Description

This is a relatively straightforward writeup for those members of VIC who are interested in a short-dated merger arbitrage play with a good upside/downside risk-reward ratio.  If merger arb is not in your wheelhouse, we suggest you skip this writeup.  In the interest of time, many of the details were excluded but can be found in the public disclosure documents, which we recommend you review.

Investment Thesis

Celgene (CELG) is made an offer to purchase Receptos Inc (RCPT) on 7/14/15 for $232 per share or about $7.2 billion. The transaction is slated to close on or around 8/24/15 through a tender offer and a second-step merger. Plenty of details can be found on the the investors relations tab of each company’s website and the SEC filings so we won’t go into a lot of detail on the specifics of the deal but highlight the key points below.

1. The deal spread annualizes to a 29% return

With the shares trading around $228, the spread to the deal price is currently about 1.7%. Since the deal is expected to close in about 3 weeks, the annualized return is about 29%, which is pretty attractive.

2. The probably of Celgene not closing the deal is very low

a. The acquisition is very strategic to Celgene

The acquisition of RCPT is very strategic to CELG. Celgene has been actively acquiring companies to fill in its dwindling pipeline.  In fact, CELG’s stock was up about 7% after the RCPT deal was announced as investors and analysts cheered both the reasonable valuation of the purchase and the fact that the purchase of RCPT would strengthen CELG’s pipeline and help bolster its long term growth rate to around 25%..  One of the big issues with the large-cap pharma/biotechs stocks has been the patent cliffs many of them are facing as their blockbusters face generic competition.  The RCPT acquisition is expected to fill the revenue gap starting about 5 years from now as RCPT’s drugs obtain FDA approval and initial sales begin. It’s generally not common to see the stock of a large-cap acquirer go up upon the announcement of a significant acquisition.  In this case, investors recognized the very strategic nature of the acquisition.  Celgene has been courting RCPT for the last 21 months and missed out on the opportunity to purchase it for $550 million in October 2013.  You can read more about the whole merger dance in a recent FT article from 7/30/15 and the 14D SEC filings:

http://www.ft.com/intl/cms/s/0/118160d4-36d4-11e5-bdbb-35e55cbae175.html#axzz3hqeEPZ9H

http://www.sec.gov/Archives/edgar/data/1463729/000119312515266171/d51890dsc14d9.htm.

It’s pretty clear that CELG wants this asset, and the strategic rationale is compelling.

b. Other deal risks

There is very little financing risk to the deal.  CELG is expected to fund the transaction with a $5 billion bond offering and cash on hand.  Given the state of the debt markets, we don’t see much risk to the financing.

Finally, the deal is expected to close in less than 3 weeks so the macro/tail risks that could derail the closing are pretty low. We don’t see much in the near term horizon that would create a material macro risk that could upset the deal.

3. Potentially significant upside if another acquirer steps in and tops the current offer from Celgene

The reason we like this merger arb situation is the potential for significant upside in the event another potential acquirer makes a higher bid for RCPT.  Although the probability of a higher bid are unknown, we feel that there is some possibility of a third party bid before the closing of the CELG transaction.

The approximately $7.2 Billion acquisition price is actually quite reasonable considering the projected revenues for RCPT’s pipeline.  

Here are some comments from CELG regarding the acquisition:

“Ozanimod, Potentially a Best-in-Class Oral Agent in Phase III Trials for Inflammatory Bowel Disease and Multiple Sclerosis

Accelerates Growth Beginning in 2019; Significant Growth Driver Beyond 2020 with Expected Ozanimod Peak Annual Sales of $4 - $6 Billion

The acquisition of Receptos significantly enhances Celgene’s Inflammation & Immunology (I&I) portfolio, further diversifies the Company’s revenue beginning in 2019 and beyond, and builds upon Celgene’s growing expertise in inflammatory bowel disease (IBD). The transaction adds Ozanimod, a novel, potential best-in-class, oral, once-daily, selective sphingosine 1-phosphate 1 and 5 receptor modulator (S1P) to Celgene’s deep and diverse pipeline of potential disease-altering medicines and investigational compounds.

Based on clinical studies, Ozanimod demonstrated several areas of potential advantage over existing oral therapies for the treatment of ulcerative colitis (UC) and relapsing multiple sclerosis (RMS), including its cardiac, hepatotoxicity and lymphocyte recovery profile. The phase III TRUE NORTH trial in UC is currently underway with data expected in 2018. The phase III RADIANCE and SUNBEAM RMS trials are ongoing and data are expected in the first half of 2017 to support a RMS approval in 2018. Additionally, Ozanimod is positioned to potentially become the first S1P receptor modulator to be approved for IBD.”

We highlight some comments by the Wedbush analyst who’s been vocal in publicizing the bull case of RCPT, including of his estimate of the peak revenue potential for RCPT and the likely price for a third party bid:

“We project Receptos’ Ozanimod could achieve about $10 billion in peak annual sales for relapsing multiple sclerosis (RMS) and ulcerative colitis (UC) plus another $5 billion for Crohn’s (with other autoimmune indications as upside potential) plus about $1.3 billion for RPC4046 in eosinophilic esophagitis (EoE) and multiple billions of dollars potential for the oral glucagon-like peptide-1 receptor (GLP-1) program in diabetes.

Consequently, we calculated an acquisition of Receptos to occur at a share price of about $348, or about $10.9 billion. Celgene ( CELG ) previously stated that it expects Ozanimod’s annual peak sales to reach about $4 billion-$6 billion for RMS and UC but no credit for Crohn’s (psoriasis, systemic lupus erythematosus (SLE), etc.) or the rest of the pipeline. Even if only $4 billion-$6 billion is counted, the proposed acquisition price of $7.2 billion is only slightly more than about 1 times peak sales.”

Other analysts have the peak revenue potential for Ozanimod at a lower number than the $4-6 bil projected by CELG.  Morgan Stanley’s analyst noted that CELG’s peak sales estimate of $4-6 bil was too aggressive and thought peak sale could reach around $4 bil. Evercore ISI projects peak sales at an even lower $2.6 bil.  We readily admit that it’s difficult to accurately predict what peak sales will be a decade down the road.  We also note that smart people can have wildly different views of what sales may be for a drug many years down the road.  However, we’d like to bring to your attention Gilead’s (GILD) purchase of Pharmasset in November 2011.  Gilead purchased Pharmasset for $11 bil for a Hep C drug entering Phase III with peak sales estimated at $3-5bil at a multiple of 2.2-3.7x projected peak revenue.  As we know now from GILD’s sales, the Hep C market was vastly underestimated.  The market continues to underestimate GILD’s revenue potential in the Hep C market, as we recently saw with the GILD’s entry into the Japanese market.  This is not to say RCPT’s sales will turn out to be as wildly successful as Pharmasset’s sales, but it goes to show many smart people can massively underestimate sales projections for a drug.  

CELG is paying a little over 1-1.5x for CELG’s estimated peak revenue potential for Ozanimod just in two indications in (UC and RMS). It’s possible RCPT’s peak sales for those two indications could attain levels of $10 bil, $5 bil for other indications such as Crohn’s, and an additional $1bil+ for the rest of the pipeline. If all these sales materialize, CELG is getting one hell of a deal.  It’s not inconceivable that another acquirer would want to pay a bit more and pick up these assets.  A multiple of 1-1.5x  (potentially conservative) peak revenues is quite low when acquisitions of pharma/biotech assets are generally being done at higher multiples -- in the 3-5x range (e.g. Kythera (KYTH) was recently acquired for 4x peak revenues in mid June with an approved product).  

Other potential acquirers:

On April 1, 2015, there was a Bloomberg article reporting that RCPT received partnership and/or acquisition interest from 10 companies.  Subsequently, on the May 5 earnings call, RCPT management commented that they could commercialize Ozanimod on their own, which was a signal to the potential acquirers to raise their offers. On June 9, Proactive Investors published an article disclosing specific offers from AstraZeneca (AZN) for $200/share and from Teva (TEVA) and Gilead (GILD) for $280/share, which were rejected and countered at $350/share.  GILD is sitting on $14.7 bil of cash, which is continuing to pile up every quarter, and has publically stated it is looking to make acquisitions to fill in its pipeline. We won’t speculate on who other potential bidders may be, but it’s widely known that large cap pharma/biotech companies continue to face loss of revenue from generics and biosimilars.  They need to fill in their pipelines through acquisitions.  The total number of healthcare M&A in 2Q15 was 314, up from 294 in 1Q15 and 279 in 4Q14. We think there is a possibility that another acquirer may outbid CELG for RCPT, especially given the relatively low acquisition price offered by CELG.

4. Setting up the trade

We suggest three different ways to set up the trade depending on your risk appetite:

a. Go long RCPT stock.  This is the easiest and the simplest way to execute the trade. You collect a 29% annualized yield in less than 3 weeks and have the free call option for significant upside if a third party bid materializes.  There’s significant downside if the deal breaks as all shares are largely in the hand of arbs at this point. However, we believe the likelihood of a deal breaking is quite low, as we discussed above.

b. A second way to set up the trade would be to go long the $230 strike call options expiring 8/21/15, which are trading around $1.55, which is the mid point of the bid/ask spread of $1.40 - $1.70/contract. There has been quite a bit of volatility with these options, so depending on you execution capabilities, you may be able to pick them up at a more attractive cost basis.  The options would expire worthless upon expiration (since the deal is expected to close 8/24/15) if no third party bid materializes but provide leveraged upside if RCPT receives a third party outbid.  The options also provide limited downside in the event the deal breaks.

c. A third way to set up the trade is a long position in RCPT with a sufficient number of $230 strike call options expiring 8/21/15 to to break even on the trade if the deal closes and there is no third party outbid. The approximate ratio of shares of stock to options is 25 contracts for every 1000 shares of RCPT. This ratio creates a roughly break even trade if the deal closes without a third party outbid:  The options expire worthless at closing, but the RCPT stock would appreciate to $232 at closing from the current price of $228 to make up for the loss on the options position.

Bottom line

Buying RCPT at $228 gives you an opportunity to collect a 29% annualized yield in less than 3 weeks (with very little downside risk) with a free call option for significant upside if another acquirer makes a bid over the current $232 offer from Celgene.  We feel that given the very high probability of the CELG offer closing on or about 8/24/15 and the possibility of a higher bid from a third party acquirer, the upside/downside risk-reward is quite attractive.

Catalyst

Catalysts:

• Closing of the acquisition by CELG on or around 8/24/15

• Possible third party bid topping CELG’s offer