(B)(N) VRX Valeant Pharmaceuticals International

Deal Book. Valeant Pharmaceuticals is one of Canada’s largest drug makers with a market value of about $22 billion, and it wants to buy Actavis Incorporated (formerly Watson Pharmaceuticals Incorporated of Parsippany, New Jersey) for the purchase price of $13 billion in a stock deal which offers the Actavis shareholders the entire current market value of their company (Reuters, April 26, 2013, Valeant in talks to buy Actavis for over $13 billion).

That doesn’t sound like a good deal to us because the Actavis shareholders could sell some of their shares in the open market and get just as much per share, and possibly more, or possibly less; their Actavis stock has increased by +20% since December and is trading at $100 per share today (please see Exhibit 2 below). For example, 1.5 million shares of Actavis changed hands yesterday at prices between $99 and $101, and more than 500,000 shares have been changing hands every day since the beginning of April at more than $95 per share, and the price keeps rising because there are more (in terms of dollars, number, or both) buyers anxious or interested to buy the stock than there are sellers who are anxious, or indifferent, or pleased, to sell at those prices.

However, the deal is more complicated than a cash deal because Valeant doesn’t have $13 billion in cash to make a tender offer for all of the Actavis stock, and Valeant recently had difficulty acquiring the much smaller (and oblique) Obagi Medical Products Incorporated for $440 million in cash (please see our recent Post, (B)(N) OMPI Obagi Medical Products Incorporated, April 2013).

Instead of cash, Valeant is offering itself, that is, it’s going to offer some number of Valeant shares in exchange for all of the Actavis shares, and the question is: What is that number? How much of itself does Valeant propose to offer in order to acquire all of Actavis in a deal that would be attractive (but not necessarily overly compelling, or too generous) to the Actavis shareholders, and not offensive (if not attractive) to the Valeant shareholders?

The answer is not moot because, apparently, the Actavis board of directors is not prepared to recommend this deal to its shareholders, and the latest news is that they have rejected it and further negotiations are on hold, and probably terminated, after months of effort (Reuters, April 27, Merger of drugmakers Valeant, Actavis on hold: source). In fact, the failure rate for “creative acquisitions or alleged mergers” is 100% – if the right cash isn’t there, the deal shouldn’t be done – and we’ll explain that below (Deal Book).

But first, we need to take care of business. Valeant Pharmaceuticals is currently in the Perpetual Bond™ at a stock price of $73 and it became eligible for the Bond at much lower prices of $50 in 2011 (please see Exhibit 1 below). Our estimate of the downside risk due to volatility is minus ($8) so that we would not be surprised by any price between $65 and $81 at the present time; we’ve reset the stop/loss to $66 (please see our recent Post, The Wall Street Put, April 2013, Exhibit 8) but that is still well above the current Risk Price (SF) of $44 (which is down from $49 in early January); accordingly, we’ve bought the July put at $70 for $3.30 and sold a July call at $75 against our long position for $3.80 so that for a gain of $0.50 per share today ($3.30 less $3.80), we can wait to see how this drama unfolds and still be assured of between $70 and $75 for the stock for the next few months no matter what.

Exhibit 1: (B)(N) VRX Valeant Pharmaceuticals International – Risk Price Chart

(B)(N) VRX Valeant Pharmaceuticals International Incorporated – April 2013

Valeant Pharmaceuticals International Incorporated (formerly Biovail Corporation) is a specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products primarily in the areas of neurology, dermatology and branded generics.

(Please Click on the Chart to make it larger if required.)

Exhibit 2: (B)(N) ACT Actavis Incorporated – Risk Price Chart

(B)(N) ACT Actavis Incorporated – April 2013

Actavis Incorporated is a global, integrated specialty pharmaceutical company engaged in developing, manufacturing and distributing generic, brand and bio-similar products.

(Please Click on the Chart to make it larger if required.)

Deal Book

In order to do the deal by exchanging shares, neither party should receive a “riskier” asset than the one that they already have which in this case means that the new VRX shares of the combined company should not be any riskier than the shares of either VRX or ACT now.

A successful merger is one that does not benefit just the investment bankers and the management of one or both companies, but can be demonstrated, as well as proved out in practice, to reduce the “investment risk” to both parties. The “investment risk” is that we might lose our money or obtain a return that is less than the rate of inflation – a negative real rate of return – which is just another way of losing our money. “Volatility risk” is only a minor factor and we can deal with that proactively, as we have just done, above, by setting an appropriate stop/loss price and/or buying a “collar” from our profits.

With respect to “investment risk”, there are only three kinds, or types, of investors (regardless of whatever else they might be): “risk seeking” investors who are willing and can afford to accept a possibly negative real rate of return in the hope of excess real rates of return, that is, above the rate of inflation; and “risk averse” investors who also hope for a positive real rate of return but will not or cannot accept a negative one, and are aware of that; and those who are proactively neither “risk seeking” nor “risk averse” may be called “gamblers”, or “reckless”, because they don’t really know what they want and will take what they get, even if it ruins them.

The “risk adjusted price” of Valeant is $44 per share and puts a market value of $44×303.6 million shares = $13.4 billion on the whole company, not $22 billion because it can’t sell itself for that; for example, what will happen if Valeant proposes to issue $13.4 billion/$73 = 183 million new shares of its own equity into the market, as opposed to 304 million shares at $44? In the first case, the stock price will plunge because some, possibly many, investors will take profits, but it won’t plunge to zero – for every seller, there has to be a buyer, otherwise nothing gets sold, and Valeant, absent bankruptcy, will still be worth something to somebody; and, in the second case, there will be a “buying frenzy” for the “bargain priced” stock, some of which, and possibly all of which, is coming from new shares issued from treasury, until the price begins to rise and meet the price of those investors who still hold the stock. We note, of course, that the shareholders equity of Valeant will increase from the current $3.7 billion by whatever cash it can get by selling its own stock out of treasury (where it has no value), and investors are compelled to try to figure out whether the cash is more productive in their pocket, or in other investments, or in Valeant, and the demonstrated price at which that happens is the Risk Price (SF) of $44 (please see below for more on that).

On the other hand, the “risk adjusted price” for Actavis is $100 which is almost exactly the same as its current stock price and, therefore, the company’s value, in the same terms or units as Valeant, is $100×127.8 million shares = $12.8 billion, and, similarly to the above analysis, if Actavis were to issue 128 million new shares at $100, they should be bought because investors have demonstrated that they would prefer to have their cash invested in Actavis at that price rather than in their own pockets or some other investment (and, as above, the cash will show up in the shareholders equity).

The bottom line is that Valeant needs to propose a merger of equals and offer all of itself to the Actavis shareholders in order to affect the deal.

Another rather pleasant way to think about this is that the “risk price” is the “Gold Standard” because all stocks that are priced at their “price of risk” have the same defining characteristic – the stock is as good as, if not better than, cash because there is the expectation of 100% capital safety and therefore, a zero or better real rate of return on it, and it is also the “least stock price” at which that presumption can be demonstrated (Goetze 2009). In those terms, because Valeant and Actavis have the same value at their risk price, the “currency” that is represented by Actavis stock is a better currency than that of Valeant because $1 of Actavis stock is “worth” $22 billion/$13 billion = $1.69 of Valeant stock.

The risk price of Actavis has increased aggressively from $67 at the end of December to the current $100 because of acquisitions that have raised its total assets from$6.5 billion a year ago to the current $14 billion, and these acquisitions have received, or earned, the approval of investors, as is reflected in the +20% increase in the stock price during the past several months, and even more, +60%, from $60 in 2011 when the stock first became eligible for inclusion in the Perpetual Bond™ (please see Exhibit 2 above, Red Line Stock Price (SP) above the Black Line Risk Price (SF), and for no other reason).

In contrast, Valeant is trading at $73 and is well-above its price of risk at $44 and rising, but also down from $49 a few months ago (please see Exhibit 1 above); moreover, our estimate of demonstrated downside volatility of the stock price is minus ($8) per quarter, which is more than ±10% of the current stock price, and demonstrates an uncertainty among investors in the value or worth of the stock in the only terms that matter – can they reasonably expect a real return – that is, positive and above the rate of inflation – on the $73 stock, and, secondly, there is a sufficiently large speculative interest (the “gamblers” referred to above) to move the price of the stock due to ambient conditions or assumptions – in contrast to Actavis, the stock of Valeant trades in one to two to three or more million shares every day, and has done so for the several years. In the jargon of economics, stock prices above the price of risk are an “economic free good” and a battleground that is a common ground for all three “types” of investors; the extent to which that price is maintained with lower ambient volatility signals a victory for “risk averse” investors and a win for “risk seekers” (and “whatever” for the “gamblers” who are, in effect, no better than bystanders or “collateral damage”).

For more of the theory, please see our Posts, The Price of Risk, August 2012 and The Nash Equilibrium & Its Stock Price, October 2012, and for more of the practice, The Wall Street Put, April 2013, and Earnings Don’t Matter, April 2013.

Postscript

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Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.