trade around current levels or gravitate higher, I think the likelihood is high that shareholders vote for the deal. Just looking at the top five shareholders, three of them are index funds (all but assured to vote for the deal) and the other two are true fundamental investors that should very much like how the deal looks on paper.  Retail should overwhelmingly vote for the deal unless Bristol’s share price drops appreciably further.  Between the logic for the deal and two management teams working the investor base, I think it highly likely that shareholders vote for the deal.

That said, in the unlikely scenario that Bristol does not close on the deal (either because an interloper successfully makes an approach to Bristol or because shareholders vote against the deal), Celgene shareholders have three things to fall back on:

1)   A $2.2bn break-up fee which equates to $3+ per share.

2)   Celgene’s remarks on the deal announcement call suggest that there were other suitors in the wings. It is very possible that if Bristol did not close on the deal, that another party would come forward.

3)   Celgene was trading at a totally washed out valuation in December of ~6x forward earnings that was in no small way catalyzed by tax loss selling and biotech underperformance in the highly anomalous trading month of December 2018.  It is hard to see how Celgene’s warranted valuation is even as low as its current trading price.  Upshot, while Celgene’s stock would certainly fall if Bristol walked from the deal, I do not believe it would fall much below $80 for any extended period absent a fundamentally, materially negative development in its underlying business.

In summary, I believe that while there are a number of angles to consider and merger arbitrage can often be considered amongst the more sophisticated/complicated investment strategies to pursue, the opportunity in Celgene shares is a straightforward one.  Buying Celgene should lead to a 21-33% IRR provided an $87.50 or better purchase price on Celgene shares.  I believe the likelihood that the deal closes is high.  As we progress towards the closingclosing,I believe that Bristol’s shares should gravitate back into the mid $50s.  While I am one who typically looks for investment opportunities with highly attractive five-year horizon’s over which value can accrue and compound, I believe that an investment in Celgene at this juncture represents a highly attractive, idiosyncratic opportunity to make a compelling return over a nine month time frame. Buy CELG.

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Discussion on the opportunity in Bristol-Myers shares:

As it pertains to Bristol, I do not recommend going short Bristol shares to lock-in the IRR on a Celgene trade.  In fact, I also recommend going long Bristol.  This deal announcement on the heels of YE 2018 weakness in biopharma has provided an excellent entry opportunity in BMY shares. The company has de-risked 2019 by providing upbeat EPS guidance that came in above the Street and the stock trades at <12x 2019 EPS, <11x 2020 EPS (without a deal), <8x 2020 eps with a Celgene deal and a 3.4% dividend yield.  Additionally, there is the possibility, although I believe low likelihood, that an interloper comes in and makes a bid for Bristol.  If this deal goes through, I’m one who thinks that at <8x 2020 eps forecasts inclusive of Celgene that Bristol looks like a homerun.

In sum, I believe the way to play this situation is buy Celgene for a short-term high IRR opportunity and buy Bristol for a very high, medium-term IRR opportunity.  BMY could easily trade at 13.9x 2020 EPS by sometime in 2020 (or $86 – 80% above its current price).

The one risk that courses through both these stocks (Celgene and Bristol) is a broad sectoral risk in terms of the potential for further drug price reform in the U.S.  While this will be a constant concern in the background, cynically it must be recognized that there’s more money spent on pharma lobbying in the US than the next few categories combined.  It also must be acknowledged that pharma has been at the center of some of the most important innovation in our economy.  It remains to be seen how persistent, but sporadic efforts on drug price reform will come to materially impact big pharma (particularly the oncology biopharma stocks).