Description

Description.  

Date: 11/24/2015

Summary

Through the current activist nomination window, Depomed (DEPO) offers an extremely attractive event-driven risk-reward. Due to DEPO's California incorporation, a shareholder friendly jurisdiction, the company has extremely weak corporate defenses - leaving a clear and open path for an activist shareholder to call a special meeting and replace the board. Any shareholder has the ability to call a special meeting with just 10% of votes and then replace the annually elected board with a simple majority of votes. Horizon Pharma (HZNP) recently launched a hostile bid for the company, acquiring ~4% of the company and overwhelmingly collecting the 10% of votes needed to call a special meeting (in fact, it's possible they already received over 50% of shareholders requesting a meeting to throw out incumbent management), which they planned to call in January 2016. After calling the meeting, Horizon publicly stated that they planned to canvass DEPO's shareholders to obtain the market-clearing price that Depomed shareholders required to get HZNP 51% of the vote. Indications from top DEPO shareholders is that the price was probably mid to high $20s per share, against a DEPO close yesterday of $17.90, a >50% premium. An acquisition of DEPO would be a win-win for both sets of shareholders (indeed, the significant shareholder overlap between the companies is what spurred the initial conversations). An acquisition of DEPO at a 50% premium would be extraordinarily accretive to HZNP: DEPO pays a full mid 30s tax rate while HZNP is domiciled in Ireland and has a single digit tax rate; HZNP operates more efficiently than DEPO with higher margins; there are SG&A cost-cutting opportunities; and finally, DEPO has debt outstanding owned by Deerfield at a nearly 11% coupon which HZNP can refinance at less than half that rate. The combination of these savings drives in excess of 30% of excess earnings power at the pro forma company while further diversifying both portfolio of drugs. Note that it is not a coincidence that Depomed's debt is held by Deerfield. Deerfield is HZNP's #2 shareholder, and HZNP has placed an ex-Deerfield partner on its slate of directors.

However, despite the obvious benefits to a transaction and the clear will of shareholders, DEPO filed a frivolous lawsuit in California state court asking for a trial in April 2016 regarding potential mis-use of confidential information related to Nucynta - effectively asking the judge to temporarily halt HZNP's bid until they hold a trial, and then assuming DEPO lost the trial, HZNP would be allowed to re-bid then. Of course, by requesting the trial in April, this effectively prohibited HZNP from purchasing the company in the January 2016 special meeting timeframe, for which they have already collected the required votes.

This leaves DEPO in a vulnerable and interesting position today - on a standalone basis, they trade at just ~10x 2017 earnings, are growing earnings between 10%-20% a year and are generating a significant amount of free cash flow. By way of example, prior to the HZNP bid, DEPO traded $21/sh - since then they have executed their relaunch of Nucynta and raised full year guidance twice; yet closed yesterday under $18/sh. The company is clearly undervalued on its own now; however, the real upside comes from a shareholder filing during DEPO's nomination window and effectively stepping into Horizon's shoes to refranchise shareholders. By filing a slate of directors (or using the directors Horizon has already submitted), a shareholder gets to piggyback off of the work Horizon has already done over the past three months in convincing shareholders of the merits of the deal, can have the board drop the lawsuit, and then participate in the upside as Horizon has publicly stated they are willing and able to pay a significant premium to today's price immediately. Horizon's own shareholders are enamored with the deal as well - on the day Horizon made their public bid, their own stock appreciated significantly (and note, to the extent DEPO agrees to a partly stock offer, they get to participate in this upside). There are further sources of upside as well - when Horizon initially launched their offer there were numerous reports of other companies who enjoy similar synergy potential (e.g. the ability to refinance high coupon debt and pay low tax rates) who have been interested in bidding on DEPO's high quality portfolio of assets - specifically ENDP has been mentioned as a potential acquirer in news reports, which follows their stated strategy of strengthening their pain franchise via accretive acquisitions. DEPO should be required to explain to its shareholders why it has failed to engage up to this point, and either demonstrate a high 20s standalone value on its own, or run a strategic alternatives process and/or engage with Horizon. To entrench themselves while depriving shareholders has hurt the company's multiple as management has lost shareholder trust. We provide further detail below.

Company Descriptions
Depomed is a specialty pharmaceutical company focused on pain and the central nervous system. Depomed acquired its flagship product, Nucynta, an opioid for moderate to severe chronic neuropathic pain, from Johnson and Johnson on April 2, 2015 for $1.05 billion. Nucynta competes with Oxycontin and Opana ER and has patent protection well into the 2020s, but was overlooked as a minor drug at Johnson & Johnson where it was not reaching its full potential. Upon acquiring the asset, Depomed formally relaunched Nucynta with an additional 250 person salesforce driving script growth 14% year over year. Other products in its portfolio include Gralise, a once-daily formulation of gabapentin for shingles that competes with Lyrica and Neurontin; and Cambia, an oral solution for acute migraine that competes with over-the-counter NSAIDs. Nucynta, Gralise and Cambia are expected to contribute ~62%, ~20% and ~8% of Depomed’s 2016E revenues respectively.

Horizon Pharma is a biopharmaceutical company with seven commercial products in pain, orphan and rheumatology. Key products are Vimovo, an arthritis and stomach ulcer drug (20% of 2016E sales); Actimmune, which has orphan dictions for Chronic Granulomatous Disease and Severe Malignant Osteopetrosis (18% of 2016E sales); Duexis, also for arthritis and stomach ulcers (16% of 2016E sales); Ravicti, an oral liquid for urea cycle disorders (19% of 2016E sales); and Pennsaid, an NSAID for osteoarthritis of the knee (19% of 2016E sales). The company is undergoing Phase III trials in Actimmune for Friedreich’s Ataxia, which management believes have sales opportunity of $800mm to $1.5bn in 2020. Horizon inverted to Ireland last year following its acquisition of Vidara and therefore enjoys an advantaged single digit tax rate . Through its HorizonCares program, it guarantees payments for drugs regardless of whether the patient is covered for its drugs under insurance and eliminates script fulfillment friction for doctors.

Situation
On July 7, 2015, Horizon issued a press release making a public proposal to acquire Depomed in an all-stock transaction valued at $29.25 per share or 42% premium over previous day closing price. A week later, Depomed unanimously rejected Horizon’s bid and adopted a poison pill. On July 21, Horizon raised its all-stock transaction to $33/share. On August 3, Horizon initiated a process to call a special meeting to remove all of Depomed’s directors and invalidate Depomed’s poison pill in court. Despite Horizon’s overtures, Depomed repeatedly refused to engage in negotiations with Horizon on a potential M&A transaction or launch a strategic alternatives process. Depomed also filed a baseless counter-suit alleging Horizon had breached its non-disclosure agreement it had signed with Janssen pertaining to confidential information on Nucynta. On November 19, 2015, a Court in Santa Clara California with relatively little sophistication issued a preliminary injunction preventing Horizon from taking any actions to replace the current board until a full trial in April 2016, conveniently timed three months after Horizon planned to increase its offer and remove the Depomed board. However, this injunction only applies to Horizon - a shareholder wishing to hold Depomed to it's proper fiduciary duties can nominate their slate immediately, replace the board to waive the confidentiality agreement and thus provide the opportunity to run a strategic process.

Note that there is tremendous shareholder overlap between Horizon and Depomed, which bolsters support for Horizon’s bid. Based on our analysis over 50% of Depomed’s shares were owned by cross-holders and hedge funds, who are supportive of a takeover. A number of top ten Horizon shareholders have also historically been top ten Depomed shareholders as well. DEPO's CEO is also personally awarded over $20mm in a change of control.

Depomed never initiated a sale process, but there are a number of potentials buyers for the asset. A July 20 Dealreporter article indicated that Endo was weighing its own bid for Depomed at ~$32/share. Endo sells Opana ER, a competitor to Nucynta, and is familiar with acute pain space. Another potential suitor for Depomed is Mallinckrodt, which has a formidable pain franchise, an Irish tax address, a penchant for M&A, a need for diversification due to its own issues and is an existing partner with Depomed. Mallinckrodt pays Depomed a high single digit royalty rate to license its Acuform slow release drug delivery technology, which expires in 2029, for both Xartemis XR (peak sales $35-$70mm) and MNK-155 (peak sales $135-$270mm). Any interloper involvement will drive the purchase price higher. We think that Endo and Mallinckrodt’s abilities to pay are in the mid to high $30’s and both have desire to diversify their business to Depomed's scarce cadre of patent protected drugs.

Horizon’s stock performance has been suppressed in the recent months as a result of negative investor sentiment following the fall-out of drug pricing scandals involving Turing and Valeant, despite having blown out two consecutive earnings releases since its original takeover proposal and repeatedly demonstrated to the market that it operates fully independently, including via a comprehensive analyst day just two weeks ago. Due to these market conditions, we think that a revised offer from Horizon would be in the form of cash and stock. Management has suggested that they would use as much cash as possible. At its November analyst day, Horizon provided an illustrative analysis of potential leverage levels suggesting over $1.5 billion of funding available on a standalone basis at 5.75x max leverage. Pro forma for Depomed EBITDA and synergies, the company has ability to raise up ~$2b billion of debt and pay 80%+ of Depomed considerations in cash assuming $28/share bid.

Pro forma for the transaction, on a DCF basis, the combined Horizon/Depomed combination is worth in the high $30’s. We projected cash flows of the top drugs through patent expiration. We assumed 25% cost synergies (Horizon cut 70% of SG&A in the Hyperion transaction), 3% savings from refinancing of Deerfield’s L+9.75% high yield debt (Horizon has guided to 5% interest saving) and Horizon’s single digit tax rate. We used 10% WACC (according to Bloomberg, Depomed’s actual WACC is 6.3%). The NPV of the total cash flow and value of its royalty stream less net debt and Deerfield debt breakage fee is ~$32/share. This is not including any potential revenue synergies that Horizon has not publicly announced. Horizon's business development activities provide further upside. On a P/E multiple basis, the pro forma company would earn well over $2/sh in 2017, driving a share price in the mid to high $30s.

On a standalone basis, Depomed is worth between $19/sh and $26/sh based on a blended DCF, EV/EBITDA and P/E multiple basis. . Note that Depomed relaunched Nucynta only this June and the full effects of the relaunch will not be fully in effect until 2017. Management believes that Nucynta can become a $500 million drug by 2018, implying a 24% 3-year CAGR, and $1 billion drug by end of exclusivity in 2028.

Catalyst

Catalyst

Amended and increased cash and stock offer from Horizon following shareholder pressure at Depomed; an alternative offer from a competitor; or a re-rating of standalone Depomed.