Is This the Merger Arbitrage Play of a Lifetime?

Merger arbitrage is consistently one of the most powerful strategies for making money on Wall Street.

The definition alone says everything…

arbitrage (ärbiˌträZH) noun – the practice of taking advantage of a price difference between two or more securities.

Well, one such opportunity just presented itself in the biotech industry.

It’s a juicy one, too.

Forest Laboratories (FRX) recently announced a definitive agreement to acquire Furiex Pharmaceuticals (FURX).

Although the deal’s agreed-upon price is $ 95 a share, it also includes an additional $ 30 “contingency.”

On the news, Furiex’s stock shot from $ 80.15 to $ 103.76.

But since the contingency could push the final value to as high as $ 125, the prudent move is to investigate the matter further.

Reason being, if the contingency is realized, Furiex shareholders would pocket a quick 20% as soon as the deal officially closes, which is scheduled to happen in late September.

So I asked biotech expert, Marc Lichtenfeld, to brief us on the situation.

He even agreed to handicap the likelihood of the deal closing at $ 125.

You’ll be hard-pressed to find anyone who can match wits with Marc in the biotech niche.

Onward and Upward,

Robert Williams
Founder, Wall Street Daily

Transcript:

Robert Williams: Hi there. Robert Williams of Wall Street Daily.I asked biotech expert, Marc Lichtenfeld, to join us today. Marc, let’s just jump right in. Get us up to speed on the very latest.

Marc Lichtenfeld: So Forest Labs is acquiring Furiex Pharmaceuticals for about $ 1.1 billion, and the reason that this deal makes sense is, Forest Labs, the big pharma company, about $ 25 billion, has I think almost two dozen products. But the jewel crown in their product portfolio is a drug called Linzess for Irritable Bowel Syndrome with constipation, severe constipation.

Now this is a drug that has recently been approved, but it’s expected to be a blockbuster, it should do a billion to maybe even as much as $ 1.4 billion in revenue this year, so it’s a big drug. Furiex also has an Irritable Bowel Syndrome drug but it’s for IBS with diarrhea so it’s for people with a similar condition but a little bit of a different situation.

This really would give Forest Labs the dominant position in Irritable Bowel Syndrome, which is a very big market, there are tens of millions of people in the United States and Europe who suffer from Irritable Bowel Syndrome and so if Furiex’s drug is approved, which is expected because it had very good Phase III data, then it really puts Forest Labs in a very strong position in a very lucrative market.

RW: Now Marc, if I understand this correctly, the wild card in all of this is the FDA. They’re going to make a classification on a certain drug of Furiex, correct?

ML: Exactly, so Furiex’s drug, Eluxadoline, is also considered a pain killer and pain killers are looked at very, very carefully by the FDA. So there’s two issues here, one, does it even get approved? And, as I mentioned, I think it does and a lot of people expect it to be, and clearly Forest Labs does, as well. But the fact that it’s a pain killer means that it can be classified according to what they call the schedule. It can be schedule 1, 2, 3, 4, or 5. The terms of the deal say that Furiex shareholders will get $ 95 a share, minimum.

Then if the drug is approved without any of these classifications or restrictions on it, they’ll get another $ 30 a share, so $ 125. If it’s labeled a schedule 4 drug, then it will get $ 10 a share, another $ 10 to make it $ 105. If it’s a schedule 5, it’ll be another $ 20. Just to give you an example of the kinds of drugs that are considered schedule 4 and 5 drugs, so schedule 4 drug would be valium and Xanax. A schedule 5 drug would be cough syrup.

So even cough syrup is looked at by the FDA as a drug with the potential for abuse so any time you have a pain killer the FDA does look at that and consider that.

Depending on how the FDA regulates this or classifies this with the schedules will depend on – weight the difference in how much Furiex shareholders receive. The fact that it is a pain killer that – and as I mentioned even cough syrup gets the scheduling. I would say there’s a decent chance it will be a schedule 4 or 5.

RW: Ok, Marc. So our readers out there who are looking to earn the arbitrage spread in this, the FDA ruling is everything in this. It’s going to dictate how much this deal closes, correct?

ML: Exactly, and so right now the stock is trading, like you said, about $ 103, which is just $ 2 off where it would – where Furiex shareholders will get paid if the drug is classified as a schedule 4, which is the most aggressive FDA classification that is expected. So like you said, that 21% is kind of misleading ‘cause that’s really a best-case scenario where shareholders get the $ 125 when there’s no scheduling or no classification at all. But I’m not sure how likely that is given that there is a pain-killing element to this drug and the FDA is always very, very concerned about the potential for abuse.

Right now the drug – I mean the stock is trading with the most conservative assumption that it gets a schedule 4 classification. If it gets schedule 5, then you’ll see it jump another $ 10 or so.

RW: So maybe the play isn’t to buy shares, Marc. Is there a way we can participate in all the upside if the FDA approval goes favorably, while also, at the same time, protect our downside?

ML: Yeah, well, I think maybe in the options market and I haven’t looked at the prices so I couldn’t tell you for sure if the options represent good value or not. But I think if there is an opportunity in the options market that would be the better way to go because that would limit your downside but let you participate in upside. So whether it’s buying the stock but owning a cheap put or just buying a call or if maybe there’s even a call spread opportunity, something like that.

But you really, if you are gonna take a shot at that extra $ 10 or $ 20, you really want to make sure that your downside is limited and you’re not risking too much to make that $ 10 or $ 20. ‘Cause right now the market is telling you that it’s gonna be – the deal’s gonna go off at $ 105 so you really want to protect yourself in case something unforeseen happens.

RW: Marc, you’re the biotech expert. You’re embedded in the industry more than anyone I know. Can you handicap this for us? What, in your opinion, is the FDA likely to do here?

ML: It’s so hard, the FDA is so unpredictable. I would say – if I had to guess – you can see how hard it is, I’m struggling here, but you would – I would guess that they’re gonna get something. They’re gonna get the schedule 4 or 5. I have a hard time picturing any kind of pain killer, as I mentioned even cough syrup gets a schedule 5 classification, so I have a hard time – any pain killer that you need a prescription for would not have something. But whether it’s a 4 or 5 I don’t know.

I haven’t seen all the data as far as the potential for abuse and the company certainly had to provide that data and do that kind of analysis but I would guess that it’s gonna be at least a 4 or 5 and the likelihood of it not getting anything where the deal goes off at $ 125 is probably pretty slim.

RW: Ok, there you have it. Thanks for your time as always, Marc.

ML: Oh, my pleasure, thanks for having me.

RW: Marc Lichtenfeld is the Associate Investment Director at The Oxford Club. And anyone who’s interested in checking out some additional research by Marc, click the link below. For Wall Street Daily, I’m Robert Williams.

 

In addition to once being a full-time trader of equities and equity derivatives, Robert has also served as the lead financial analyst for a Forbes top-50 private corporation and an analyst for the endowment of a major academic institution. Learn More >>