Description

I don’t know about anyone else, but lately when I log into VIC and take the Bargain Meter poll, I’m forced to admit I’m not finding many value stocks out there right now. Given how challenging the current market environment is for me, I’ve been looking less at traditional bargain stocks and more at merger arbs.

I’ve found two merger situations that look compelling enough to share, and have included below a brief write-up for each one. ALR is a situation that that offers moderate upside, and ~20% downside in the worst case, and has an extremely high likelihood of success. INNL is a situation with somewhat less certainty, but offers the potential of a multi-bagger return if everything goes just right.

I’ve tried to keep each write-up succinct and focused to save everyone time, but I am more than happy to flesh out either thesis in the Q&A section. As always, thanks for reading.

ALR:

Description: ALR has been involved in the most contentious merger in recent memory. Now that ALR has filed its 10-K, and ABT has agreed to amended merger terms, there is virtually no risk remaining. However, concerns over the past acrimony between the two companies means there is still a ~2% spread between where ALR trades today at $50/share and the cash buyout price of $51/share. I expect the deal to close by early August, so buying here creates a very high-probability 8% annualized return.

Why The Opportunity Exists: To call this merger contentious is an understatement. All the details are readily available in the public record, but I will note that the merger was first announced on 2/1/16 at $56/share, and since has included ALR financial restatements, a subsidiary having its Medicare and Medicaid billing privileges revoked, and a lawsuit from the acquirer ABT alleging the triggering of a Material Adverse Change clause. It’s no wonder that arbs are cautious after all this drama, but on 4/14/17 ABT and ALR dropped the merger terms to $51/share and on 6/5/17, ALR finally filed its 10-K, all but eliminating any possibility of the deal breaking.

Timeline: The recent filing of ALR’s 10-K is key to keeping the deal timeline intact. That timeline is now:

July 7th: ALR shareholder meeting to vote on the acquisition

July: regulatory approvals from the FTC, the Canadian Competition Bureau, and the South Korean antitrust authority.

Early August: merger to close (inferred).

September 30th:  The official date by which regulatory approvals must be received, and the absolute latest date by which the merger should close.

Potential Downside: I feel strongly that at this point there is almost no chance of the deal breaking. However, should disaster strike, ALR’s share price would at worst likely return to ~$40/share. This is where the stock was trading when the deal was mired in legal limbo. Importantly, the Delaware Court of Chancery (where the lawsuit would continue on any deal break by ABT) has “never found a material adverse effect to have occurred in the context of a merger agreement.” https://www.themalawyer.com/material-adverse-effect-clauses/

Further support for ALR is offered by the stock’s reaction to a 4/5/17 court filing by ALR asking ABT to reveal documents on the due diligence process. That filing pushed ALR’s stock up 12% on the day on the expectation that the documents would conclusively show that ABT understood what it was buying and that no MAC existed. It is telling that less than two weeks later, ABT agreed to the terms of the revised deal.

In short, buying ALR at ~$50 offers a near-certainty of an 8% annualized return, while any downside risk is remote and manageable.

INNL:

Description: INNL is being acquired by Gurnet Point for $1.75/share cash, and up to an additional $4.90/share in contingent value rights (CVR). The first CVR payment of $0.70/share appears to be readily achievable, and makes buying INNL at ~$2.20 a good trade. If any of the other CVRs pay out, this will be a real home run.

INNL was seeking FDA approval of a bupivacaine collagen-matrix that could be implant after surgery for pain relief. This is a relatively untapped market that could greatly cut down on opioid use. However, on 12/16, the FDA replied with a Compete Response Letter (CRL) denying INNL approval, saying that their matrix was a drug/device combination, not just a drug, and therefore additional data would be required.

After meeting with the FDA, INNL determined that all issues could be addressed with a few short-term studies and that a resubmission was possible by YE17. Unfortunately, their financial resources were so minimal ($14.9mn cash and $27mn in debt at YE16) that clearing even this minor hurdle was beyond them.

At this point, Gurnet Point L.P saw opportunity and negotiated the take-over. Gurnet Point is affiliated with Waypoint Capital, the family fund of Ernesto Bertarelli, and is run by Christopher Viehbacher. Bertarelli was the CEO of Serono, a biotech firm sold to Merck for $13.3bn, and Viehbacher is the former CEO of Sanofi and chairman of Genzyme. Clearly, both men have a strong track record of value creation in the biotech space, and their interest goes a long way towards validating INNL’s certainly that they can successfully respond to the FDA’s CRL.

Why The Opportunity Exists: If the FDA CRL is so manageable, and extremely sophisticated biotech investors like Bertarelli and Viehbacher are willing to pay up to $6.65/share for INNL, why is it trading at ~$2.20 today?  There are multiple factors contributing to this valuation discrepancy. Currently, INNL is an illiquid microcap, making it impossible for a large fund to acquire a position. Even for smaller funds, the idea of holding a non-tradable CVR possibly into 2020 is unattractive. This creates all kinds of mark to market issues, and it’s obviously much less appealing to enter a trade when there’s a decent chance you may have moved onto another firm before it pays out. Real-world issues like this definitely cause funds to steer clear of trades that look great on paper.

Timeline:

June 28th: INNL shareholder meeting to approve the acquisition.

First CVR Payment Event: Gurnet Bidco will pay $0.70 in cash per CVR if on or before December 31, 2018, XARACOLL is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following open abdominal Hernia repair.

Second CVR Payment Event: Gurnet Bidco will pay an additional $1.33 in cash per CVR if, on or before December 31, 2018, XARACOLL is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Soft Tissue repair (and not limited to hernia repair).

Third CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.00 in cash per CVR if, on or before December 31, 2019, XARACOLL is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repair; or, if not

$0.60 in cash per CVR if, after December 31, 2019 but on or before June 30, 2020, XARACOLL is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repair.

Fourth CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.87 in cash per CVR if global net sales of XARACOLL exceed $60 million in any four consecutive Calendar Quarters ending on or prior to December 31, 2019; or, if not, $1.00 in cash per CVR if global net sales of XARACOLL exceed $60 million in any four consecutive Calendar Quarters ending on or prior to March 31, 2020.

Potential Downside: The risk of the acquisition falling apart is essentially nil, and so the only real downside scenario to consider is the unlikely possibility of INNL failing to address the FDA’s CRL. In this case, downside would be to the $1.75 acquisition price.

In summary, buying INNL today gives a very strong probability of a ~55% return by YE18 (initial outlay ~$2.20/share until deal close, committed capital $0.45, with the first CVR paying $0.70) , with a possibility of much more upside should Bertarelli and Viehbacher be able to use their biotech expertise to maneuver the bupivacaine collagen-matrix into additional indications or sales.  

Catalyst

Entire thesis above is catalyst driven