Current Price –$122.5
Offer Price – $131.7
Upside – 7.5% or $900 for Odd Lot holders
Expiration date – 8th of March, 2019
This is a rather standard split-off transaction of which I have already posted quite a few. The most recent ones were FTV/AIMC, CBS/ETM, PG/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.
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.