AbbVie's Acquisition Of Shire: Skepticism Creates Buying Opportunity

|
 |  About: Shire PLC (SHPG), ABBV
by: Small Pharma Analyst

Summary

AbbVie has agreed to buy Shire for $54B.

One of the drivers for the acquisition was a tax inversion, which may be derailed due to political opposition.

The acquisition has many other positive drivers, and will likely be consummated even without a tax inversion.

The uncertainty surrounding the acquisition has provided a buying opportunity - in particular, options strategies offer good risk-reward.

On June 30, 2014, Dr. Paul Nunzio DeSantis wrote a Seeking Alpha article that predicted the acquisition of Shire (NASDAQ:SHPG) by AbbVie (NYSE:ABBV) for $54B. Nearly 3 weeks later, on July 18, the acquisition was announced for... $54B, corresponding to an ADR price of $275. In his article, Dr. DeSantis provided an in-depth analysis of the merits of the acquisition and how it will benefit ABBV in many different ways - both from obtaining a portfolio of growing products and a rich pipeline as well as for financial reasons. The analysis was spot on and exactly predicted the actual takeover price.

While the ADR shares of Shire rose to $258 soon after the announcement, negative publicity regarding the so-called "tax-inversion" aspect of this deal has recently caused many investors to question whether the acquisition will actually take place. The first shot across the bow was fired by Treasury Secretary Jack Lew, who wrote a letter to Congress on July 16 urging legislators to enact a law to close the tax-inversion loophole, retroactive to May 2014 - the date when this tax-inversion strategy gained notoriety from the now-aborted Pfizer takeover attempt of AstraZeneca. Given the inability of Congress to pass any legislation, Mr. Lew's letter and rhetoric were largely ignored by investors, although the Shire price drifted down.

However, on August 5, Mr. Lew and President Obama raised the stakes by indicating the Treasury Department was looking into legal ways to limit tax inversions by "administrative actions," again retroactively. Whether the executive branch actually has the authority to change the tax code is debatable, but Wall Street sat up and listened this time. The SHPG share price dropped from $247 to $235.

A few days later, Walgreens succumbed to political pressure from Illinois home-state senator Dick Durbin, announcing that their acquisition of UK-based Boots would proceed, but without a tax inversion. This resulted in a further share price decline of Shire to a low of $230 on August 8, about 16% below the target price of the deal. AbbVie, which is located in a suburb of Chicago, is not a house-hold name like Walgreens, but is likely also realizing a good deal of political pressure from Senator Durbin and his negative publicity campaign against tax-inversion strategies. With the spotlight on the tax-inversion issues, investors have become increasingly skeptical as to whether this deal will actually take place. The stock price of SHPG has hovered near $235 over the past few days and remains well below the $270-275 target acquisition price.

On Friday, August 8, a few articles surfaced which referenced a Credit Suisse interview with the CFO of AbbVie, Bill Chase, who indicated AbbVie was committed to the acquisition of Shire, regardless of the controversy concerning the tax inversion. As noted in two articles (the Financial Times here and Barron's here), even without a tax inversion, ABBV will capture numerous other financial benefits from the Shire acquisition, including the ability to make use of their off-shore earnings that they cannot repatriate without paying 35% tax. In addition, if AbbVie decided to back out or significantly changed the terms of the deal now, they would be required to pay Shire 3% of the proposed acquisition price, or about $1.6B. Furthermore, never underestimate the power of pride. ABBV does not want to look foolish, so they will offer many justifications of why the deal should go forward even if there is no tax inversion. As quoted in the Barron's article:

In a client note Thursday, Credit Suisse analyst Vamil Divan wrote that his conversation with AbbVie offered 'reassurance' on the deal, adding that 'despite potential changes to the U.S. tax code that may make inversions less attractive, AbbVie's CFO (Bill Chase) reiterated their view that the Shire deal is compelling even beyond the benefits of an inversion.'

The Credit Suisse note on Friday did not impact the share price much that day, but ignited a good deal of action on Shire options that afternoon. Over 23,000 options traded that day, more than 10-fold the normal level, including some large-volume spread trades in Oct 2014 and Jan 2015 options. The relatively high prices of the Oct 2014 and Jan 2015 call options are suggesting many investors think there is an excellent probability this deal will make it to the finish line under the current terms and are taking advantage of the uncertainty via option trades.

We outline below a few trades that offer the potential for excellent short-term returns while mitigating downside risk.

Covered Call Strategy

Six covered call strategies are outlined in Table 1. These strategies involve buying the underlying security in 100 share lots and selling calls expiring either in Oct 2014 or Jan 2015.

For those new to options, each option lot controls 100 shares of the stock. By selling a call option, the trader agrees to offer to sell 100 shares of the stock to the buyer of the option at the strike price on or before the expiration date. For example, for the Oct 240 option, the seller of the call option offers to sell 100 shares of Shire to the buyer of the option at $240 on or before Oct 18, 2014. For this privilege, the buyer of the option pays the option price. If the stock price is below $240 on the expiry date, the option expires worthless and the seller keeps the gains from selling the option. If the share price is above $240, the buyer profits as he/she has purchased shares below the current price and therefore has realized a profit. The downside for the option seller is that the underlying security might drop during this period and to exit the position they would have to buy back the option (in order not to have a naked call) and sell the shares.

Table 1. Covered call strategy. Based on 100 shares of Shire at $237 (Aug 11 close)

Call option to sell

Immediate gain on option sale per lot

Gain on sale of stock at expiration

Maximum upside

Annualized gain on upside

Downside break even share price

Oct 240 at $14.70

$1470

$300

$1770

41%

$222.3

Oct 250 at $4.50

450

1300

1750

40%

232.5

Oct 260 at $3.00

300

2300

2600

60%

234

Jan 240 at $20.70

2070

300

2370

23%

219.3

Jan 250 at $15.34

1534

1300

2834

29%

221.66

Jan 260 at $8.18

818

2300

3118

31%

231.82

Click to enlarge

The closing price of Shire on Aug 11 was $236.92 which we will round to $237 for this exercise.

For a shorter term trade, the $240 option which expires October 18, 2014 was last traded on August 11 at $14.70 (row 1). Therefore, an investor could purchase 100 shares of Shire for $23,700 and sell an Oct 240 call option for an immediate gain of $1470. Assuming the stock price will close above 240 on October 18, 2014, the return on this trade would be $1770 or 7.5%, for an annual return of 41% for the 2-month trade. The risk of this trade would be that the timeline is too short and that controversy around the takeover might still exist, such that the shares do not trade above 240. Or, the acquisition could be called off, causing the shares to drop well below the current price. We think these risks are low, as ABBV has indicated they intend to close the deal by the end of the year and the outcome of the acquisition will definitely have clarity by October. This is a very attractive trade as the shorter term time frame reduces the time risk where macro events could cause an overall market decline or significant change in the US dollar/UK pound exchange rate.

For the longer dated call (row 4), the Jan 17, 2015 240 call was last traded at a price of $20.70. Assuming the acquisition goes through, the investor would give up his/her shares at a price of $240 on Jan 17, 2015. The total return for this trade would be $2070 (option) plus $300 (sale of 100 shares) = $2370, or almost exactly 10% gain. For the 5 months for the trade to mature, the annual return is thus 23%. Given that ABBV has noted it intends to close the acquisition by the end of 2014, the likelihood that this trade reaches fruition is high.

There are many variations on these trades. For example, instead of selling calls priced at $240, an investor could sell higher value calls, such as $250 or $260, which sell for less up front, but have the opportunity for larger gains from share price gains at the expiry date. These strategies have more risk with less downside cushion (last column) in case the acquisition deal falls apart.

Options-Only Strategies

Another conservative strategy is to only trade options, which limits the downside in case the deal is not concluded and the stock drops back to pre-acquisition levels (190). A number of very large call option spreads were traded over the past few days, as outlined in Table 2. As shown in column 3, the amount of money placed at risk is small relative to the purchase of 100 shares, but the potential percentage gains are quite large - 2- to 3-fold in the cases shown - if the stock price closes on the expiry date above the price of the option which was sold.

Table 2. Some large option spread trades on Shire since August 8, 2014

Call option bought

Call option sold

Spread cost - maximum loss if stock closes below bought option strike price

Potential gain - if stock closes above option sold strike price

Oct 245 for $15.53

Oct 260 for $8.18

$735

$1500

Oct 245 for $14.00

Oct 265 for $5.00

$900

$2000

Oct 255 for $9.35

Oct 270 for $4.00

$535

$1500

Click to enlarge

The 245-260 October spread looks very attractive if an investor can find good entry points for both. The proposed buy out target is $270 per ADR share, but the price is dependent on ABBV share price as well as the US dollar/UK pound exchange rate. Nonetheless, it is very likely the acquisition closing price will be above $260 per share so this is a low risk-high reward option spread.

In addition, potential option spreads for the January options are shown below and are based on August 12 last trades. As above, I like the 245-260 spread as a low risk-high reward trade.

Table 3. Potential option spread trades for Jan 17, 2015 options

Call option to buy

Call option to sell

Spread cost - maximum loss if stock closes below option bought price

Potential gain - if stock closes above option sold price

Jan 245 for $17.90

Jan 260 for $9.50

$840

$1500

Jan 250 for $14.10

Jan 265 for $6.36

$774

$1500

Jan 245 for $17.10

Jan 265 for $6.36

$1074

$2000

Click to enlarge

Summary

The spotlight and negative political rhetoric surrounding tax inversions have created uncertainty - acquisition deals that have already been announced that include a tax inversion strategy perhaps will not go forward. However, in the case of the AbbVie acquisition of Shire, the likelihood that the deal will consummate at the agreed-upon price is high - perhaps >80%. AbbVie is intent on the acquisition as it has many positives for the company - the tax inversion was only one of many drivers. The current stock price reflects this uncertainty, pricing in only about a 50% probability of the deal completing, and provides a buying opportunity either of the shares outright or through use of call options.

Disclosure: The author is long SHPG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author owns options in Shire.