When I was a kid, I was a huge baseball fan and card collector. I spent many hot summer afternoons negotiating trades with my friends, swapping Mark McGwire and Dwight Gooden rookie cards along with players to be named later. These often turned into heated exchanges with each of us making a compelling case for what these cards were worth.
This back and forth over pieces of cardboard involved a lot of relative valuation, even though we had no idea at the time. Player stats, rarity of the card, prior trades we'd made, and how bad you thought the other person wanted what you had all went into the decision making. It's pretty sophisticated thinking for 9-year-olds.
But it's lousy for stock analysts. I hate relative valuation. It's garbage. But I'm in the minority because it's used all the time and is here to stay -- not just with baseball cards. Whenever you buy a car or a house, the value is most likely going to be based on the value of transactions of similar products. While relative valuation methods admittedly have a place for assets such as houses and baseball cards that don't generate cash, I don't like it one bit for assets that do spit out cash. A discounted cash flow analysis is far superior for calculating the intrinsic value of a company.
So why all this talk of valuation? U.K.-based Shire Pharmaceuticals
Transkaryotic's board of directors disagrees with us. In a very well-written and compelling letter to the company's shareholders, it said that I2S was included in the overall valuation of the company under the assumption that it would be approved. Technically, that is true. But I'm going to call shenanigans.
The devil is in the details. The merger proxy statement provides details on the fairness opinions provided by SG Cowen and Bank of America Securities, which are being used to justify accepting Shire's offer of $37. Frankly, I am concerned that their approach does not fully capture the value of Transkaryotic's pipeline. Their methods are overly reliant on relative valuation analysis. Making it an especially hard pill to swallow is the comparison of Transkaryotic to companies that look nothing like it. Transkaryotic is nothing like MedImmune
To be fair, discounted cash flow analysis was done, but in my opinion the time periods used were too short to capture the full value of the company's drugs. Thus, while the board was technically correct to say that I2S's value was included in the fairness opinions, I think it's a bit misleading to say that the full value of the drug was accounted for. Since I2S sales will not peak for at least seven or eight years, there is no choice but to model the drugs out into the distant future -- certainly farther out than in the assessments done by SG Cowen and Bank of America Securities. There is no other way to really capture the value of this drug.
Transkaryotic's value comes primarily from the drugs Replagal, I2S, Dynepo, and GA-GCB. I modeled revenues from these drugs out through 2019 and then subtracted the projected expenses for manufacturing and selling the products. This gives the cash flows for each drug. These cash flows were then taxed, and the present value was obtained using a discount rate of 12%.
Once I had the base case, I also modeled out a pessimistic scenario, which assumed that some things went badly for the company -- like, say, disappointing performance from Dynepo against entrenched and generic competition and the failure of GA-GCB to gain significant traction against Genzyme's
As it turns out, my estimate of Transkaryotic's fair value is very close to what Shire is offering to pay for the company. On top of that, despite using slightly different methods than SG Cowen and Bank of America Securities, there is some overlap between all of our results in the big picture.
I don't want to imply that $36 is a hard absolute number. Valuation is always more art than science, and that is especially true when we're talking about small biotechs. I see $36 as a starting point for discussing what the company is worth; there's certainly some wiggle room.
As with the SG Cowen and Bank of America assessments, the details of what I did are crucial, but I can only touch on it briefly here. Full transparency is important to us, so please click on the links below to view spreadsheets containing all three of the valuation models (you will need Microsoft Excel to download the files).
The bottom line
If Transkaryotic is worth somewhere close to $36 today, does that mean shareholders should automatically accept Shire's offer of $37?
My answer is a clear and resounding no. First, this is an all-cash offer, so the acquisition is a taxable event for Transkaryotic shareholders. If you're going to get dinged for a 15% hit at the long-term capital gains rate, then I believe you should be compensated for that.
Second, Transkaryotic is very likely to increase in value in the coming years. By selling today, shareholders are missing out on the company's future growth -- a lost opportunity unless you can take the proceeds from selling the shares and put it into an equally attractive investment. Such an investment may or may not exist, and shareholders may not be able to get returns somewhere else that they could have gotten by holding onto Transkaryotic. Thus, there is an opportunity cost for which Transkaryotic shareholders should require compensation.
Taking into consideration the tax hit and the lost opportunity, Transkaryotic shareholders should require a premium to the company's fair value before accepting a buyout offer. There's no hard-and-fast answer to how much of a premium should be offered, but I think 25% is reasonable.
To accept a buyout offer, Transkaryotic shareholders should be asking for a price somewhere near $45 a share. That is certainly higher than Shire's current $37 offer. Transkaryotic shareholders should therefore reject the current offer.
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