When Shareholders Attack

(Editor's note: Carl Icahn's recent share purchase does not give him a proxy vote on the Shire acquisition. He has expressed his intention to seek appraisal rights for his shares in the Delaware court system.)

Sometimes a board of directors does something so cockamamie that outside investors have to scratch their heads and entertain conspiracy theories. But let's not assign to conspiracy what can best be explained as incompetence.

The decision in question was made this spring by the board of orphan-drug company Transkaryotic Therapies (Nasdaq: TKTX  ) , proposing to sell itself outright to Shire Pharmaceuticals (Nasdaq: SHPGY  ) for $37 per share in cash. The price marked a 22% premium to the market value of Transkaryotic. But the deal was announced before the release of final test results for Transkaryotic's I2S treatment for Hunter's syndrome, a rare childhood disease.

Two months after the announced merger, the data came back stunningly positive, suggesting that this drug could generate as much as $200 million in new yearly revenue for Transkaryotic. Outside shareholders, who today own more than 75% of the company, had been waiting a long time to see those results. In the intervening years, they'd endured an SEC investigation, the loss of 90% of the value of their company, and an overhaul of the executive ranks.

I expect that, when the deal goes up for vote on July 27, these primary owners of Transkaryotic will summarily reject the plan.

The chorus of opposition
We have told our tens of thousands of Hidden Gems members that they should shoot down the deal. I believe that the firm should either remain a stand-alone or that it be sold for in excess of $50 per share (more than 30% higher than the proposed price). This valuation work comes from advisors running a service that has returned 35% versus S&P 500 gains of 11%.

We were joined last night by billionaire Carl Icahn, who has taken aim at such companies as Hewlett-Packard (NYSE: HPQ  ) , ImCloneSystems (Nasdaq: IMCL  ) , and Blockbuster (NYSE: BBI  ) . Icahn disclosed that his firm has taken a 5% stake in Transkaryotic. Icahn purchased shares above the all-cash deal price of $37 and will vote against the merger. So too will investment firms Porter Orlin and Millennium Group -- owners of more than 16% of Transkaryotic. And in a remarkable move, given that the merger is non-hostile, Institutional Shareholder Services (ISS) -- a watchdog of corporate governance that holds no stake in either company -- is urging investors to deny the merger on the grounds that $37 per share significantly understates Transkaryotic's value.

Interestingly, Shire's chairman, Matthew Emmens, apparently agrees. At a Deutsche Bank conference in May, he crowed about how cheap he would be buying Transkaryotic.

Why so much opposition?
There are plenty of reasons to reject this deal. Here are three of mine.

1. CEO Michael Astrue's resignation
This past week, Transkaryotic's board of directors publicly affirmed the unanimous support of its directors for the deal, but it left the former CEO off the list. In agreeing to the acquisition, the board overrode the opinion and wishes of Astrue, who resigned instantly in disagreement "with the price, structure, and timing of the deal." In April, both Astrue and board member Walter Gilbert (winner of the 1980 Nobel Prize in chemistry) voted against the merger. In its merger filing, the board of directors disclosed that the company's CEO:

"expressed his belief that we should remain independent at least until we learned the results of the pivotal clinical trials of our I2S drug candidate. Mr. Astrue also expressed his belief that we should have approached potential buyers more broadly prior to entering into the merger agreement with Shire."

The board's decision to overrule Astrue is particularly distasteful because of his extraordinary performance as its leader. When he took over as CEO in November 2003, Transkaryotic was in tatters. The stock was trading below $4 per share as the SEC announced it would bring civil action against the firm for disclosure and securities violations. Into that mess stepped Astrue, a graduate of Yale University and Harvard Law School. He cleaned up the business, embraced partnerships with larger drug companies, and presided over a 10-fold return for shareholders in less than three years.

A year ago, I interviewed Astrue, as we do the CEOs of recommended companies in Hidden Gems, and I concluded that he comes as close to being a Level 5 leader as any small-company executive I know. Astrue waved off compensation in his first three months, focused the organization on teamwork within its industry, and set a higher standard of ethics than existed at the firm.

When this deal is rejected, I recommend that shareholders call for his return as CEO, granting him an opportunity to nominate his own slate of directors. I suggest this will lead to investment returns vastly superior to a $37 buyout by Shire.

2. Of fairness opinions and blackmail
A second reason to oppose the deal has to do with fairness opinions and break fees.

Transkaryotic's board has defended its decision by citing fairness opinions obtained from Bank of America (NYSE: BAC  ) and SG Cowen that support a sale price of $37 per share. That's a weak leg to stand on. For the uninitiated, the subtext to fairness opinions generally goes something like this, "Tell us what you want to hear, then we'll find a way to justify it."

For context, Warren Buffett does not seek fairness opinions when BerkshireHathaway (NYSE: BRKa  ) makes acquisitions. For that matter, I wonder what the fairness opinion would have concluded about the intrinsic value of Transkaryotic back when Astrue took over as CEO in 2003 with the stock below $4. I doubt it would've called for $37 in less than three years. Astrue's departure has negatively affected the value of this company. His return will do the reverse.

What is additionally stunning is that these fairness opinions were obtained before the release of the positive results for I2S. Transkaryotic's board of directors is now saying that the fairness opinion was based on assumptions of a successful launch of the drug. That strikes me as absurd, but I'll accept it for the sake of argument. If that's the case -- if the board expected the drug results would be positive -- then I ask why they would ever agree to pay a $52 million fee in the event the merger didn't clear.

This is where I struggle with incompetence versus conspiracy.

If the fairness opinion assumed that the I2S test results would come back positive, what other reason than blackmail is there for Transkaryotic's board to agree to a $52 million payment in the event its shareholders went against the deal? I question the legitimacy of this break fee, arrived at without the consent of Transkaryotic's primary shareholders (who own more than 75% of the firm).

3. Where are the shareholders' yachts?
Finally, throughout its defense of the deal, the board has emphasized just how beneficial this merger is for the company's constituents. But who will enjoy the spoils? Management will take home substantial retention bonuses. The employees at Transkaryotic will automatically receive a lump-sum payment equal to half their annual salary.

But what will the shareholders get?

Transkaryotic's merger filing answers that plainly: "Following the merger we will no longer exist as an independent, stand-alone company and our stockholders will no longer participate in our growth or in any synergies resulting from the merger." But even that overstates the benefits to shareholders! Outside owners will have to bear the expense of capital gains taxes, a cost that is not factored into the deal price.

By assenting to an all-cash transaction, Transkaryotic's board has forced all of us to evaluate this as a purely financial transaction. Strictly by the numbers. And now, one investor after another along with a neutral corporate watchdog have concluded that a sale at $37 per share does not represent fair value for long-term owners of Transkaryotic. It's the equivalent of selling an A+ business situation at a B+ price.

Conclusion
I want the boards of directors at Transkaryotic and Shire Pharmaceuticals, their employees, and their individual and institutional shareholders to understand exactly why we have told our Hidden Gems members to reject the merger.

We are not alone in this decision. We agree with former CEO Astrue, who opposed the deal. We agree with Shire Pharmaceuticals Chairman Matthew Emmens, who thrills at how cheap he might buy Transkaryotic. We agree with Carl Icahn. We agree with Porter Orlin and Millennium Group. And we agree with neutral watchdog Institutional Shareholder Services.

The price of $37 per share is substantially too low.

Given that, we urge the two companies to either meaningfully boost the cash buyout price or to negotiate a fair exit to the deal (considerably below the absurd break fee). If the merger fails to go through, we urge Transkaryotic's board to immediately return Michael Astrue to the CEO seat, giving him latitude to nominate a board of directors capable of representing the long-term interests of the majority of the company's shareholders.

If you'd like to hear what other investors think, and join a group of active shareholders, take a free trial to Hidden Gems with no obligation to subscribe.

Tom Gardner is co-founder of The Motley Fool. He owns no shares of companies mentioned in this article. The Fool has a disclosure policy.


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