Here's a quiz: A company has agreed to be purchased for $37 per share in cash. The shareholder vote to approve is forthcoming. At what price should the company's shares trade?
The answer, in the case of Motley Fool Hidden Gems recommendation Transkaryotic Therapies (NASDAQ:TKTX), is above $37.
True enough, shares have traded as high as $37.10 today. That's more than 230% higher than they traded when we originally recommended the company in Hidden Gems. So, does this mean that shareholders have lost their mind? Why, when a company's stock is due to be exchanged for cash, would people be so daft as to buy it a single penny above the price Transkaryotic's management agreed to sell to Shire Pharmaceuticals (NASDAQ:SHPGY) back in April?
Well, investors believe there's a good chance that the price of the purchase is going up. I, along with Tom Gardner and Charly Travers -- our in-house biotechnology expert and the original source of the recommendation -- have chewed this issue over, and have some thoughts on the state of the Transkaryotic-Shire merger. Back in April, Charly described the news that Transkaryotic had been sold as "bittersweet." You'd think that after such big gains in little more than a year, he'd be more sanguine.
That would also assume that Charly thought Transkaryotic was fully valued. He didn't, and events interstitial have only bolstered his opinion. We believe now more than ever that the merger agreement was ill-timed and underpriced. Several large shareholders have vowed to vote against the deal as priced. We are urging our members and all outside owners of Transkaryotic -- institutional and individual investors alike -- to vote against this deal. The company should undoubtedly be sold at a higher price.
Let us explain by sharing what's strange about the Transkaryotic deal.
In essence, management gave Shire Pharmaceuticals a low-risk call option on the company's I2S drug trials for treatment of Hunter syndrome. When Transkaryotic's board of directors made the deal with Shire, there was a perfect risk trade-off. The company was valued at $37 per share because the drug test results were unknown. But we pointed to the fact that the trial results were due back from the FDA before the company's shareholders would vote on the merger. If the phase 3 trials had come back with negative or inconclusive data, Shire's shareholders would likely have voted down the merger deal. Why wouldn't they? While Transkaryotic has substantial intrinsic value outside of I2S, including its already released Replagal, the company's pipeline is quite thin. There's no question that, eventually, Transkaryotic would have been best suited as a component of a larger organization.
But there's also no question that if the I2S data had come back negative, Shire's shareholders would have scoffed at Transkaryotic's price tag, and would have likely voted the deal down. What is Transkaryotic worth without I2S?
That's an academic question, because phase 3 results were positive. Very positive. Our question becomes: How much is Transkaryotic worth now?!? The answer, we believe, is a heck of a lot more than $37 per share. A heck of a lot more than even $37.10 per share.
Here's how we see it.
Transkaryotic has four drugs of value: Replagal, I2S, Dynepo, and GA-GCB. Replagal is already approved in Europe and is generating revenue. Dynepo is approved but won't be sold until sometime next year. GA-GCB is the company's version of Genzyme's (NASDAQ:GENZ) Cerezyme, which sells about $800 million per year. GA-GCB is a few years from launching. We now know that I2S had excellent phase 3 data and is on track to launch next year.
The clearest winners are Replagal and I2S. The other two have more modest potential because they are up against very entrenched competitors.
Our back-of-the-envelope calculations put Replagal at $100 million in sales this year, peaking around $150 million in a few years. I2S is going after a market that is worth $300 million to $400 million. Hunter syndrome is a fatal condition without existing treatment, so we believe Transkaryotic could capture $200 million in annual revenues.
Dynepo and GA-GCB are in huge but tough markets. Dynepo competes with Amgen's (NASDAQ:AMGN) Aranesp and Johnson & Johnson's (NYSE:JNJ) Procrit, both of which are multibillion-dollar products. Unlike Replagal and I2S, we expect somewhat low market share, with revenues around $100 million to $200 million combined.
So that gives $500 million in annual revenue for Transkaryotic, materializing about five years from now. While we've carried out more sophisticated valuation work, let's share some quick calculations.
If we use simple net margins typical for the biotech industry, we would expect that 15% to 20% of sales fall to the bottom line, for a net income of roughly $80 million to $120 million. For this, Shire is trying to buy the entire company at an enterprise value of $1.3 billion. That's a steal, in our opinion. With the positive results on I2S, our valuation shows that Transkaryotic could be trading well beyond $70 in two or three years. We discount that back to a value of about $50 today. Shire is attempting to purchase the business for $37.
But is the shooting match over already?
We can certainly imagine, given Transkaryotic's turbulent history, why its board might have wanted to take the deal with Shire. Transkaryotic has had to endure an SEC investigation and multiple failed drug trials, and its name has been dragged through the mud. It is more than understandable that a board would say "let's take the bird in hand" and agree to a merger to lock in some of the potential gains for I2S and lock out the potential for renewed heartbreak. But since the FDA's findings came out ahead of the merger vote, shareholders have every reason to value the company higher.
Further, if shareholders needed any indication that the agreed price was too low, it was the resignation of CEO Michael Astrue. He was most responsible for the transformation of Transkaryotic from a humiliated also-ran into a legitimate participant in the development of orphan drugs. Astrue resigned in disgust following the announcement of the terms of the deal -- he believed that the price was too low. Apparently, the market agrees. Since the announcement of the deal, and particularly since the I2S data results were released, Shire's stock has rocketed higher.
Institutional shareholders, controlling about 14% of Transkaryotic's shares, have pledged opposition to the deal at this price, while Warburg Pincus, which also controls 14%, pledged its votes in favor of the deal with Shire.
As we've noted in the past, we firmly believe that Transkaryotic's long-term interests lie in being part of a larger company -- its own drug portfolio is far too sparse. In this vein, we believe that the decision to align with Shire is a positive outcome for the company. But as minority shareholders, we believe that the benefits of this long-term association should matriculate to existing shareholders. Under the current terms of Transkaryotic's deal with Shire, we don't believe that's the case. The price tag of $37 per share deeply undervalues Transkaryotic. This is in some ways the opposite of what has happened to Johnson & Johnson in its ongoing merger with Guidant (NYSE:GDT). Guidant received bad news when some of its defibrillators were recalled, which has caused the market to expect that J&J's bid price for the company will be revised downward. In the Transkaryotic's case, I2S trial results were very positive. This is information that comes before the vote and, as such, should be reflected in the valuation. The reality is that as of now, Transkaryotic ought to be able to negotiate from strength.
Transkaryotic's merger vote is scheduled for July 27. We counsel that shareholders vote "NO" should the price of the deal remain at current levels. We would highly recommend to the board that it attempt to secure the return of Michael Astrue as CEO and that the company recognize the premium that control of the potential cash flows from I2S and its other therapies should command from Shire or any future suitors.
In Hidden Gems, we are reluctant corporate activists. We prefer to see management and the board run their business. But with tens of thousands of members, we will take action when it is warranted. We helped to remove the CEO of Flamel Technologies (NASDAQ:FLML). It is our intention to use this same influence when we sense that our members' interests are not being served.
Transkaryotic at $37 per share, given the new I2S data, is a joke. These shares are worth 30% more today. The market knows it. We're pretty certain Shire's executive group knows it, and we'd welcome an open conversation with those members in the interests of outside owners. Absent that, we recommend voting "no" on July 27 to block this acquisition at $37 per share.
Tom Gardner, Charly Travers, and Bill Barker assisted in generating this report.
Bill Mann owns none of the companies named in this article. He is a co-writer of the Motley Fool Hidden Gems newsletter. A 30-day free trial to Hidden Gems gives you access to Bill Mann and Tom Gardner's best small-cap stock ideas, as well as a vibrant community of shareholders.Click hereto start your trial today! The Fool has a disclosure policy.
