Eli Lilly (LLY) – Split Off – 7.5% Upside ($900 for Odd Lots)

Current Price –$122.5

Offer Price – $131.7

Upside – 7.5% or $900 for Odd Lot holders

Expiration date – 8th of March, 2019

SEC Filling

 

This is a rather standard split-off transaction of which I have already posted quite a few. The most recent ones were FTV/AIMCCBS/ETMPG/COTY and LMT/LDOS. I recommend reading through those and examining share price behavior of involved companies during and after the tenders to familiarize yourselves with risks involved in this kind of transactions.

In short, every $100 of Eli Lilly (LLY) stock accepted in the tender will be converted into $107.53 of Elanco Animal Health (ELAN) stock subject to the upper limit of 4.5262 shares of ELAN per LLY share. Tender will expire on the 8th of March 2019. Odd lot tenders will be accepted on priority basis and there is no borrow on ELAN stock to hedge the position.

 

Important points to consider:

  • ELAN borrow is not available on IB (not sure about other brokers), therefore those tendering will be exposed to ELAN share price movements. It will take approximately 1 week after the tender expiration for LLY to distribute new ELAN shares. Drop in ELAN share price during this week might fully eliminate any upside from the trade. Premiums on put options are too expensive to be worthwhile. Borrow might still reappear, as has happened on previous split-offs.
  • As a result of the split-off ELAN float will increase five-fold from 20% to 100% of outstanding shares, which might result in considerable selling pressure at least in the short term.
  • Final exchange ratio will be determined based on the VWAPs on the 4th, 5th and 6th of March, so one might wait till then to enter the position (IB deadline for tendering is usually noon on the expiration date). Keep in mind that due to upper limit on the exchange ratio, upside might be reduced or eliminated till then.
  • Transaction is subject to upper limit of 4.5262 ELAN shares per share of LLY. At current prices the exchange ratio is below the upper limit. If the spread widens (i.e.  LLY gets more expensive and ELAN gets cheaper) till/during valuation dates, the final pay-off might be less than 7.5% or get eliminated altogether. Exchange ratio calculations can be tracked on daily fillings.
  • As only c. 6% of LLY shares will be exchanged in the split-off, LLY share price is unlikely to be effected much by this arbitrage situation and proration is likely to be high.
  • Odd-lot holders (less than 100 shares) will be exempt from proration.
  • If the offer is undersubscribed (unlikely) then Eli Lilly will retain ownership of ELAN. There is a minimum condition requiring LLY to distribute at least half of its ownership, otherwise the tender offer might get cancelled.
  • Both companies already reported annual earnings and there are no material expected/scheduled events till the tender expiration.

 

Quick thoughts on Elanco valuation

Eli Lilly IPO'ed Elanco Animal Health in Sep 2018 at $24/share (above the initially expected pricing range of $20-$23) by issuing 20% of shares to the public. IPO was well received by investors and shares popped +50% on the first trading day. Now five months later LLY is offering it's full 80% stake in ELAN in exchange for c. 6% of its own stock.

Such a fast dumping of shares should not bode well for the perceived valuation of ELAN stock. LLY is highly informed seller and the message is clear - management believes ELAN stock is more expensive than LLY and the switch even with additional premium creates value for the remaining Eli Lilly shareholders.

In terms of ELAN performance since IPO, the 2018 guidance has been been sort of met - revenue in the middle of the guided range (6% YoY growth), slight miss on GAAP EPS, however adjusted EPS was above the expected range. Guidance for 2019 shows 1.7% growth in revenues and c. 10% drop in adjusted EPS.

Elanco trades at 27x forward adjusted EPS. Zoetis, it's main competitor in animal health care industry, also trades at the same 27x forward adjusted EPS multiple. However, Zoetis has higher scale (revenues are 2x larger) and it expects 7% (or 4.3% organic) growth over the next year.

With the above superficial view in mind (and otherwise a complete ignorance on the animal health care industry) I do not have any arguments in favor of Elanco undervaluation. I would say that at best it is fairly valued relative to Zoetis. So in case there is a selling pressure following tender expiration, I would not feel very confident in holding Elanco shares for longer term expecting a rebound.

 

My position

If anyone is interested in my intentions on this - I do not have a position at the moment, but intend to enter one (with 99 shares) closer to expiration date if the spread remains favorable.  If past split-offs are of any guidance then unhedged positions should work positively.

Obviously every case is different and I might get burned - I have no experience or confidence with large cap animal pharma stocks that trade at 27x earnings.

46 COMMENTS

  1. Paul

    Is it possible to hold the odd lots in separate taxable and IRA accounts (99 shares in each) and earn the full arbitrage amount in each? Or has this window closed?

    1. dt

      I am not able to answers this fully, as I have one single account only. However, from what I read around having accounts at different brokers or different types of accounts counts as separate for odd-lot purposes. But it might change at any time – it used to be possible to submit a number of odd-lot positions at IB until one day all of them got aggregated.

    2. Walter

      FYI, Interactive Brokers doesn’t let you do this anymore. They used to, but then at some point started counting shares across all accounts, so you won’t get the odd lot.

  2. lyjgeorge

    If short is possible, then the way to hedge is “long 100$/LLY stock , and short 107.53$/ELAN” ?

    1. dt

      When the exchange ratio is known (i.e. two days before the expiration), that should be the trade.

  3. Terence

    LLY price rose recently, causing the upper limit to kick in. The expected 7.5% upside is now only 5%. Wonder what % buffer is good enough for an un-hedged position?

    As DT said, ELAN stock float will increase 5x. Past split offs resulted in big increases in the float, but I think 5x is higher.

    1. nuggy5

      Isn’t the public float about half of what is being distributed to LLY shareholders? Ie ~72mm float now with 146mm being distributed to LLY.

      It looks like almost 25% of the current float is short so I am not sure what kind of price action we’ll see after distribution.

      1. dt

        293m of ELAN shares will be distributed if tender is fully subscribed. 146m is just minimum condition for the tender to happen.

    1. dt

      Something was wrong with the newsletter. Should be fixed now. But let me know if the problem persists.

  4. dt

    There is some ELAN borrow available on IB today and I opened hedged position. However the exact exchange ratio will be determined only over the coming 3 days.

  5. Martin Hernon

    dt, ELAN borrow is now showing rate of about 70%, does that change your strategy? IB indicating a rate this high means high rate of forced buy-in. Maybe put options?

    1. dt

      Short position will be open for one week only, so 70% annually translates into 1.5% cost. Hedging via March put options is also possible, but last time i looked premiums were too high.

      I am not too worried about forced buy in and also think that unhedged position might work out as well.

      1. Chaim Gewirtz

        Why one week? Doesn’t it usually take two weeks to receive the shares?

    2. mcg mcg

      No, it doesn’t mean a high rate of forced buy-in. Borrow costs are an input in option pricing so those should be pricing about the same amount of premium.

  6. Michael Lax

    I sold in the money call options on Elan as a hedge, less expensive than shorting at current borrow rates.

    1. Random Deals

      What’s the strike price and expiration date for your call options? There is no protection below the strike price. For April 18 call options, it looks like the volume for strike prices below 30 is very low. The March 15 expiration is too soon. You will probably not have received the ELAN shares by then.

      1. Michael Lax

        Sold the March 15th 28 strike price, hopefully the brunt of the post-tender decline will be over by then or the shares will have been received.

    1. mcg mcg

      depends on your broker, but you’re more than likely too late.

  7. Prateek Kumar

    Anyone know what the exact deadline at Interactive Brokers is for submitting the tender instructions?

  8. Fa

    When shall we expect to receive our ELAN shares coming from our tendered LLY?

  9. Random Deals

    From past experience, in both PG and LMT exchange offers, the delivery dates were 6 business days after the expiration dates.

  10. wlblount

    This is a first for me. Do you try to cover? or let them cover for you? does it matter? I dont want to get doubled up.

  11. Alex15

    Very bad situation. Personally, I don’t have any experience in this. But I wait for them to cover me. Yesterday the volume in the shares increased, so maybe by 9 am situation looks better.

    1. work 22

      I wouldn’t stress about it either. You have a cushion, losing money on this is possible but unlikely. ELAN also might go up and you might thank IB for buying you in. That’s happened to me before! And if not, well, it won’t be a big loss.

      1. nostradamus

        Close-out resolved

        In my experience on the bigger names these buy ins usually get resolved in the morning fortunately.

  12. dt

    I am not too worried about this. If the short leg of the trade gets closed out, I will still have a buffer of 7% and only 3-4 days till new ELAN shares are distributed.

    And who knows, maybe ELAN continues to trend upwards and eventually I will be happy that the short got closed earlier than I wanted.

    In any case, not much can be done about this now and so to borrow words from a wise man ‘then why worry':
    https://www.youtube.com/watch?v=9YRjX3A_8cM

  13. wlblount

    “ELAN.REC” showed up in my positions at IB this morning.

    Might not be the place here for the discussion, but as some of the comments above touch on, what would be wrong with selling calls 3-4 strikes in the money (90s delta)? sell April, cover when shares show up?

    1. Benjamin Perley

      I wonder how many of those 17k odd-lots were natural holders or people like us?

  14. dt

    So in the end borrow fees consumed c. 1.5% (10 days holding) of the spread and returns on unhedged positions were higher.

    I opened position 3 days before the exact exchange ratio was known and by shorting at the upper limit in the end have pocketed $900 (after borrow fees).

    Odd-lots buying on the 7th of March (when the exchange ratio was already known) and not hedging would have received $1000+ (depending when the position was closed yesterday, with $1000 return minimum).

  15. Rick Sanchez

    I did this unhedged and sold out today for +7.6% returns (right in line with estimated returns at time of posting) — thanks again dt!

  16. Bateman

    This one worked out best if you bought LLY early ($120), and sold ELAN($32.50) late.

  17. makarid

    I am sorry but have anyone found any logical reason for the ELAN huge stock price surge?

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