Illumina Has Very Small Upside At These Levels

Jan.26.12 | About: Illumina, Inc. (ILMN)

On Tuesday January 24th, European pharmaceutical giant Roche (OTCQX:RHHBY) announced it will seek to acquire all outstanding shares of Illumina Inc (NASDAQ:ILMN), a U.S. developer of DNA sequencing tools for $44.50 a share in cash. Shares of ILMN opened at $52.63 on Wednesday and climbed higher to close at $55.15. This close is over 20% higher than the Roche offer, indicating the market is expecting a higher bid to emerge.

Background. Roche first approached ILMN in December of 2011. At the time, Illumina was trading around $28-$29. As rumors of a potential deal leaked into the market the genetic company's price began rising. On Tuesday before the news broke out, ILMN closed at $37.68. Roche disclosed in a press release that it had several times approached the board of Illumina trying to start deal negotiations but ILMN showed no interest. Earlier in January, Roche made a $40 offer to Illumina which was rejected as "opportunistic". According to Roche Chief Executive Severin Schwan, the lack of cooperation from Illumina left Roche no choice but to take the current offer of $44.50 directly to ILMN shareholders. Roche intends to commence a hostile tender offer immediately and also nominate directors for election to the Illumina's board. Roche CEO Schwan called the offer "full and fair" and said that Roche has no intention of raising it.

At this point, a lot of the potential upside from a higher offer is already priced in and investors buying ILMN at these levels have in my opinion very small upside even under best case scenario while a price collapse back to December levels of $28-$30 is not impossible provided Roche withdraws its offer. Further, in the near term of the next few weeks and months ILMN's price will almost certainly drift down a few dollars once today's excitement fades a bit.

Illumina's Defense. The typical anti-takeover defense of today's corporations consists of a poison pill plus a staggered board. Basically a poison pill can only be removed by the board of the company. A staggered board ensures that no more than 1/3 of directors can be replaced each year, so it would take at least 2 annual meetings for the aggressor to have majority on the target's board. Illumina has a staggered board and given the hostile bid by Roche will likely adopt a poison pill very soon.

However the ILMN staggered board is not as bulletproof as it may seem. The last annual shareholder meeting was in May 2011 so by law, ILMN has to hold the 2012 annual meeting no later than June 2012. This year 4 of the 9 directors are up for reelection or replacement.

According to New York Times' Deal Professor Steven Davidoff Roche has found a loophole in ILMN's defence. The staggered board provision is in the corporate charter of Illumina. But the charter also states that the number of directors on the board (currently 9) will be as specified in the corporate by-laws. To amend the by-laws the approval of the board is not required, only the 2/3 majority of the shareholders vote. So if Roche can get ILMN shareholders to go with the deal they can amend the by-laws to increase the board number by 2 additional directors. This way 6 directors will be up for election this year and if Roche is successful it will have 6 directors versus the incumbent 5 on the board and so a merger will be a certainty. This is the same tactic that Roche successfully used to take over Ventana Medical Systems (which traded with ticker VMSI) in 2008.

All Roche needs is the support of Illumina shareholders which will not be easy at the current market price of ILMN compared to the much lower offer of $44.50. So in order to get shareholders to back the acquisition Roche will likely have to raise the price. Raising the offer much higher than 25% from $44.50 (this would make the price $55.63) however is very unlikely considering that Roche CEO claims the $44.50 offer is final.

A Strategy of Attrition. Given the current ILMN market price of $55 very few shareholders will tender their shares at $44.50. If the Ventana saga is any indication, Roche will take its time and keep extending the $44.50 tender offer trying to just wear out shareholders and arbs into selling out and thus depressing the price. Many existing shareholders will prefer to sell their stock at the current market and take profit, since they own their stock from the 30s, rather than wait and see whether this already priced-in higher bid will materialize.

In the case of Ventana, Roche made its first offer in June 2007 for $75/share and subsequently extended the expiration of the offer 5 times dragging it over 7 months until finally in January, Ventana accepted an increased offer of $89.5 (a 19% increase.) If we translate the same numbers to the ILMN offer it would mean that 7 months from now Roche will raise the offer to $52.95 and the ILMN board will accept for the reasons described above (see "the loophole") and shareholders will tender their shares.

Why would Illumina shareholders tender their shares at around $53 if the price is currently $55 ? The price of Ventana also climbed much higher than the Roche offer of $75 reaching a high of $90 within weeks. However, by January 18 2008 it was trading at $85.25 and the increased offer of $89.50 appeared attractive especially compared to the alternative i.e. the deal falling apart completely.

The possibility of another bidder: Some investors may hope that the tender offer may attract another buyer and start a bidding war. In a recent case Valeant Pharmaceuticals (NYSE:VRX) attempted to buy Cephalon (NASDAQ:CEPH) with a $73 tender offer after management rejected the offer as being too low. Eventually Teva Pharmaceuticals (NASDAQ:TEVA) stepped in with a competing offer of $81.50. Note that even that was just an 11.6% increase.

However ILMN has not disclosed that it is currently in negotiations or even has been contacted by any other potential suitors. It remains unclear whether any buyer will go head to head with the likes of a giant such as Roche.

Summary. Barring the unlikely event that another suitor may step in and start a bidding war, investors buying at these levels will likely see ILMN drift down to as low as $50 over the next 6-7 months. Eventually if they have managed to hold on, they will have the opportunity to tender their shares at a price almost as high as the current market prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.