Cephalon Inc (CEPH) and Tyco International (TYC) are both companies that have been in the headlines because of buyout interest. While we believe that they are both valuable companies with important assets, we think various factors could limit their potential near term upside.
Cephalon Inc (CEPH)
Cephalon, the maker of narcolepsy drug Provigil, is the subject of a $73 per share cash buyout offer from Valeant Pharmaceuticals (VRX). Cephalon's board of directors have already rejected the offer citing that $73/share significantly undervalues the company.
Cephalon trades at a cheap valuation even after jumping past the buyout offer with a forward P/E of 12.83 and a trailing EV/EBITDA of 5.34. In large part because of the low valuation and Valeant's perceived desire to close a deal, the market has priced in a higher bid from Valeant or another bidder. Since the deal announcement, the stock has trade at least $2 above the buyout price. In addition, hedge funds have piled into the stock. Taconic Capital recently reported a 7.46% stake in Cephalon at an average price of $76.02.
Despite the cheapness and institutional interest, Cephalon's upside may be limited. The company's cheap valuations are distorted by strong trailing earnings that don't account for Provigil's exclusivity expiration in 2012. According to the most recent 10-K, the narcolepsy drug contributed to 41% and 48% of the company's total sales in 2010 and 2009. While Cephalon is has another narcolepsy drug, Nuvigil, it contributed only 7% of the company's overall sales in 2010.
Finally, while there is certainly additional upside potential if another suitor steps into the fray, it would be reasonable for investors to question Valeant's ability to increase it's buyout offer. While CEO Michael Pearson has earned a strong reputation, even the current purchase could stretch the imagination considering that Valeant has $3.5 billion in debt and only around $1.1 billion in sales.
Tyco International (TYC)
Several reputable news outlets including Reuters and the Wall Street Journal reported that French giant Schneider Electric SA (OTCPK:SBGSY) was interested in acquiring U.S. conglomerate Tyco International for $30 billion. Schneider ultimately walked away from a potential deal after the leaked story caused Schneider's stock to drop. In the aftermath, analysts now view Tyco as "in play."
We are bullish of Tyco because of modest valuations and attractive assets in durable businesses. With a forward P/E of 14.38 and a price/sales of 1.42, Tyco has a reasonable earnings yield and cost optimization opportunities.
But despite these attractive attributes, the company could have limited upside as a buyout candidate. Merger and acquisition activity has picked up, but Tyco's $24 billion market capitalization is still a major deterrent that will limit risk appetite and potential buyers. Companies like Honeywell (HON) and United Technologies (UTX) have been mentioned as potential interested parties but even then it would make more sense if Tyco sold itself off in pieces. Considering that Honeywell is itself mentioned as a sum of the parts valuation story, Honeywell is an unlikely candidate to make large scale acquisitions.
Finally, the most important deterrent might be the structural tax advantage that Tyco enjoys because it is headquartered in Switzerland. In the year ending Sept 2010, Tyco's effective tax rate was 10.87%. This tax issue severely limits the ability of US based companies to pay a significant premium for Tyco since the change a potential increase in tax rate is already an implied premium.
Cephalon and Tyco are both attractively priced companies that will continue to draw buyout interest. Potential acquisitions could be driven by strategic partners interested in synergistic potential or foreign buyers cashing in on their home currency strength. Despite this, we think both Cephalon and Tyco have limited upside as potential buyout candidates and bullish investors should wait for additional share price weakness before adding to their positions.