Tesaro: Quick Goodbye

Summary

• Tesaro is being acquired by GSK in a +$5 billion deal.
• Investors in the UK pharma giant do not like the move at all, as a result of the steep premium and the losses which will be incurred.
• Unfortunately, the very fat premium (on a percentage basis) has not been steep enough to bail out my long-term upside calls.
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Tesaro (NASDAQ:TSRO) has been a promising biotechnology company, at least in my eyes, and now in the eyes of GlaxoSmithKline (NYSE:GSK) as well. The British major pharmaceutical company has reached a deal to acquire Tesaro at a $5.1 billion price tag.

Investors in Glaxo do not like the deal at all given the premium paid and the steep losses incurred, as well as financing costs incurred along the way. While investors in Tesaro have finally received some sort of a buyout/bailout, this was unfortunately not steep enough to bail out my long-term calls.

The Deal

GSK has reached a deal to acquire Tesaro for $75 per share in cash, a pretty impressive 110% premium compared to the average price seen over the past 30 days, although the price is far lower than a peak of nearly $200 in early 2017.

With the deal, GSK is acquiring Zejula, being approved in both the US and Europe to treat adult patients with recurrent ovarian cancer in response to platinum-based chemo, regardless of their biomarker status.

Apparently, GSK is a believer that Zejula might be approved for first-line maintenance treatment of ovarian cancer, creating a potentially a larger market opportunity of course, with trials already being underway under the PRIMA study, among others.

The different path of therapy, as Zejula is a so-called PARP inhibitor, gives GSK expertise which it potentially can use in other cancer types as well. Note that Zejula might potentially be used in the future for other sorts of cancer as well, either as monotherapy or as a combination treatment.

Of course, the $5.1 billion deal will not be accretive at first with revenues from Zejula totalling $166 million in the first three quarters of the year. In the long run, GSK expects nice accretion to adjusted earnings per share from 2022 onward, while dilution is seen until that moment in time by as much as 5-9% in 2019 and 2020.

This is clearly not liked by the shareholder base of GSK as its shares are down 8% at the moment of writing. This move corresponds to roughly $8 billion in shareholder value having gone up into smoke, being a greater sum than the deal tag as investors most likely are afraid of continuation of the losses incurred by Tesaro, and now thus GSK.

What's The Outcome For Investors?

In June, I last looked at the prospects for the business in an article named "Consider Calls". I was very cautious, given the slow pick-up in Zejula sales being accompanied by continued cash burn. At the same time, I recognised the potential for a long-term breakthrough or M&A as well, as I have been considering long-term upside call options. In fact, I considered those calls to be lottery tickets with shares trading around $40 at the time.

In May of 2018, the company reported second quarter revenues of $49 million, while operating expenses totalled $202 million, for an operating loss running at $600 million a year, creating huge cash burn.

Third quarter sales of Zejula came in just above $63 million as shares fell towards the $30 mark and even lower early in November on the back of those results and the fact that operating losses still easily run at $500 million a year. This observation and the fact that Zejula's sales are only seen at $67-72 million in Q4 made that investors grew even more cautious.

Ironically enough, I noted some comments made by executives over the past year. Management claimed sales potential of $700-$800 million in the US and EU combined in 2020/2021, as I pegged valuation potential at $5 billion in that case. The $5.1 billion deal actually comes a lot sooner at a similar valuation. I noted that this back-of-the-envelope calculation was too simplistic, given the cash burn and time needed to realise that, as well as scepticism which management has been losing. Nonetheless, a $2 billion enterprise valuation in June looks quite compelling in relation to the potential.

Given the losses, I approached equity as a call option at the time, with the equity valuation being too steep to consider shares a call option. Hence, I have bought some long-term calls, with a too steep premium (with the benefit of hindsight). I ended up buying the $75-$100 calls for 2020 with premiums coming in around $3 for the $90 call expiring early 2020. Unfortunately, that has proven to be the wrong strategy with options actually becoming nearly worthless now despite the deal. The option market is clearly indicating that no competing offers will arrive, while the lower priced strikes and the stock have done very well, of course.

A painful lesson for the strategy and the small speculative allocation, but congratulations to those who had the guts to hold onto the shares for so long in what has been a volatile and painful road, for some.

Analyst’s Disclosure: I am/we are long TSRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Long through calls