Merger Arbitrage : TRBN/ EBS

I usually do not get interested in risk arbitrage situation unless there is the potential to earn out-sized absolute return. Most risk arbitrage offer around 15-20% annualized returns, and actually less on large deals. However this one offers great odds for the price of participation.

The idea is not mine it was emailed to me from a reader so hat tip to G&B.

Emergent BioSolutions (EBS) is acquiring Trubion Pharmaceuticals (TRBN) in a deal valued at up to $135.5 million. Emergent will pay $96.8 million, or $4.55 per share in cash and stock, upfront for the company and issue milestone-based Contingent Value Rights (CVR) worth up to $38.7 million more. Milestones are based on mid- and late stage clinical trials of TRU-016 for the treatment of chronic lymphocytic leukemia and non-Hodgkin’s lymphoma, which is partnered with Abbott (ABT).

The math is simple for this merger arbitrage: there are no returns from the merger cash and stock consideration. However you will get the CVR for free at current prices, well close to it for 2 cents. SO effectively you have a cost free shot at earning $1.9 over the next 36 months. You can’t get better odds than these.

When the deal was announced the implied value of the CVR was 27 cents. However now it is 2 cents. See the progression of the implied value in the table below.

Risks

• Will the merger close:
• financing issues: cash consideration for the financing is $27 million only, while TRBN has cash and short term investment of $45 million on its balance sheet as of June 30, 2010. So EBS is actually getting paid to take the company to ensure its going concern.
• TRBN shareholder’s vote. Management own is 5% of the company and I think there is abig likelihood that shareholders will vote yes for the deal
• regulatory approval: already cleared.
• Will the CVR pay out?
• Pfizer potential for cancellation of their clinical studies as they have cancelled a program before merger announcement in July. The amount at risk is $12million. Pfizer decided to pare the dumped drug, TRU-015, comes as Trubion released trial results showing a higher than usual placebo response in a mid-stage trial, or not so exciting results. Pfizer picked up rights to both drugs as part of its 2009 acquisition of Wyeth. It is possible that Pfizer is paring rationalizing its R&D spending so some of these clinical studies will be canned.

Even a 5% probability of CVR payout will ensure to earn four times your invested capital. I was in at 3 cents CVR implied value.

Spin-off Idea: Cardinal Health

By end of business today Cardinal health, CAH, will spin-off its medical care division, Carefusion, CFN, and it will focus on drug distribution. The spin off is very interesting midst all the talk of health-care reform because whenever there is uncertainty it pays to go long.

The market is very hot for the CFN spin off. Although CFN accounts for only a small portion of CAH's revenue, maybe less than 7%, it makes third of its profit. The business is very high margin and its potential for growth is solid. The independent company will be able to focus on new products and free to allocate capital to R&D. But it is fully valued when the when issued shares trade at $19. I figure its value is around $20-$23.

What is interesting is the parent company. The market is betting against it. Short volume has increased significantly over the last month or so. Wagers against health-care shares rose more than 7 percent, the most of 10 groups, to 890.3 million as President Barack Obama proposed an industry overhaul. Shorts thesis is earnings will come be under pressure due to health-care reforms. May be it is true. But CAH margins will stay intact and it will be part of the solution.

Once the spin off is complete, CAH is no more than a logistics provider to drug makers. It provides supply chain services to them and have no R&D commitments. Drugs like goods funnel in and through its distribution network reaches customers. So if health-care reforms lead to reduced costs of drugs, CAH's input costs and revenue will come down in tandem. Its margins will not be affected. Sure the absolute level of revenue and earnings will decline but the company value will be still intact.

I am liking going long CAH rather than CFN, it gives better odds.