Prescription for Takeover Fever

Canadian-based Valeant Pharmaceuticals International Inc. (TSX: VRX, Friday’s close $51.37) last week made a hostile US$5.7 billion (US$73 per share) bid for US drug-maker Cephalon Inc., (NASDAQ: CEPH) a 24.5% premium to Cephalon’s recent price of US $58.75 per share. The transaction would be financed by additional debt, nearly tripling Valeant’s debt load to $11.2 billion from $4.5 billion. Valeant went public last year after it merged with another Canadian drug giant, Biovail.

Valeant’s offer will go directly to shareholders. However, Cephalon itself is proposing to buy the remainder of Australian cancer drug company ChemGenex Pharmaceuticals that it didn’t already own, putting a lower buyout value on Cephalon. According to Valeant, Cephalon felt the Valeant bid was too low. So a battle could be shaping up with a possible white knight waiting in the wings – it’s a battle that Valeant might lose if shareholders reject the offer.

Valeant’s shares popped to $51 from $42 last week in anticipation of the deal. They could just as easily deflate again if new offers come from other bidders. And it could retain its current value if the deal ultimately goes through. Such is the events that follow companies when they are in play.

Options allow one to play the “in play” game, but… at a cost. Typically, when pricing equity options it is virtually impossible to value company specific risk. And for individual companies, it is those events unique to that company that have the most impact on the stock price. And usually, those events are non-public and cannot be reasonably predicted.

Valeant presents an interesting case study, because the company specific event has been made public. Knowing the details allows option traders to more effectively price risk. We know, for example, that if the deal goes through, Valeant will take on leverage which by definition tends to make the stock price more volatile. Longer term then, a successful takeover will permanently raise the volatility implied by Valeant options.

In the interim, Valeant options are being priced based on the probability of a successful takeover. Which is to say, somewhere between the higher premiums that would be associated with a longer term increase in volatility naturally associated with additional leverage. And the value of a failed takeover, in which the stock drops sharply in the short term, but longer term, returns to its normal volatility pattern.

If you are looking to trade the “event” which is the takeover, you must make your own assessment as to the probability of the deal going through as initially set up. If you believe that to be a low probability, then buy Valeant puts, because that would imply a high likelihood that the stock returns to its previous trading pattern. Look at the Valeant July 48 puts at $2.70.

If you think that the deal is likely to go through, then you could look at a covered call write, or cash-secured put. With this scenario, we assume that traders have already factored into Valeant’s stock price, a high probability of success. Leaving limited upside potential, but… limited downside as well. Look at buying Valeant at $51.37 and writing the July 52 calls at $4.00. Or if you prefer the cash secured put, write the July 50 puts at $3.50.