When a company in your portfolio gets acquired

Investors love when a company produces great financial results. This means that the company is performing well and maybe even generating a profit. Shareholders can usually expect a dividend and the share price to trend upward.

But beyond a solid company, investors absolutely adore a company that gets acquired. The acquisition of a publicly listed company will command a premium to the existing share price. While every acquisition is different, it’s not rare to see a premium of at least 30% based on the average share price of the last couple of trading days.

It’s a bit like winning the lottery overnight. The stock price of the acquired company skyrockets by 30% in a matter of seconds.

This happened to be me this month with the acquisition of cancer drugmaker Celgene.

If you are willing to review your portfolio when the stock market crashes, you owe it to yourself to do the same when an opportunity to capture profits presents itself.

The Acquisition

Last week, Bristol-Myers Squibb decided to purchase Celgene in a cash and stock deal valued at $74 billion. The merger is subject to various regulatory approvals and is expected to be completed in the second half of 2019.

Under this tie-up, Celgene shareholders will receive one Bristol-Myers Squibb share and $50 in cash for each share held (or $102.43 per share at the time of the announcement). Based on Celgene’s Wednesday close (January 2), this represents a premium of over 53.7%. As a result, the day following the announcement, Celgene shares surged more than 28%. However, Bristol-Myers Squibb shares tumbled more than 11%. They have since then regained some ground.

According to Refinitiv, the financial data provider, the merger is the largest healthcare deal on record.

What are my options?

Option 1: Do nothing

The first option is to acknowledge the announcement and then ignore the share price volatility. This is the default scenario where you have decided to hold your Celgene shares until the closing of the acquisition.

If I choose this option, on the closing date, my broker – Interactive Brokers – will surrender my Celgene shares in exchange for an equal number of Bristol-Myers Squibb shares. As there is a cash component, my broker will also ensure that I receive $50 for each Celgene share I hold. This cash will simply be deposited in my account.

Even if your account base currency is in pounds, which is my case, the $50 will not be converted. Your broker would have to consult you to do so unless you had already agreed to separate terms when the account was opened. Indeed, exchanging dollars for pounds is a financial decision. This is yours to make and your broker will not risk liability for any potential losses if you are unhappy with the exchange rate or if the pound happens to plummet later down the road.

A few things to consider…

This option implies the following:

• Overall, you are happy with the deal and you want to see it through
• As there is an exchange of shares, you need to take a view on the company whose shares you will receive. If you are happy with the company’s prospects, you are likely to accept the share exchange and hold the shares of Bristol-Myers Squibb
• As for the cash component, you need to decide if you want to leave it in your account, reinvest it or make a withdrawal
• There is always a risk that the transaction will not close. If that happened, the share price of Celgene would probably collapse. You must consider this too.

Although this option appears to be the simplest, this is not necessarily true. There is actually a lot of work involved to determine whether you are happy to hold the stock of a new company. Remember to do your due diligence.

Option 2: Sell the Celgene stock

The second option is to sell the Celgene shares prior to the closing of the transaction.

There are few reasons to do so:

• Capture the premium as soon as possible (even if it’s not the full premium). You are likely to do so if you believe that there is limited upside in holding through closing. In this volatile market, this is not an unreasonable plan.
• Avoid the execution risks. The transaction might not close, which could be detrimental to the Celgene share price. Remember that this deal must clear regulatory approvals.
• You are not keen on holding Bristol-Myers Squibb shares. Even if the transaction did not close, you are happy to exit the Celgene trade and this is a good opportunity to do so.

Working out the math

As discussed, there are multiple factors to take into account. However, the most important one will be the share price of both Celgene and Bristol-Myers Squibb. After all, the goal is to make as much money as possible.

The first question to answer is whether you made money. And in Celgene’s case, it’s not that obvious.

I purchased Celgene a while ago and then averaged down when concerns emerged that some of its recent trials were producing disappointing results. Celgene’s blockbuster cancer treatment – Revlimid – faces increased competition, which is why it is critical for the company to produce new revenue-generating drugs.

The best case scenario

My average cost per share stands at $111.75. On January 2, 2019 – a day before the announcement – it cost $66.64 to own one Celgene share. On the same day, the share price of Bristol Myers Squibb was at $52.43.

Therefore, one share of Bristol Myers Squibb at $52.43 and a cash payment of $50 value Celgene at $102.43 a share. This quick addition is consistent with the announcement made by both companies.

No need to be a math genius to see that my average cost per share is higher than the Celgene valuation. All things being equal, I bear a loss of $9.32 per share. It could be worse, actually, it has been a lot worse. For full disclosure, I only own 13 shares, which will amount to a loss of $121.16 ($9.32 * 13).

This is the best case scenario. In a rational market, nobody will value a share above $102.43 because that’s the price tag announced by both companies. If Bristol Myers Squibb announced that this would be the price – absent any other purchasers – there is no hope of reaching a higher price. Once the acquisition closes, Celgene will no longer exist as an independent entity and there will not be any listed shares to trade on a public stock exchange. Bristol Myers Squibb set a ceiling for Celgene’s share price.

A quick note: not to contradict myself but there is a scenario where I could recoup all my losses. If the share price of the Bristol Myers Squibb share I receive increases by at least $9.32 in the next few months, or years, then I stand a chance to recoup my losses. That’s a big increase and is unlikely in the short term.

The worst case scenario

As of February 9, Celegene share price stood at $87.91. Yes, there was a surge in the share price after the announcement of the acquisition. However, you will have certainly noticed that $87.91 is still a far cry from $102.43. As things stand, the Celgene share price is currently undervalued by $14.52.

In my case, this does not even include the $9.32 loss per share that will occur even if the transaction closes. Therefore, as of this post, I’m nursing a loss of $23.84 per share, or a total of $309.92 (($9.32 + $14.52) * 13). This is starting to be a bit more painful.

Is this free money?

If you do not have any shares in Celgene, now might be a good time to jump in. As explained above, the share price is undervalued by $14.52, which is a hefty 16.5% discount.

If only things could be that easy. The market is unlikely to price the full premium because there is still uncertainty. The main uncertainty relates to the closing of the transaction. As you know, the merger is subject to certain regulatory approvals. If both companies fail to obtain such approvals, then the merger might be abandoned. Alternatively, divestments of valuable divisions may be required in the presence of anti-trust considerations.

One useful indicator is the amount of the breakup fee. When both the acquirer and the target believe that there is a chance that the deal will go through, a high breakup fee might be set. At a minimum, a high fee guarantees that both companies will do whatever it takes to close the transaction.

In this transaction, both companies set the breakup fee at $2.2 billion. This is obviously incredibly high. If either company walks away from the mega-merger, it will have to pay $2.2 billion to the other. Markets may take comfort and view this as an indication that the deal has a higher chance of going through.

A caveat – Contingent Value Right

To simplify the analysis, I have ignored a third component in the Celgene acquisition. In addition to receiving (i) a cash payment of $50 and (ii) one Bristol Myers Squibb share, Celgene shareholders will receive (iii) one Contingent Value Right (or CVR) for each share owned.

This CVR is a right to receive a $9 a share cash payment which will be triggered by the achievement of certain regulatory milestones. The Celgene CVR is based on receiving FDA approval for three drugs currently in Celgene’s pipeline: ozanimod (by December 31, 2020), liso-cel (JCAR017) (by December 31, 2020), and bb2121 (by March 31, 2021).

In other words, if it turns out that the Celgene pipeline of drugs acquired by Bristol Myers Squibb proves to be more valuable than anticipated, Celgene shareholders will share the upside and receive an additional $9 per share.

If you believe that those trials will be successful, then add $9 for each share to the above-mentioned calculations. I decided to not factor those in because I have no idea whether those trials will turn out to be any good. As a result, I prefer to exclude potential profits that might never see the light of day. This is a more conservative approach.

Remember to do the math and look into the company acquiring the business if there is a share component in the transaction. In doing so, you should be in a position to make an informed decision as to what you want to do.