XBIT's Tender: A Profitable Trade Or Capital Destruction?

Summary

• XBiotech Inc. recently completed a tender offer and bought back 14 million shares at a price of $30.00 for a total cost of $420 million.
• The tender was oversubscribed. As a result, the pro-ration factor in effect was approximately 33.25%, meaning that most subscribers to the offer had their tender orders only partially filled.
• Owners who purchased between mid-2017 and November 2019 and participated in the repurchase generated significant returns and the tender served them well.
• More recent investors (and traders) likely got burned unless they avoided proration through a small odd lot position.
• Since the tender concluded, XBIT has fallen. The high offer vs. market price, plus the large subsequent decline, raises to-be-determined questions regarding the soundness of the capital allocation strategy.

Introduction:

XBiotech Inc. (NASDAQ:XBIT) is a pre-market biopharmaceutical company. They are in the business of trying to develop and commercialize “True Human”™ monoclonal antibodies to treat various diseases including type 2 diabetes, infectious diseases, cardiovascular issues, and others. The organization has been listed since 2015.

Source: XBiotech USA Biopharmaceutical Next Generation Antibody Therapy

I was not aware of XBIT until January when management announced this tender offer; this is because Contra the Heard Investment Letter does not hold pre-revenue entities like XBiotech. Instead, we prefer established companies with long track records and revenues going back many years. (Those readers interested in how we select investments can get a sense of that by reading either of these two Seeking Alpha articles: Searching For A Bargain - Volume II: A Detailed Contrarian Watch List Review and Searching For A Bargain: Where Contrarians Look After A Multi-Year Bull Market.) Nevertheless, it popped onto my radar because I personally sometimes buy into these situations.

The Tender:

This modified Dutch auction was announced January 14 and established a price range between $30.00 and $33.00. Management’s intention was to spend $420 million and close the deal in mid-February. The buyback went off without a hitch; it closed on time and in accordance with its original terms. The final price was at $30.00, at the bottom end of the modified Dutch auction range. This resulted in the repurchase of 14 million shares.

Though buying back 14 million shares represented a huge sum and roughly 32.67% of all common stock outstanding, the tender was still oversubscribed by a significant margin. As a result, the pro-ration factor in effect was approximately 33.25%, meaning that most subscribers to the offer had their tender orders only partially filled, and retained the rest of their shares. This oversubscription was not surprising, however, because XBIT traded at $18.62 on the last full trading day before the offer commenced. The gulf between $18.62 and the $30.00 to $33.00 acquisition range would understandably entice shareholder participation.

It appears the market anticipated this pro-ration. The stock never came close to the acquisition range. The closest it got was $26.40, which was still far from $30.00.

This spread was interesting, and I ended up buying via an odd lot. Although the exact definition of an odd lot can vary, they generally refer to positions less than 100 shares. That was the definition for this tender too.

I selected an odd lot option because it meant proration would not impact me. In other words, the odd lot option meant I knew 100% of my tendered position would be acquired. Avoiding proration was important because I thought the offer would be oversubscribed. I also feared the post-close downside risk and was not interested in owning the enterprise longer term.

On a side note, I was confident it would close as it was not subject to financing. I also thought the odds of a modification to the tender’s terms or an outright cancellation were low given the firm was riding a wave of optimism (and cash) after the Janssen Transaction. Still, the risk of modification or cancellation can never be ruled out entirely. Fortunately, this deal closed on time, and was not modified or cancelled.

The Aftermath:

This repurchase worked out well for investors, and for traders who participated via odd lots. It rewarded those who bought between mid-2017 and November 2019 as well. During that time, the ticker bounced between roughly $3.00 and $15.00. Investors in this camp could have sold into the rally after it was announced, sold down to less than 100 shares and tendered the rest, or tendered their entire position and accepted pro-ration. Regardless, this camp likely did very well.

Traders who did not participate or who purchased after November 2019 may have been less fortunate. The shares have fallen sharply to around $13.00 today. This is the lowest level since the sale of its True Human Antibody Bermekimab Targeting IL-1a to Janssen in early December.

Going forward, the verdict is out as to whether this exercise was a sound capital allocation strategy in the eyes of the buy and hold investor. Skeptics may ask, “Why didn’t executives select a lower price range given the stock was trading in the high teens?” Or, “Why didn’t management keep more cash on hand to fund future developments, engage in M&A, or even start a dividend?” Owners asking these questions could make a strong argument that top brass overpaid given the pre-deal price of $18.62 and the acquisition range between $30.00 and $33.00.

Though management could likely have executed this transaction at lower valuations and still have seen it oversubscribed, the verdict is out as to whether this tender has built or destroyed long term value. A sign the enterprise overpaid will be if it issues stock or options under $30.00. Continued price declines or even stock stabilization from here would be another sign of overpaying. Alternatively, a sign the enterprise got a deal will be if XBIT rallies over $30.00 during 2020 or sells another product for hundreds of millions like they did to Janssen.

A lot of this outcome will depend on the organization’s development and commercialization pipeline. On the one hand, the pipeline looks deep and promising. The firm is developing many drugs to tackle some of society’s most pressing healthcare issues. The Janssen Transaction was also a huge win and represents a material transformation for the organization. This should give investors and the management team confidence. On the other hand, the shares are under pressure and momentum is running against investors. Given the puts and takes, I have rated the corporation as neutral from today’s price.

The c-suite’s ability to maintain a clean balance sheet with minimal debt or dilution while they work towards commercialization milestones will be important as well. Historically, the officers have done an excellent job in this regard. The balance sheet remains debt free, and even prior to this buyback dilution was a minor issue.

Conclusion:

XBiotech Inc. recently completed a tender offer and acquired 14 million shares. The company paid $30.00 a share for a total cost of $420 million. This represents a whopping 32.67% of common stock outstanding, but it was still oversubscribed. The pro-ration factor in effect was approximately 33.25%. Owners who purchased between mid-2017 and November 2019 and then participated in the tender generated significant returns given that XBIT traded between $3.00 and $10.00 for much of that period. More recent investors likely got burned unless they avoided proration through an odd lot which is how I chose to approach this situation.

XBIT has fallen sharply since the transaction closed. Post-deal declines are common, but the tender’s high offer price vs. market price, plus the large subsequent decline, raises questions regarding the soundness of the capital allocation strategy. Answering this soundness question will depend in large part on the organization’s future development and commercialization pipeline, and management’s ability to maintain a clean balance sheet in the process.

Therefore, it’s still too soon to answer the second part of this article’s question: “A profitable trade or capital destruction?” Though the trade was profitable for many, long-term investors will have to wait and see to find out if the strategy destroyed or empowered their capital.

Disclaimer:

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

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