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This article is part of our Rising Star Portfolios series.
Sometimes you just have to watch it happen without you.
Near the end of March, I ran a screen I had developed to try to find companies that might make good candidates for my Messed-Up Expectations portfolio. In that port, I'm looking for companies at prices reflecting growth expectations that are lower than what they're likely capable of, and getting high returns when the market corrects its mistake.
Among others, the biotech company Cephalon (Nasdaq: CEPH ) showed up. It appeared that priced-in expectations were for shrinking free cash flow over the next 10 years before "improving" to no growth at all from then on (discounting at my 15% hurdle rate). Somewhat intriguing, so I put it on a list of ones to look at further.
Before I could, though, Cephalon's share price jumped 34% to over $75 a week later when Valeant Pharmaceuticals (NYSE: VRX ) began a hostile bid at $73 per share, valuing the company at $5.7 billion. Cephalon called the offer too low and rejected it. Now the two companies are locked in a battle over who will control the board of directors, as Valeant has nominated its own slate using a consent solicitation process.
Assuming the SEC approves the solicitation letting it move forward, and Cephalon's shareholders give the nod to Valeant, then Valeant has plans. The company said it would move to remove a poison pill provision currently in effect at Cephalon (a measure designed to make takeovers more difficult) and look at Cephalon's books. That might or might not lead to a higher offer.
It's going to be a hard fought battle, though. Cephalon has begun to urge its shareholders to reject the consent solicitation, saying that the current board is most familiar with the company and best suited to maximize shareholder value, as well as saying any board nominated by Valeant runs the risk of being biased in favor of Valeant.
Given what's happened, I have to ask myself, "Would I have chosen to invest in Cephalon?" The answer is, "Probably not."
Cephalon is facing the same patent cliff many other drugmakers are. In this case, Provigil, a sleep disorder drug that made up about 40% of Cephalon's revenue last year, loses patent protection next year. Valeant seems to believe that it can reduce costs enough to make the deal profitable, even after that expiration.
Other mid-size pharmaceutical companies are also facing patent expirations. For instance, Forest Laboratories (NYSE: FRX ) loses protection on anti-depressant Lexapro next year and Alzheimer's drug Namenda in 2015. In its fiscal third quarter, Lexapro accounted for 55% of Forest's revenue, with Namenda contributing 30%.
Regardless of the risk of drastically reduced revenue in the not too-distant future -- something I'm not willing to take on in the MUE port -- the interest in Cephalon is causing speculation that others might be targets. If Valeant fails in its bid for Cephalon, Jazz Pharmaceuticals (Nasdaq: JAZZ ) or Medicis Pharmaceutical (NYSE: MRX ) might be next, according to one analyst. Their prices have moved up recently, thanks at least in part to such speculation.
All in all, I can't invest just on the hope that a company is going to be taken over. That's not a successful long-term strategy because I can't predict when such deals will be announced. So while I might wish that I had purchased shares before the announcement -- unlikely, given its dependence on Provigil -- I can live with having missed this one. There are plenty of other opportunities to look at.
To see what else is on my list of potential buys, visit my MUE discussion board.
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).