MDS INC MDZ
September 29, 2009 - 1:15am EST by
Nails4
2009 2010
Price: 8.00 EPS N/A N/A
Shares Out. (in M): 120 P/E N/A N/A
Market Cap (in $M): 950 P/FCF N/A N/A
Net Debt (in $M): 0 EBIT 0 30
TEV ($): 900 TEV/EBIT N/A N/A

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Description

 

MDS is not an easy company to understand. Prior to a few weeks ago, it had three completely different business lines. It's currently undergoing a complicated and dramatic restructuring, and it faces significant operational, legal, and political uncertainties. Despite all that, we think MDS offers extremely attractive upside, for almost no risk. Given the complexity of the situation, we are guessing the market is simply overlooking it.

Prelude

First, let's get the boring bits out of the way. Here is the Cliff Notes version of the company's business and future plans. Prior to September, MDS owned three business lines.

  • Analytics: making mass spectrometers and other very high end scientific instruments
  • Pharma: contract research organization (CRO) for biotechs and large pharmaceutical companies. This is similar to companies like CRL, CVD, PPDI, etc.
  • Nordion: processes and sells radioisotopes. Radioisotopes are exactly as they sound--radioactive atoms used to diagnose and treat diseases, to irradiate food, to sterilize bandages, and so on. We'll spend most of our time here.

Coming into 2009, all three business segments were in trouble, victims of the economy (and other things we'll talk about later). So despite having a rock solid balance sheet, the stock performed very poorly. However, on September 2, the company announced that it's selling the Analytics business to Danaher for $650 million in cash, versus a then market cap of maybe $700 million. Concurrently, they announced that the remainder of the Pharma business (parts of which had already been on the block) is for sale as well. Most of the proceeds are earmarked for stock buybacks and debt retirement. When this is done, the only business line left will be Nordion. As it was obvious the company was essentially trading for less than cash, the stock rallied massively on the news, going from $6 to $8.

By our nature, our interest tends to pique when stocks fall, not rise. However, MDS is an exception. It seemed to us that the stock didn't go up enough!

To demonstrate this, we need to figure out two key factors. One: Nordion's value, which is MDS's core business going forward. Two: how much the Pharma segment will fetch. When we are done, we will add together these pieces, plus the current net cash and the net proceeds from the Analytics sale and come up with the total valuation of the company.

NRU, AECL, MAPLE, PCR, and Other Fun Acronyms (OFA)

Nordion is a hard puzzle to crack, as it faces uncertainties on many different levels and is a unique business with no pure-play competitors. To understand this beast, let's start with a little history.

Once upon a time, Nordion was owned by the Canadian government. In 1991, a right-leaning Canadian administration decided to privatize it, creating the core of the present day Nordion. The centerpiece of this privatization was an exclusive long term contract between Nordion and Atomic Energy of Canada (AECL), a government owned corporation that does nuclear related research, builds nuclear reactors, and things like that. AECL owns the nuclear reactors that produce raw isotopes (Molybdenum-99, or Mo-99), Nordion processes and markets them and shares the revenue. We think Nordion probably got the better end of this deal, as AECL does most of the heavy lifting, including building and maintaining expensive reactors and getting rid of the radioactive waste. To this day, this contract represents over a third of Nordion's revenues and over half of its profits.

But this happy tale has a flaw: the main reactor (National Research Universal Reactor, or NRU) responsible for producing these isotopes is almost 60 years old, and will be obsolete soon. Nordion's management long foresaw this problem, and negotiated with the AECL over a decade ago to build two new reactors, known as MAPLE, to replace the NRU. As you can imagine, building nuclear reactors is a tricky business, and the MAPLE project almost immediately ran into problems. After a massive ballooning of costs and years of delay, MAPLE finally neared completion in 2003, when another lightening bolt struck.

The problem: contrary to its design, MAPLE had a positive power coefficient of reactivity (PCR). Without delving too deeply into nuclear physics, PCR essentially means that the reactor runs "hotter" as power increases. This is very bad because it makes the reactor more vulnerable to accidents and meltdowns; in contrast, a negative PCR acts as a "check" on reactor activity if things go awry. Although a positive PCR does not theoretically disqualify a reactor from operating safely, regulators were understandably extremely reluctant to take chances, and MAPLE was cast into bureaucratic purgatory. Several more years of hand wringing, renegotiations, recrimination, expensive tests, and feasibility studies failed to fix the issue. Then finally, in May 2008, AECL unilaterally terminated the MAPLE project.

Nordion reacted predictably. The company sued AECL and the Canadian government for CAD$1.6 billion and is simultaneously negotiating with AECL to resurrect MAPLE. Nordion is optimistic in its case, as AECL's actions seemed to clearly violate their most recent contract, which required AECL to finish MAPLE. Meanwhile, this drama morphed into a messy political battle. On one hand, nearly all of the world's Mo-99 supply, which is critical in diagnosing a variety of life threatening illnesses (e.g. cancer), comes from five ancient reactors that are increasingly unreliable. MAPLE was the world's best immediate hope in remedying the situation. On the other hand, MAPLE is a virtual budgetary black hole for the Canadian tax payer. Fixing the PCR issue threatens to make the hole much blacker and deeper, because nobody knows how much it will really cost. Prime Minister Harper recently made some press comments about how "Canada will be out of the isotopes business"--this is not good.

At this point, let's leave this particular mess and nosedive into another: the ancient reactor known as NRU. NRU is the world's largest supplier of Mo-99 with a 40% market share. However, this old workhorse is definitely suffering from rheumatoid arthritis. In recent years, the reactor's reliability diminished, necessitating periodic unplanned shutdowns. This is always a tricky proposition, owing to NRU's vital position in the isotopes market. For example, in 2007, responding to a worldwide isotope shortage, the Canadian government actually passed emergency legislation to force NRU to restart after it shut down to install some safety-related equipment. Then, in May 2009, a much more serious problem arose when a heavy water leak was discovered at the base of the reactor vessel. NRU was forced to shut down for major repairs and doesn't expect to be running until early 2010. This incident, although dramatic and costly, is only symptomatic of a deeper issue--the reactor simply cannot run for much longer, no matter how much AECL patches it up.

Nuclear reactors are subject to strict licensing rules and NRU is no exception. Its current license expires in 2011 and AECL will likely push for a renewal to 2016. However, this is probably the last renewal the reactor will see. Although it's not certain, as NRU may need additional (expensive) upgrades to get the renewal, we are optimistic. Primarily, we think the world needs more than five years to obtain another supply of Mo-99 to replace NRU. Politically, it's probably worthwhile to spend the additional capital to buy some time and to avoid a breakdown in a critical medical service. On the other hand, we also think that NRU will continue to diminish in reliability, which will unfortunately impact Nordion's revenues.

Needless to say, the twin MAPLE and NRU fiascos are a huge cloud hanging over Nordion. There is significant operational, legal, and political uncertainty, which the market absolutely hates. Accordingly, it seems to us, based on MDS's stock price today, that almost no value is being assigned to the Nordion business. We will demonstrate later that this is a mistake.

Mo, Tc, and the Fastest Depreciation Schedule in the World

Before we get ahead of ourselves, we need to talk about the Mo-99 supply chain. A deeper understanding of industry dynamics is vital to gauging Nordion's future without NRU or MAPLE.

The process starts with a chunk of metal containing Uranium-235 (a.k.a. atomic bomb fuel). This metal is placed into a nuclear reactor, which bombards it with gazillions of neutrons. The U-235 absorbs the neutron and splits into new atoms (fission). A small percentage of the these new atoms are Molybdenum-99.

The chunk of metal containing Mo-99 is removed from the reactor after a few days and is dissolved by extremely strong acids into a nasty soup. Heavy duty chemical processing then "filters" this soup, extracting the useful Mo-99 and discarding the corrosive, radioactive dregs. This waste is AECL's responsibility.

The resultant Mo-99 is shipped from NRU to Nordion's facilities nearby, where it undergoes some further processing before being shipped to a company called Lantheus, who makes a device called a Technetium Generator.

Let's back track a step. Technetium-99 (or Tc-99), not Mo-99, is actually the useful product we are looking for. When Mo-99 undergoes radioactive decay (an unavoidable, automatic process), Tc-99 is the result--hence the need to make Mo-99. Anyway, Tc-99 is radioactive, and can be bound to various pharmaceuticals. These drugs are absorbed by the body in different ways: one might go into the brain; another might target breast tumors. At this point, imaging equipment can detect the radiation from Tc-99. The resultant picture, similar to an X-ray film, is extremely useful in diagnosing a vast variety of diseases.

So, back on topic: A Technetium Generator is a fat, short barrel (like a small trash can or a large thermos) shielded with lead, holding a core of Mo-99. Lantheus ships these barrels to hospitals, who extract Tc-99 as they need it. The barrels last about a week.

When reading all this, it's important to keep in mind that this entire process involves miniscule amounts of material--millionths of grams at a time. I read a recent government study that claimed a single gram of Mo-99 is worth $46 million.

But of course, a gram of Mo-99 is not worth anything if you can't sell it in time. Here, we introduce to you the most important concept in the entire industry: the half life. If you remember some high school physics: through radioactive decay, one isotope will gradually change into another (we already mentioned that Mo-99 decays into Tc-99). After one half life pass, 1/2 of the original isotope remains. After two half lives pass, 1/4 of the original isotope is left, and so on it goes. Some half lives are hundreds of years long, others are measured in microseconds. Mo-99 and Tc-99, our stars of the day, have half lives of 66 hours and 6 hours, respectively.

These half lives have vast implications on how the industry operates. If you do the math, it turns out Mo-99 decays at a rate of about 1% per hour. So imagine if you have a gram of Mo-99 and then decided to take a nap. When you wake up, you would have lost $460,000. If you delayed a whole day, you lost $10 million. The half life also explains the role of Technetium Generators in the Mo-99 supply chain: because of its extremely short half life, hospitals have to retrieve Tc-99 multiple times per day from the generator and it's nigh impossible to transport Tc-99 over significant distances.

The challenge of the half life means that the isotopes industry has to be among the leanest in the world. Logistics and efficiency are paramount--even an hour of delay anywhere can take huge chunks out of operating profits. No doubt, this can prove costly, especially given the overall fragility of the supply chain, which spans the globe. However, it's also a very stiff barrier to entry because of the steep learning curve presented to would-be competitors. Not only do they have to build critical relationships with nuclear plant operators and hospitals, but also if they are just a tiny bit less efficient than the incumbents, they will lose big money. Thus, it's no surprise that a very small number of companies dominate Tc-99: Covidien COV and Nordion account for 60% to 70% of the market.

The second implication is that Nordion's Tc-99 business is utterly dependent on NRU and/or MAPLE. There are other reactors being proposed in the U.S. and elsewhere. However, Nordion simply cannot afford the logistical delay in shipping isotopes from Missouri or Argentina or nearly anywhere else into its main facility in Ottawa. In other words, this facility is a stranded asset and will be impaired if NRU is gone and MAPLE doesn't get fixed.

Nordion Valuation and Outlook

As we said before, Mo-99 is not Nordion's only business line, although it's probably the best one and accounts for a bit over 50% of segment profits. The other businesses are Cobalt-60, and Radiopharmaceuticals. Let's run through these quickly.

Cobalt-60

The biggest use of this isotope is to sterilize medical supplies, ranging from bandages to syringes to surgical instruments. This is a large but mature market and is growing in line with medical expenditures.

Essentially, radioactive Co-60 is loaded into a machine that "channels" the radiation onto whatever you are trying to sterilize. There are a few competing technologies, principally ethylene gas and electron beam. We won't bother explaining these in detail, but the important thing is that each technology has certain applications best suited for it. For example, Co-60 radiation can discolor certain surfaces and make certain materials more brittle. So, for these, ethylene gas is used. Over time, the market shares of these technologies seem to have stabilized. It bears to mention that all three technologies have been around for decades and are all well established.

Nordion is the world's principal supplier of Co-60, with an 80% market share. It has decades-long exclusive partnerships with several Canadian nuclear power plants (CANDU reactors) to produce raw Co-60 on a contract basis. The process is relatively simple: Co-59 is loaded into the reactor core, and is bombarded with neutrons. Eventually, the Co-59 absorbs an extra neutron and becomes Co-60. It takes almost two years to make a single batch of Co-60, and for this reason Nordion's revenues can be a bit lumpy, depending on exactly when a batch is completed. The reactor core does need to be modified to accept Co-60, so not every power plant is capable of, or is willing, to produce Co-60.

Co-60 has a relatively long half-life of 5.2 years, translating into roughly 12% of decay per year. The implication is that sterilization machines must be re-fueled periodically. This recurring revenue stream is this segment's bread and butter.

Altogether, selling Co-60 is a pretty good business. Pricing power is strong, barriers to entry are high, and demand is steady. Although price is not terribly transparent, the company told us that it gets base pricing increases several times per year, ahead of inflation at a minimum. MDS also has plans to expand by acquiring a new stream of raw Co-60 from Russia, which is slated to grow volumes 30% through 2016. Unfortunately, the company doesn't break out the margin contribution explicitly here, but based on last quarter's results, we think the EBITDA margin is around 25%.

Radiopharmaceuticals

This business line is small (described to us as being "well less than a third of Nordion revenues" by the company), but is relatively fast growing. The company is pretty tightlipped on performance and strategy, but disclosure may improve once the Analytics and Pharma segments are sold.

There are two major products here. The first is TheraSphere, which is a fancy name for atoms of Ytrrium-90 encased in tiny glass balls, used to treat inoperable liver cancer. The Y-90 has a very short half life so the radiation has little long term affect on patients. The FDA granted limited approval for TheraSphere in 1999 under a HDE license (much lower bar for approval, only for less than 4,000 patients a year). Given the newness of the technology, acceptance by doctors has been slow but improving (last Q had 23% growth, but that decelerated from previous quarters). That said, the path forward is very murky. On one hand, the limited FDA approval may mean that the ultimate market is small. But, increasing doctor's acceptance, additional positive clinical data, and a potential change in reimbursement policies in Europe and the U.K. (whose government healthcare agencies do not reimburse for the procedure), may trigger another big growth spurt down the road.

The other product is called Glucotrace, which is a branded version of a molecule called FDG--essentially a radioactive glucose molecule used in PET scans. Nordion just started a facility in Belgium dedicated to this, so we might see a small revenue bump next quarter. At first glance, this product seems to have a lot of potential--Glucotrace's half life is extremely short at just 110 minutes, meaning that hospitals need to be extremely close to suppliers to do PET scans, and suppliers might come to dominate their respective localities. Unfortunately, barriers to entry are also very low, as Glucotrace (and generic FDG) are produced in cyclotrons, not a nuclear reactor. Cyclotrons are pretty cheap to build at just a few million dollars, and there are a lot of them in existence. Nordion's strategy seems to establishing a brand name around Glucotrace, but this is probably an uphill battle.

In general, although there is clearly potential in Radiopharmaceuticals, we are not prepared to assign a lot of credit here, though if something works out, we are prepared to be pleasantly surprised.

Earnings Power and Baseline Nordion Valuation

Using company disclosures, the last quarterly results, and making some of our own assumptions, we think Nordion without NRU and MAPLE can earn about $40 million in EBITDA a year conservatively. Last quarter, stripping out a derivatives gain, the business earned about $10 million EBITDA, with abnormally low Co-60 shipments. But currency was a small tailwind.

Then, we subtract from this number some corporate expenses, which we estimate at around $10 to $15 million, leaving somewhere between $25 and $30 million in "baseline" EBITDA. Formerly, the "corporate expenses" would have been about $25 million. But, with the divestiture of Analytics and Pharma, they are shutting down a lot of the old corporate functions, will fire 110 people, and the old CEO is leaving, replaced by the COO. My understanding is that the COO will not be replaced. We figure the $25 million can drop to $15 million fairly easily.

Given the modest cash tax rates and capital investment needs, most of this turns into free cash flow. We think this earnings stream is worth about $200 million, which translates into 7 to 8 times baseline EBITDA, a high-single-digit free cash flow yield, or about 10 times earnings. Given this high quality of the Cobalt business, we are very comfortable with this number. And in fact, it may be conservative.

Next, we should include the cash MDS should receive from selling Mo-99 from the NRU before it's shut down for good in 2016. Remember, we are pretty optimistic that NRU's license will renew in 2011. The truth is, Mo-99 is a superb business thanks to MDS's sweetheart contract with NRU. In a normal year, this generates between $40 and $50 million in EBITDA, which again overwhelmingly converts to free cash flow. We have almost seven years of this earnings stream between early 2010 (when NRU is scheduled to restart) and 2016. Of course, how you should value this earnings stream is up for debate, given the uncertainty of the license renewal and the diminishing reliability of the reactor. For ourselves, we ran a discounted cash flow model with pretty conservative assumptions and came up with $100 million. Intuitively, this translates into 2x "normalized" EBITDA, and maybe 3x annual free cash flow. (FYI: assumptions included 25% drop in reactor availability, 15% discount rate, 25% cash tax rate, minimal cap ex)

So, we think no matter what happens with MAPLE, Nordion is worth $300 million. At this point, let's take a step back and look at what the market is valuing MDS at.

Intuitive Look at MDS Valuation

As I write this, MDS has a $950 million market cap. We know the company will receive after fees about $600 million from selling the Analytics business (taxes are minimal). Also, we concluded that Nordion is worth at least $300 million, no matter what happens with MAPLE.

This implies that the rest of the company is being given away for next to nothing! Of course, that's not true. The Pharma segment certainly has positive value, and MDS has a healthy amount of net cash plus some other assets on the balance sheet. On top of this, as MDS is in arbitration with AECL and is suing the Canadian government for CAD$1.6 billion, a material positive outcome is not out of the question. In other words, some sort of a positive resolution on MAPLE and NRU represents a substantial imbedded call option for shareholders.

Call Option Valuation

We see two realistic positive outcomes stemming from the legal actions against AECL and the Canadian government. The $1.6 billion number is saliva inducing, but we don't think such a big award is likely. Indeed, MDS's current legal strategy seems to be to pursue the arbitration with AECL with all of its resources, and to use the gigantic lawsuit as a lever in these negotiations. In other words, the $1.6 billion lawsuit is effectively in hibernation, a Damoclean sword.

The first and best outcome is if AECL is compelled to complete MAPLE, as they originally promised to do. If this happens, then the cloud of uncertainty hanging over Nordion dissipates and Nordion is transformed into a very good business, with dominant market positions over Mo-99 and Co-60. Here, Nordion can easily earn EBITDA between $80 and $90 million a year and can be easily worth $800 million, owing to the quality of its franchise. This obviously would produce a huge boost to the stock price.

The second realistic outcome is a substantial financial settlement from AECL and the Canadian government. Instead of $1.6 billion, we think a more realistic number is $350 million. This basis behind this number requires a bit of history: AECL originally did not own the MAPLE project. Instead, MDS owned MAPLE and spent most of the initial capital--$350 million. In 2006, as uncertainty mounted, MDS transferred ownership of MAPLE to AECL, in exchange for AECL's promise to finish the project. AECL, of course, stiffed MDS. It seems plausible to us that MDS ends up recovering its investment in MAPLE. Another factor may weigh into this scenario: the Canadian government is thinking about privatizing AECL. If this happens, they probably won't want a giant lawsuit hanging over the company (investors generally don't like that). We think this makes a financial settlement somewhat more probable.

Please keep the $350 million and $800 million numbers in mind for later.

The Balance Sheet

At July 31, the balance sheet showed about $50 million of net cash, but we have to make several adjustments. First, there are several "hidden" assets, consisting mostly of $75 million in Other Long Term Assets, which are essentially money owed to MDS by the Canadian government and AECL (these arose from some previous legal actions and an old asset swap). Also, there is about $10 million of asset-backed paper, recorded at fair market value, which MDS foolishly bought a few years ago (and suffered a big loss on). Offset against these is a $20 million (net of tax) penalty for retiring its senior bonds early, which they plan to do with the Analytics proceeds.

A little arithmetic later and we have a final "cash" balance of $115 million. We'll save this number for later.

Pharma's Worth

Pharma is a contract research organization (CRO). Essentially, they work for biotechs and pharmaceutical companies to help develop new drugs. However, valuing this division is difficult, mostly because MDS's old management team made a complete mess of what should be a decent business. The entire segment barely made a dime in the past five years, despite being in a "hot" and rapidly growing industry.

The problems started in the early 2000's, when MDS screwed up some bioequivalence studies, which are used to test generic drugs versus branded drugs. The FDA came down hard, and MDS suffered greatly. Although the FDA issues were eventually resolved, MDS's reputation was shot. It incurred huge impairment and restructuring costs; new customers were scarce and old customers sued them.

But that doesn't mean Pharma's assets are worthless. In fact, we think to the right buyer, this business can be quite valuable. Let's take a closer look at this segment's various constituents.

Roughly, Pharma can be split into two parts: Early Stage and Late Stage, with early stage being a bit bigger. Then, these can be broken down further. Early Stage consists of Preclinical, Phase I, and Bioequivalence. Needless to say, the Bioequivalence portion has shrunk substantially. Aside from that though, Early Stage is actually not a terrible business. In particular, MDS is the second or third largest Phase I provider in the world. They also opened a brand new 350 bed facility in Phoenix about a year ago.

Late Stage is another story. This piece can be broken down into Central Labs and Phase II-IV. Phase II-IV, in particular, is bad news--despite substantial effort and investment in recent years, this business never attained the scale to generate significant profits. Unlike the strong market position of Phase I, Phase II-IV is more like the 10th biggest player in the industry. Moreover, late stage contract research depends more on reputation, so MDS's soiled moniker certainly didn't help. Central Labs is basically a big lab that does tests (like blood samples) on a contract basis. It's a bit stronger, but it's not that great either. Even though management doesn't break out margins between Early Stage and Late Stage explicitly, I suspect that the strong Preclinical and Phase I businesses are subsidizing the weak Late Stage ones.

The good news though, is that the terrible Phase II-IV has already been sold--for net proceeds of $40 to $45 million. This is great because we know the book value and rough revenues attributable to this business, and can use it as a baseline to value the other parts. In particular, the $40 to $45 million price tag represents about 1.15 times book value and roughly 0.35 times 2008 revenues (I may be off a bit on the revenue multiple, but I don't think by much). Since Phase II-IV is by far the worst chunk of Pharma, the rest of the pieces should command much higher multiples.

At this point, you might wonder: why would anyone pay for these substandard, potentially money losing businesses? The answer is that MDS's mismanagement and impaired reputation meant that it was extremely difficult for Pharma to achieve critical scale. A strategic buyer, with a better reputation, can create enormous value if it's able to buy up the facilities, retain some of the existing clients, and channel additional volumes through them. Contract research is ordinarily a pretty profitable business: MDS's competitors command operating margins in the mid-teens.

Since Pharma doesn't make money, we used multiples analysis for our valuation. We think Early Stage is at a minimum worth $150 million, and Central Labs is worth about $50 million. We think these are very conservative estimates, especially for Early Stage. In fact, we wouldn't be surprised if this segment ends up fetching closer to $250 million. Anyhow, our initial estimates imply:

Early Stage: 0.6x 2008 revenues; 1.25x book (book was our estimate)
Central Labs: 0.4x 2008 revenues; 1.5x book (book was company disclosed)

We note that this business has been rocked by repeated writedowns of goodwill and assets over the past few years. In a sale, the book may be understated, in our opinion.

These are also huge discounts to close peers--Charles River CRL, Covance CVD, and ICON ICLR trade for around 1.5x-1.8x revenue and 1.8x-2.8x book value. ICON is probably the closest comp here, given their smaller size. ICON even has a central lab operation of similar size! Another possible comparison for Central Labs is Quest Labs DGX or Lab Corp LH. These companies also trade for pretty impressive multiples (though they are obviously much better companies).

Adding Up the Parts

At this point, we've covered all the major parts, so it's time to add up the results.

$600 Analytics
$300 Nordion Baseline
$115 Balance sheet
$200 Pharma
_____________
$1,215 million Equity value

But that's not all. Following the consummation of the Analytics sale, MDS plans to do a very large buyback ($400 to $450 million, or a huge percentage of the market cap) through a Reverse Dutch Auction. If the company is able to complete this buyback with limited market impact, a ton of value accrues to current shareholders. In other words, the company is buying a massive quantity of undervalued stock.

So: $450 million buys 56.25 million shares at $8 per share, out of 120 million shares outstanding.

Post buyback equity value = $1,215 - $450 = $765 M

$765M / (120-56.25) = $12 per share.

Next, we have to think about the "call options" we mentioned earlier. All of the following scenarios assume that $450 million is used to buy stock at $8 per share. We won't run through the math again.

If the first and best call option (if Nordion is worth $800 million instead of $300M) comes to pass, we think MDS is worth close to $20 a share. If the $350 million call option hits, we get somewhere closer to $17.50. Lastly, if Early Stage gets sold for $250 million instead of $150 million, we make an extra $1.50 per share. This is not a bad series of outcomes.

On the other hand, the downside is extremely limited. We find it extremely difficult to believe that MDS is worth less than $6.50 per share, as this number is backed essentially by cash from Analytics and cash on the balance sheet, and Nordion is profitable.

Let's connect the dots: with the stock is around $8, the downside is a measly $1.50 per share, while the upside is over $4 in a conservative scenario. If any of the "call options" hit, we can easily make $8 to $12 a share! This sounds like a good deal to us.

Reverse Dutch Auction

We are going to assume everyone is relatively familiar with the process. If not, Google is your friend.

The issue with MDS is that they are tendering for a massive number of shares--almost half the current market cap. Also, MDS's largest shareholder is an asset manager called ValueAct, and I suspect that they won't want to sell. Thus, MDS may be trying to buy an even larger percent of the "truly free" float.

In short, we worry that this offer may ramp the stock price significantly. If MDS buys shares at inflated prices, a very large amount of value may be destroyed for current shareholders. Thus, we need a strategy to protect ourselves.

Thus, we intend to submit our shares for tender at a price of around $10. We think this is around the maximum price MDS can do the buyback and not destroy shareholder value. This scenario ignores the option value and only takes into consideration the $1.2B "base worth". Obviously, we would love it if the tender happens at a really cheap price (let's say $7) and we get to keep our shares. But we definitely don't want to get stuck with the bag if MDS overpays. There is really no downside here. Either we tender our shares and do okay, or we do better because they make an accretive buyback.

Considering that the auction will probably be less than two months from now, we'd be reasonably happy if we lose our shares at around $10. This represents a total return of about 30%, or annualized return of almost 200%.

We'll figure out our exact strategy once the company files the necessary proxy documents. I actually voted my shares in favor of the shareholder proposal to sell analytics today. I expect this proposal to pass and the auction will follow shortly thereafter.

 

Catalyst

Pharma sold for more than we expect

legal resolution or at least clearing of outlook for MAPLE

earnings power of businss showing through post restructuring

past earnings completely clouded by massive charges and all sorts of distortions. That should mostly go away soon.

New CEO -- Current COO and former head of Nordion. The old CEO, who destroyed all sorts of value, will be gone imminently.

Buyback happens at a decent price

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