At DKI, we’ve been making an effort to be more transparent in how we make investment decisions and to provide more educational content. There are several interesting lessons which can be extracted from the recent scPharma takeover announcement. Before we dive in, I want to be clear that while a likely acquisition was a key part of DKI’s initial thesis for buying the stock, I have had no material non-public information in the stock at any time. Everything I’m about to present is speculation based on my thoughts regarding what was most likely. It’s a way to make sense of what happened, and should not be interpreted that I have certainty regarding any of the negotiations or motivations of the people involved. I am speculating based on experience; nothing more.
Was the Deal Price Low:
Several of us were surprised at the low price of the deal vs our expectations relative to $SCPH’s > 100% growth rate. In prior conversations with management, I formed the opinion that they were smart and shareholder-oriented. They always said if selling the company got the best value for shareholders, they’d consider it at the appropriate time. This leaves me with two likely reasons for the valuation:
- Low probability that management didn’t see more value in the company. I have the takeover price (assuming we get the full $1.00/share from the CVR) at under 3x revenue. That’s for a company growing > 100% this year and > 80% next year. Based on takeover multiples from comparable companies, I would have never expected a value this low. Management would have been capable of doing the same analysis and would have hired an investment bank to do a fairness opinion. That I. bank would have done the same analysis I did. So, why sell so cheaply?
- High probability that they got stuck with a low stock price enabling a low valuation with a high premium. I’ll explain…Above, I note that the valuation for $SCPH was low. However, the stock price was low as well. The deal price (again assuming full value for the CVR), was about a 40% premium to recent prices; both last trade and average closing price for the last 90 days. A typical takeover premium is around 20%. If management chose to fight the offer as too low and unfair, a Blackstone-funded MannKind had the ability to launch a tender offer directly to shareholders. While I would have hesitated to sell at 2.7x revenue, I suspect most shareholders would have hit the bid at a 40% premium to the most recent sale price and at a price that was about 3.5x the recent low in the stock. In that event, management would have had the difficulty of explaining why they were turning down a big premium, and would have been terminated in the event of a successful tender offer. It’s likely that at least some of the $SCPH management got nice offers to remain with the combined company. I’m not suggesting any malfeasance; just noting the likely course of events and the evident incentives. This kind of situation is common. If you think management acted badly, then ask yourself if you think shareholders would have voted against a big acquisition premium. (If some long-time DKI subscribers are seeing a similar issue with another portfolio company, I do as well, and have personally conveyed that exact thought to the company.)
What Happens to the CVR? Do I See it in my Brokerage Account:
I don’t know the answer to this. If you don’t want to own the CVR, then you need to sell $SCPH before the deal closes. If you own the stock when the deal closes, you get the CVR (contingent value right) and can’t trade it. I’ve seen situations like this in the past, but the mechanics were always handled by the back office of a hedge fund. Either you’ll see the CVR in your account, or the company will record your information and ensure you get a check as milestones are met. If you’re curious, I suggest calling your brokerage firm and seeing what they say. Feel free to put any answers in the comments.
Why Did the Stock Price Rise then Fall – Did that Mean the Deal Broke:
On July 24th, just one month ago, $SCPH stock spiked and traded as high as $6.28. Following that, the stock slid and shortly afterwards, traded as low as $4.13. Does that mean there was insider trading and that the deal broke? First, I think some level of insider trading here was obvious. From July 23rd to July 24th, the stock rose almost 20% intra-day on no news. That’s almost always insider trading. For clarity, I’m not accusing management (or anyone in particular). The list of people who see some level of detail include analysts, investment bankers, PR firms and press-release writers, accountants, attorneys, lots of secretaries and people in the copy room and mail room, drivers, travel agents, and someone who overheard half a phone call on a golf course. That list also includes the back-office support people at a dozen different firms. There were hundreds of people who knew.
That explains why the stock rose. So, did the stock fall because the deal broke? Not necessarily. Like me, the insider trading might have been done by people who thought a deal price would be higher and they were subsequently surprised by the lower-than-expected price. At a minimum, the CVR tells us that there was a difference of opinion between $SCPH management and MannKind management. You typically see post-deal adjustments like a CVR when the seller says “we’re worth more than that” and the buyer says “prove it”. In this case, 16% of the deal value will be unlocked when $SCPH proves that it can deliver on regulatory approvals and continued revenue growth. So, it’s likely that the deal hit a rocky patch because there was a difference of opinion on valuation. The CVR was likely a last-minute patch allowing MannKind to pay for value if they received what $SCPH management promised. As I wrote earlier this week, I think it’s more likely than not that we see the full $1.00 in CVR value next year.
Will We Get Another Bid:
I don’t know. If we look at takeovers in prior DKI positions, we have Houghton Mifflin which was bought for $21 in cash. While I thought the company was worth in the high-$20s, the stock had risen from below $5 to over $20 in 13 months. DKI subscribers made over 4x their money in just over a year. There was also some evidence that the deal had been shopped. It was obvious that there was no bigger bid coming. Last year, we made more than 70% in Shockwave Medical in 3-4 months when JnJ bought the company. I had a $300 – $350 acquisition target price. JnJ paid $335 in cash, or 3% above the mid-point of my valuation range. That deal had definitely been shopped as Boston Scientific had done due diligence the year prior.
I don’t know if JnJ, Boston Scientific, or Medtronic took a look at scPharma. I don’t know if MannKind came in with a big premium and pushed for a quick deal. While it’s not likely we get a higher bid, given the low valuation and the fact that $SCPH is a microcap, it wouldn’t take much for one of the big companies in the medical device space to come in with a higher bid. Right now, I think the market is undervaluing the CVR and that there’s a small but non-zero probability of a higher competing offer. That’s why I’m holding.
IR@DeepKnowledgeInvesting.com if you have questions.
Information contained in this report is believed by Deep Knowledge Investing (“DKI”) to be accurate and/or derived from sources which it believes to be reliable; however, such information is presented without warranty of any kind, whether express or implied and DKI makes no representation as to the completeness, timeliness or accuracy of the information contained therein or with regard to the results to be obtained from its use. The provision of the information contained in the Services shall not be deemed to obligate DKI to provide updated or similar information in the future except to the extent it may be required to do so.
The information we provide is publicly available; our reports are neither an offer nor a solicitation to buy or sell securities. All expressions of opinion are precisely that and are subject to change. DKI, affiliates of DKI or its principal or others associated with DKI may have, take or sell positions in securities of companies about which we write.
Our opinions are not advice that investment in a company’s securities is suitable for any particular investor. Each investor should consult with and rely on his or its own investigation, due diligence and the recommendations of investment professionals whom the investor has engaged for that purpose.
In no event shall DKI be liable for any costs, liabilities, losses, expenses (including, but not limited to, attorneys’ fees), damages of any kind, including direct, indirect, punitive, incidental, special or consequential damages, or for any trading losses arising from or attributable to the use of this report.
