In our last Merger Arbitrage Mondays post we briefly mentioned the acquisition of Tobira Therapeutics (TBRA) by Allergan (AGN) where Allergan paid a huge premium to acquire Tobira and the stock skyrocketed 721% in response. Shareholders of Tobira would receive $28.35 in cash upon completion of the acquisition. The deal also includes a Contingent Value Right (CVR) that could pay up to $49.84 per share if certain conditions are met. Considering the “potential” deal value is $78.19, why is the stock trading at $38.99? I have attempted to answer this question in this article and have also shared a model I used to determine the value of this deal.
For the most part, I like the KISS (Keep It Simple Stupid) principle when it comes to investing and try to avoid “black box” investments where the investment is challenging to analyze. However I do sometimes make an exception to this rule and especially when it comes to merger arbitrage. The acquisition of the North American operations of the bottling company Coca-Cola Enterprises (CCE) by The Coca-Cola Company (KO) was one such case and I wrote a special report about it several years ago. Sometimes the more complex deals provide an opportunity that may not exist with the simple deals provided you understand the risks associated with the situation.
I have invested in situations that included a CVR as a kicker, where investors get one or more additional payments in the future if certain milestones are met after the closing of the deal. These kinds of CVRs are often seen in pharma/biotech types of deals where the company being acquired has drugs in their pipeline that could get approved long after the deal has closed. I have also seen CVRs attached to the disposal of real estate in deals such as the acquisition of Safeway by Cerberus Capital Management. I have participated in some of these deals that include CVRs because the merger spread in those deals were sufficient to make the CVR almost free.
This is not the case for Tobira because the cash portion of the deal ($28.35) is dwarfed by the CVR ($49.84) and the current price of Tobira ($38.99) indicates the market is assigning a value of approximately $10.64 to the CVR. This 8-K filing lists the conditions associated with the CVR as given below:
Each CVR represents the right to receive the following cash payments, without interest and less any applicable withholding taxes, with each payment conditioned upon the achievement of certain milestones as follows:
• Enrollment Milestone. Parent will be obligated to pay $13.68 per CVR if, on or before December 31, 2028, the first human is enrolled in a Phase 3 trial of cenicriviroc (“CVC”), which trial includes, as one of its primary outcome measures, an evaluation of improvement in fibrosis of at least one stage with no worsening of steatohepatitis (or a substantially similar measure with respect to such evaluation or a similar disease characteristic).
• Submission Milestone. Parent will be obligated to pay $4.53 per CVR if, on or before December 31, 2028, a new drug application is submitted to the United States Food and Drug Administration (the “FDA”) for approval of any pharmaceutical product or combination of co-administered products containing CVC as an active ingredient for the treatment of non-alcoholic steatohepatitis with fibrosis or fibrosis due to non-alcoholic steatohepatitis (“NASH”, and any such product, a “Product”).
• First Commercial Sale Milestone. Parent will be obligated to pay $13.56 per CVR if there has been, on or before December 31, 2028, the first sale in the United States in an arm’s length transaction to a third party of a Product whose approved label includes an indication for the treatment of NASH following regulatory approval for marketing of such Product by the FDA (such sale, the “First Commercial Sale”).
• Sales Milestone. Parent will be obligated to pay $18.07 per CVR if, within any four consecutive calendar quarters during the three consecutive year period commencing with the first calendar quarter immediately following the date of the First Commercial Sale, there are worldwide net sales (gross amounts received for sales of the Product, less certain permitted deductions) of a Product exceeding $1 billion.
The key to figuring out what the CVR is worth lies in figuring out the probability associated with the successful completion of each milestone, estimating how long it would take for each milestone to be reached and then discounting that future payment back to current dollars.
I built a simple model to estimate the value of the CVR so that we could add the deal in our Merger Arbitrage Tool and came up with an estimated value of $12.54 for the CVR. I am not a pharma/biotech analyst and so both the probabilities I assigned to the successful completion of each milestone and the time it would take to reach the milestone were uneducated guesses. This was one of my motivations to write this article as I would really love to get feedback from folks with experience in this sector to see what they feel the probabilities should be for each of these milestones.
When I looked at the value the market was assigning to the CVR portion of the deal, I was surprised by how close my guesstimate was. The model is given below and I would be happy to share a link to the Google Spreadsheet of this model if you would like to download a copy or verify the formulas used.
|CVR Milestone||Value||Probability||Potential Payment||Years after 2016||Present Value of Potential Payment|
|First Commercial Sale Milestone||$13.56||30%||$4.07||10||$2.50|
|Sales Milestone ($1 billion in 4 consecutive quarters within 3 years after commercialization)||$18.07||10%||$1.81||12||$1.01|
|Total Potential CVR Payment||$17.72||$12.54|
|Cash Portion of Deal||$28.35|
|Total Present Deal Value||$40.89|
|Current TBRA Stock Price||$38.99|
|Disclaimer:||This is nothing more than an example for illustration. The probabilities used or the years after 2016 when the milestone will be reached are guesses. Please do your own research and build your own model. You are welcome to use this model but we do not warrant the accuracy or completeness of the model.|
Some CVRs are tradable on a public exchange while others cannot be traded or transferred. The CVR associated with the Tobira deal cannot be transferred (with some exceptions) or traded.
We included the deal in our Merger Arbitrage Tool under the “Special Conditions” category with an estimated deal value of $40.89. At this price, the deal offers a spread of 4.87% or 18.53% annualized if the deal closes by the end of 2016.