Quest Diagnostics (NYSE: DGX) recently bid $8.00 per share for Celera Corp (Nasdaq: CRA)

Here's why I believe this bid is too low:

1.       CRA had $4.22/share in net cash and the present value of a long term receivable on 12/25/10.

2.       The minimum pre-tax and post-tax values of CRA's royalty on Odanacatib, a phase 3 osteoporosis drug fully funded by Merck (NYSE: MRK), exceed $3.00 per CRA share and $2.00 per CRA share, respectively.[1]

3.       CRA received a bid of $1.64/share for their Products business conditioned upon CRA securing access to a next generation sequencing platform to support a future generation of products. A ~60% probability of CRA securing such access implies $1/share[2]

4.       CRA's tax assets are worth more than $1 per CRA share to an acquirer like DGX.

5.       Credit Suisse, hired by CRA's Board to value CRA, values CRA's Lab Services at a minimum of $1.40/share using the transaction multiples of comparables.

These asset values suggest CRA's minimum value is between $10 and $11 per share. As I explain below, if shareholders do not tender to DGX and pursue their appraisal rights, I believe DGX will ultimately pay at least $11 per share within 2 years of the merger date.

In the sections below I elaborate on the value of each asset above and on the Delaware Court appraisal process that non-tendering shareholders will pursue.

1.       Per CRA management projections below, net cash should grow in 2012 and beyond.[3] I don't believe CRA management was incentivized to project unreasonably. If you speak with CRA, they will tell you they face severe competition and reimbursement risks and that the DGX deal is the best option for shareholders. 

February 2011 Forecast

 (a) Adjusted EBIT, or earnings before interest and taxes, excludes amortization of purchased intangible assets; restructuring and employee-related charges, including severance expenses; legal and insurance settlements; and impairment of intangible assets.

2. CRA's royalty on Odanacatib:

CRA's 2010 10K states that CRA is "entitled to receive mid to mid-high single digit royalty payments from the sale of drugs, if any, resulting from the program," of which Odanacatib is a central part. I interpret this royalty description to mean an average royalty of 6.5% through 2023, the last year of patent protection.

Per CRA's SC14D-9 filed on 3/28/2011, Credit Suisse concludes CRA's drug assets are worth between $0.86 and $1.01 per CRA share:

"Credit Suisse also applied multiple ranges based on the selected transactions analysis to corresponding financial data for the Company on a sum-of-the-parts basis, to derive separate implied aggregate value reference ranges for the Company's clinical laboratory testing service (Lab Services) business segment, on the one hand, and the Company's products (Products) and corporate services (Corporate) business segments, on the other. Credit Suisse derived an implied aggregate reference range for the Company by adding these ranges together both with and without giving effect to potential revenue generated by the Company's non-commercial, development stage drug assets. These drug assets include the Company's agreement with Merck & Co., Inc. for the development of small molecule inhibitors of cathespin K for the treatment of osteoporosis, and royalties and milestone payments associated with the small molecule drug discovery and development programs sold by the Company to Pharmacyclics, Inc., in 2006. The Company's net cash as of December 25, 2010 was then added to derive an implied equity reference range for the Company. The LTM revenue of the Company's business segments was based on the Company's public filings. The per share value of the contribution of the Company's non-commercial, development stage drug assets was based on the discounted cash flow analysis discussed below. Credit Suisse's sum-of-the-parts selected transactions analysis indicated the following implied per share equity reference ranges for the Company, as compared to the per share consideration of $8.00 to be received by the holders of Shares pursuant to the Merger Agreement:

The shares of the Company for this purpose were calculated on a fully-diluted basis, including all restricted stock units and calculating shares underlying employee stock options using the treasury stock method."

I believe that MRK can estimate the value of Odanacatib far more accurately than Credit Suisse because MRK has far more experience in osteoporosis. Here's how I get at least $3.00/share in pre-tax value for this royalty:

The following two articles estimate the average cost per patient in an osteoporosis phase 3 trial:

Article#1: http://appliedclinicaltrialsonline.findpharma.com/appliedclinicaltrials/Regulatory+News/Osteoporosis-Clinical-Trials-Not-for-the-Faint-Hea/ArticleStandard/Article/detail/678148

Article#2: http://www.lifesciencesworld.com/news/view/11080

 I assume the average cost per patient in MRK's Odanacatib trial is $30,000. MRK is running a 5 year phase 3 trial involving 16,716 patients that started in September 2007.

1.       Assume MRK spends $500MM developing Odanacatib between Sept 2007 and Sept 2012, spending  $100MM every Sept, with the first payment on 9/30/07 and the last on 9/30/12.

2.       MRK averaged a pre-tax ROE of 48% from 2000 through 2010 (49% from 1980 through 2010).

3.       Assume that MRK's target ROE, after applying all risk factors, equals at least 48%

4.       Compounding each of MRK's 5 $100MM payments at 48% (except the last one which is discounted at that rate for half a year) implies a risked pre-tax minimum NPV of $1.24BN

5.       MRK has averaged a 28% EBITDA margin since 2006, a 30% EBITDA margin since 2001, and a 31% EBITDA margin since 1980, with a range from 22%-44%.

6.       At a 30% EBITDA margin for this drug, a 6.5% royalty equals 22% of MRK's pre-tax NPV, implying $270MM in minimum value or $3.29 per CRA share.

Amgen's Denosumab, a de-risked comparable to Odanacatib, also involved nearly 20,000 patients in its trials (about 40% in trials for osteoporosis, the rest pursuing other indications). Geoffrey Porges of Sanford Benrstein & Co expects that by 2013, Denosumab sales will exceed $3.8 billion.

The Biotechnology Value Fund, LP (BVF), CRA's largest shareholder post DGX's bid, stated in its Feb 2010 CRA 13D, that the drug assets could be worth "a significant multiple" of CRA's market cap, at the time near $500MM.[4]  BVF succeeded in fetching fair(er) value for Facet Biotech post Biogen's bid and is trying to do the same with CRA (read their recent letter to Quest attached to their SC13D filed April 4, 2011). 

I focus on a pre-tax minimum value for Odanacatib (rather than post-tax) because unless a CRA shareholder recovers the current cost of purchasing a CRA share, say $8.00, then a tax should not be paid. In other words, adding only CRA's net cash, the pre-tax minimum value of Odanacatib, and the 5% annual interest earned during the Delaware appraisal process (explained in CONCLUSION section below) implies $8 per CRA share.  Moreover, CRA's tax assets may offset all of the tax liability and the IP of Odanacatib may reside in a jurisdiction with a tax rate much lower than the 35% I assume to derive my post-tax value.[5]

3.       $1.64/share bid for Products Business: as the narrative below explains, the $1.64/share bid depended on CRA "securing access to a next generation sequencing platform". Given the mid-point bid of $135MM after near 6 months of formal due diligence under CA, I estimate a 60% probability of CRA securing such access. I don't think the bidder would have spent 6 months on due diligence without believing that securing such access was materially probable. I interpret "materially probable" to mean between 55% and 65%.

Applying a 60% probability to $1.64/share mid-point bid implies $1 per CRA share. The narrative below provides more context:

"At an in-person meeting of the Company Board held on August 19, 2010 with representatives of Credit Suisse, Latham and members of the Company's senior management present, the Board discussed the strategic options available to the Company, including the sale of one or more business segments of the Company... During the following week, Bidder C expressed verbal interest to the Company regarding an acquisition of the Company's Products business for a purchase price of $125.0 million to $165.0 million based on its review of non-confidential information of the Company. Bidder C indicated that any proposed transaction involving the Company's Products business would be conditioned upon the Company securing access to a next generation sequencing platform to support a future generation of products in the Products business.

On August 25, 2010, Ms. Ordoñez made an in-person presentation to a representative of Bidder C regarding a potential transaction involving the Company's Products business. Bidder C executed a confidentiality agreement with the Company and moved into formal diligence regarding the Company's Products business in early October.

 In February 2011, members of the Company's senior management and representatives of Bidder C continued discussions regarding a proposed sale of the Company's Products business. Bidder C indicated that any such proposed transaction would be at a purchase price of $125.0 million to $145.0 million in cash... After extensive discussion, which included a review of the potential sale of the Company's Products business, the Board determined that the Company's senior management should proceed with a potential strategic transaction for an acquisition of the Company, rather than also continuing to pursue a potential strategic transaction for an acquisition of the Products business."[6]

4.       On the conference call announcing the bid for CRA, DGX's CFO, in answering a question re CRA's tax assets, stated "Yes, Bill, those are outlined in Celera's 10-K and their footnote 16. And we expect to realize certainly the majority of that $117 million and it could reach over $100 million and we would expect to realize most of that over the next four years." The NPV of CRA's $123MM tax assets to an acquirer like DGX is ~$95MM at a 5% discount rate assuming an annual limit (equal to the product of the adjusted long term tax-exempt rate and the enterprise value of CRA at DGX's bid price) on usage of the tax asset due to change of control, which assumes 9 years to consume the entire tax asset rather than 4. [7]

In an amendment to the SC14D9, Credit Suisse values CRA's tax assets to CRA as a going concern at $45MM (using 14% discount rate), or $0.55/share, estimated by Credit Suisse as follows[8]:

 The Company's NOLs were included as part of the Company's financial assets assuming no limitation on their application. Based on estimates provided by the Company's management, Credit Suisse calculated the taxes saved through the use of the Company's NOLs through 2020, and determined that the Company's NOLs would be fully utilized by 2017. The estimated taxes saved through the use of NOLs was as follows (in millions):

These tax savings were discounted at a range of 13.0% to 15.0% based on the Company's estimated weighted average cost of capital to derive their present value.

5.        $1.40/share value for Lab Services:

 The key here is to look at the details of comparable transactions that Credit Suisse provides in pages 34-35 of the SC14D9 and the following amendment to the SC14D9:

 http://sec.gov/Archives/edgar/data/1428156/000119312511100762/dsc14d9a.htm

The lowest mean multiple of Revenue (Lab Services wasn't profitable in 2010) is 1.7x while the lowest Revenue multiple is 1.0x.

Assuming Lab Services is no worse than the worst comparable, it should be valued between $1.00 and $1.60 per CRA share.Credit Suisse's minimum value of $1.40 per CRA share for Lab Services implies that Lab Services is not worse than the worst comparable but rather near the mean.

The Delaware appraisal process:

The details of this process are in the bottom of the SC14D9 under the heading SECTION 262 OF THE GENERAL CORPORATION LAW OF THE STATE OF DELAWARE, pages III-1 and III-2

Figure out how much time it can take: my guess is 1 to 2 years, including appeals, but I encourage you to come up with your own opinion. If you think it ends up being longer, please explain in Q&A.

The Delaware appraiser will pay CRA shareholders the value it deems appropriate as of the merger date.  Any developments after that date are not considered and neither is the "transaction price":

In Golden Telecom, Inc. v. Global GT LP, 2010 WL 5387589 (Del. Dec. 29, 2010),

"The Supreme Court rejected these arguments and affirmed the Chancery Court's appraisal. The Court started with the statutory language of Section 262(h). It noted that Section 262(h) "neither dictates nor even contemplates that the Court of Chancery should consider the transactional market price of the underlying company." Instead, the Supreme Court noted, "in determining 'fair value,' the statute instructs the court" to "take into account all relevant factors." In doing so, under Delaware law, the Supreme Court further noted, the Chancery Court was to assess Golden's fair value "as a going concern, as opposed to the firm's value in the context of an acquisition or other transaction." Section 262(h) required the Chancery Court to conduct an "independent evaluation of the 'fair value' at the time of the transaction," and this independent evaluation vested the "Chancellor and Vice Chancellors with significant discretion to consider 'all relevant factors.'"[9]

CONCLUSION: Per Section 262 of the general corporation law of Delaware, "Unless the Court in its discretion determines otherwise for good cause shown, interest from the effective date of the merger through the date of payment of the judgment shall be compounded quarterly and shall accrue at 5% over the Federal Reserve discount rate (including any surcharge) as established from time to time during the period between the effective date of the merger and the date of payment of the judgment"

Thus, even if CRA's minimum fair value is $10/share, given that the Delaware Chancery court adds 5% per year to the value it believes fair, winning a two year court battle against DGX would result in DGX paying at least $11/share to non-tendering CRA shareholders. (I continue to underline "minimum" and "at least" to stress that a minimum fair value is not necessarily equal to fair value; though I risk stating the obvious: fair value may be much higher)

Other Considerations:

Why is Quest, a $10BN market cap company, investing so much time and energy in CRA, a ~$200MM EV before the Quest bid was announced? CRA's revenues will add about 1% to Quest's 2011 revenue growth.  Quest's CEO explains in answer to an analyst's question (I add other excerpts):

Surya Mohapatra - Quest Diagnostics Incorporated - Chairman, CEO

 "Ashim, you are ahead of me actually. First of all, you know we are going to operate Celera and BHL independently and our relationship with Abbott stays and as you know, that this transaction is really, really very important for us and very strategic for us because we have a lot of capability of product development but we didn't have any capability on discovery. And we wanted to really get involved in creating product pipelines so that we can build this compelling business and the disease states.

...the most important thing is that Celera has done a tremendous job as far as creating new discovery and a product pipeline.

...Kathy and her team is going to help us tremendously to have a pipeline and, as you know, it is all about differentiation and what we are doing is transforming the Company from a simple lab company to be a powerhouse of diagnostics

...You know, one of the other exciting things for me is to have Kathy Ordonez and her team on our senior management and leverage her extensive background in molecular diagnostics. And, you know, we have told three or four years ago that we are going to invest heavily in anatomic pathology, genetics and esoteric testing to build up compelling business in cancer, cardiovascular disease, infectious disease and neurological disorders."

These excerpts indicate that much of CRA's value to Quest resides in CRA's pipeline and know-how, yet Quest is not paying for either. Remember one of Quest's conditions for purchasing CRA was keeping the CRA management that Quest felt would be integral to diversifying Quest's business and transforming it into a diagnostics powerhouse.[10] 

Quest's actions suggest it did not consider the drug assets non-negotiable when it unveiled its $7.75/share bid on Jan 27, 2011: Per the history of CRA's interaction with Quest, provided in CRA's SC14D-9 (pages 13-24), CRA discloses that Quest originally bid $10.00 per CRA share but post the publication of a critical KIF6 meta-analysis and editorial, Quest lowered its bid to $7 per CRA share on November 22, 2010 and CRA rejected this offer

"On November 22, 2010, Parent delivered a written non-binding offer letter to the Company proposing to acquire the Company at a purchase price of $7.00 per Share in cash.

The Company Board authorized representatives of Credit Suisse to indicate to Parent that the price was inadequate and that the proposed transaction should be structured such that the Company's drug assets would be separately valued.

In mid December 2010, Parent indicated to the Company that it declined to continue negotiations with the Company regarding a proposed strategic transaction.

On January 4, 2011, Dr. Mohapatra telephoned Ms. Ordoñez to convey Parent's continued interest in the Company. Ms. Ordoñez noted during this discussion that, were the parties to reach an agreement, the drug assets of the Company should be carved out. The Special Committee met telephonically that same day and received an update from the Company's senior management on discussions with Bidder C and Parent. During the meeting, the Special Committee also discussed potential research partnering activities that might be available to the Company.

During the week of February 7, 2011, Ms. Ordoñez and Mr. Green met with Dr. Mohapatra, Robert Hagemann, Senior Vice President and Chief Financial Officer of Parent, and Mr. Shorten at Parent's offices located in Madison, New Jersey to discuss potential deal structures pursuant to which the Company's drug assets would be separately valued, including, for example a structure pursuant to which the Company stockholders would receive (i) per Share consideration in connection with an acquisition of the Company and (ii) a separate contingent value right (on a per Share basis) with respect to future realization of value from the Company's drug assets.

On February 11, 2011, Mr. Shorten telephoned Ms. Ordoñez to indicate that Parent would not agree to a transaction that would involve a separate valuation of the Company's drug assets, such as through the issuance of contingent value rights. Parent indicated that the proposed purchase price of $7.75 per Share in cash set forth in its January 27 offer fully valued the Company and all of the Company's assets."

My takeaway: Ms Ordonez (CRA's CEO), even after Quest walked away in mid December with its $7/share bid, insisted on January 4, 2011, to the CEO of Quest that "the drug assets of the Company should be carved out." This insistence, after Quest walked away in December when CRA recommended such a carve-out, conveys Ms Ordonez's view that Quest would consider such carve-out. The accuracy of her view was confirmed by Quest's CEO and CFO choosing to meet with Ms Ordonez and Mr Green during the week of Feb 7, 2011 to "discuss potential deal structures pursuant to which the Company's drug assets would be separately valued, including, for example, ...a separate contingent value right with respect to future realization of value from the Company's drug assets."  Quest attended this meeting after having discussed such carve-out since December.  If the drug assets were non-negotiable, would Quest have attended such meeting and taken a week to respond to the carve-out request?[11]

Other questions:

Did the KIF6 articles justify a reduction in Quest's bid from $10 per CRA share to $8 per CRA share? On the conference call announcing Quest's bid for CRA (transcript is available at http://sec.gov/Archives/edgar/data/1428156/000093041311002085/c64863_ex-a5d.htm), Ms Ordonez  was asked whether CRA had seen an adverse impact on KIF6 revenues as a result of the critical articles published in October 2010. She stated "We have not seen material adverse impact on our KIF6 volume as a result of publications looking at the risk aspect of that marker in, frankly, a different patient population than that in which we discovered and validated it...the penetration of usage of KIF6 among physicians who are ordering testing on new patients has been quite high". (The full context of this KIF6 discussion is available in the Appendix at the end of this write-up)

Moreover, such questioning of KIF6 is not new. As CRA explains in its 2010 10k, "a presentation and abstract at the annual meeting of the American Heart Association in 2009 claimed that KIF6 carriers were not associated with increased risk for major vascular events (MVE) or response to simvastatin in a preliminary analysis of the Heart Protection Study (HPS)." CRA explains that "Non-replication [of the usefulness of it's KIF6 test in these studies] might be due to a variety of reasons...studies of different design, studies that enroll different types of patients, or studies that compare different drugs. Other reasons include: studies that are statistically under-powered to find such an association; limitations common to case-control studies, such as the absence of fatal myocardial infarctions in cases; analysis of a different clinical phenotype (such as coronary stenosis in CAD, or non-coronary vascular events in MVE) than was done in prior studies; the absence of clinical information on underlying drug use in the case control patients; statin use in the placebo arm of the HPS; and potentially different effects of different statins on KIF6 noncarriers." (page 42)

Also note (in Appendix below) how Quest's CFO comments on Quest's modeling of KIF6; the way he says it is important.  He says he is "very comfortable" with the modeling of KIF6 revenues; he could have said "we feel comfortable". By adding the "very", I believe he is saying that Quest will exceed its cost of capital on this purchase even under low probability, high stress test scenarios.

Full disclosure: I own CRA shares, calls and puts.

APPENDIX:

KIF6 discussion from conference call announcing Quest's bid for CRA (transcript is available at: http://sec.gov/Archives/edgar/data/1428156/000093041311002085/c64863_ex-a5d.htm)

Bill Bonello - RBC Capital Markets - Analyst : Okay, great. And then in terms of - this is a question for both Kathy and Surya, in terms of KIF6 trends, I am wondering, Kathy, if you can tell us what you are seeing lately in terms of demand for KIF6? Has that growth slowed at all in light of some of the latest studies that have come out? And then Surya, whether you could comment on whether this is a test specifically that - sometimes there is tests you don't offer that doctors are sort of telling you they wish you had; does this fall into that category?

 Surya Mohapatra - Quest Diagnostics Incorporated - Chairman, CEO

 Okay, I can tell you that first but if people have told us that I wish you had KIF6 but you know like any science discovery, Bill, there are always some papers and as we do more and more tests, people realize there are some positive some negative, but Kathy is going to add more, but what is really interesting for me is that although some paper came out but still the KIF6 -people are ordering KIF6 to know whether their statin is working or not.

 But I am sure once we know one particular product there are other products in (inaudible) so Kathy why don't you tell Bill what you see at KIF6 now?

 Kathy Ordonez - Celera Corporation - CEO

 Sure. We have not seen material adverse impact on our KIF6 volume as a result of publications looking at the risk aspect of that marker in, frankly, a different patient population than that in which we discovered and validated it.

Bill Bonello - RBC Capital Markets - Analyst: And Kathy, would you say it is continuing to grow at the same rate that it had been or not in percentage but sort of in - are you sort of increasing tests in absolute amount sort of at the rate you had been?

Kathy Ordonez - Celera Corporation - CEO

 I think the important dynamic, because as we have talked about, the penetration of usage of KIF6 among physicians who are ordering testing on new patients has been quite high. The real growth driver for KIF6 and, frankly, our other genetic tests is sample volume, and that is what is critical now.

 Bob Hagemann - Quest Diagnostics Incorporated - SVP, CFO

 And Bill, this is Bob. I would comment that, yes, we looked specifically at each of the tests that Celera is selling, each of the tests that are in the pipeline, and developed views on how we thought each of them would grow and we feel very comfortable that we have conservatively modeled KIF6 at this point.

[1] CRA has described Odanacatib as a, "possible replacement for Merck's Fosamax® franchise with peak revenues over $3 billion." (Jan 13, 2011 JP Morgan conference presentation, slide 22) MRK plans to file an Odanacatib NDA in 2012.

[2] This bid represents the mid-point of Bidder C's bid in Feb 2011. I explain why I assume 60% in section#3, which elaborates on this bid

[3] "The estimated Company unlevered, after-tax free cash flow through 2015, derived from the EBIT projections set forth in the February 2011 Forecast and based on guidance from Company management with respect to the adjustments for non-cash expenses, capital expenditures and working capital adjustments, was as follows (in millions):

Credit Suisse calculated the present value of the Company's interest in its non-commercial, development stage drug assets based on forecasts of launch dates, peak sales and milestone and royalty payments for the Company's non-commercial, development stage drug assets by the Company's management and publicly available research analyst reports. In performing this analysis, Credit Suisse combined traditional discounted cash flow methodology with estimated clinical-trial success rates to yield probability-adjusted after-tax free cash flows related to each drug asset. The probability rates for clinical trial success were derived from a study published in 2002 by the Milken Institute based on data from the Tufts University Center for the Study of Drug Development, and were not based on any judgment with respect to the particular drug assets. These cash flows were discounted at a range of 13.0% to 15.0% based on the Company's estimated weighted average cost of capital. Credit Suisse chose this range of discount rates as appropriately illustrative based upon its assessment of certain financial metrics for the Company and other companies it deemed comparable.

The Company's NOLs were included as part of the Company's financial assets assuming no limitation on their application. Credit Suisse calculated the present value of the tax savings to be derived through the use of the Company's NOLs through 2020 by applying discount rates ranging from 13.0% to 15.0% based on the Company's estimated weighted average cost of capital." (page 37, SC14D9 filed March 28, 2011)

[4] See BVF's 13D filed in Feb 2010 at: http://sec.gov/Archives/edgar/data/918923/000092189510000159/sc13da107422_02092010.htm

[5] As you will see below, my low-end present value of CRA's tax assets is $45MM, derived by Credit Suisse. CRA's tax assets as of 12/25/2010 were $139MM and the net tax assets were $112MM.

[6] Source: CRA's SC14D-9, p19-21

[7] The adjusted long-term tax-exempt rate can be found at http://www.pmstax.com/afr/exemptAFR.shtml

[8]See section entitled "Discounted Cash Flow Analysis" under Item 4 in the following document link: http://sec.gov/Archives/edgar/data/1428156/000119312511100762/dsc14d9a.htm

[9] Source: http://www.natlawreview.com/article/delaware-supreme-court-holds-chancery-court-not-bound-merger-price-or-fairness-opinion-appra

[10] "On February 22, 2011, the Company Board met telephonically to discuss Parent's proposal and Parent's requirement that the execution of a definitive merger agreement be conditioned upon (i) execution of an employment agreement with Ms. Ordoñez and offer letters with certain other members of the Company's management and (ii) receipt of confirmation from Abbott that following the closing of the proposed transaction, neither Parent nor any of its affiliates (other than the Company) would be subject to certain provisions of the Abbott Agreements." (Source: CRA's SC14D-9, page 22)

[11] Quest took several days after this meeting to convey its decision to reject the carve-out despite having discussed this topic at length internally and with CRA for several months.