Special Situation: Genzyme Contingent Value Rights (GCVRZ)
It’s impossible to value! At least that was my reaction when I first looked at the terms of these contingent value rights. There are 6 potential cash payments that a holder of the CVR may receive. Each cash payment is contingent on a milestone being achieved. Five of the six milestones have to do with the drug Lemtrada, a potential treatment for MS, which is currently under development. The other milestone (and likely the first in chronological order) is based on production levels of Cerezyme and Fabrazyme drugs. I have no idea whether any of these milestones can be achieved and I am willing to bet that neither do 99%+ of the current holders of the CVRs. But exactly because of this, I think there is a high likelihood that either currently or during the life of this security there will be significant mis-pricing by Mr. Market. Since there is no way to truly value the security until we get more information as we move along in the drug development/production process, my guess is that the CVR price will be quite volatile and, contrary to any rational pricing model, will follow the market but with a significantly high beta.
How are we going to tell, then, when the CVR is priced too high, or, more interestingly, priced too low? The only thing we can do is take our cues from Mr. Market and our understanding of what merger securities (like our CVR) have historically done. Right now I would venture that the market mood is rather optimistic, so that should be inflating the price of the CVR. On the other hand, one might expect that because the CVR made up such a minor portion of the takeover purchase price ($74 in cash plus one CVR per Genzyme share) and the CVR is a complex security not appropriate for most equity funds, there would be selling pressure until the end of the current quarter. OK that sets the stage. What is the only thing we know for sure? The current market price. So let’s start there. Let’s assume that anyone who is holding on to this strange security is also doing some kind of rational analysis, maybe even assigning a likely date and probability to each of the milestones being achieved. If we reproduced such a model we should be able to come up with an expected nominal value of the CVR cash flows which would then be discounted to get to a net present value somewhere around the current market price. That’s all well and fine you say, but how can anyone estimate the dates the milestones will be met, what probability that the milestone would be met and then what discount rate would we use? Well, we can’t exactly, but in essence we’re not trying to predict what will really happen, rather, we are trying to guess what Mr. Market thinks will happen. So using a bit of common sense and juggling the pieces around a bit I’ve come up with a scenario or two that is consistent with the one piece of information we have, the current market price. Listing the milestones and taking a totally uninformed stab at the dates at which the milestones might be reached and assigning a probability to the achievement of each milestone, we can come up with an expected nominal cash flow stream (see Table 1 below). In order to come up with a net present value (read, market price) we then need to discount the expected cash flows by some discount rate. But which one? Theoretically, if one used the 10 year treasury bond rate, 3.3% (close to the same period covered by my milestone date guesses), as the discount rate, we should be willing to pay $3.17 for the CVRs. I don’t know about you but I certainly wouldn’t accept a 3.3% return given that the variability of the potential outcomes. So what about if we add the expected equity return of 7% on top of the 3.3% 10 year treasury return?
|3||Sales target 1||12/31/15||$2.00||35%||$0.70||$0.60||$0.44|
|4||Sales target 2||12/30/16||$3.00||25%||$0.75||$0.62||$0.43|
|5||Sales target 3||12/30/17||$4.00||10%||$0.40||$0.32||$0.21|
|6||Sales target 4||12/30/18||$3.00||5%||$0.15||$0.12||$0.07|
Maybe I’m double counting here, risk free rate plus full equity premium, but even at a 10.3% return I don’t think this investment would be attractive for me. Even Mr. Market, known to be semi-delerial at times, would be hard pressed to justify these investment parameters. So in Table 2, below, I’ve sharpened my pencil, reduced the probabilities and increased the hurdle discount rate to 15%. Is this realistic? I don’t know. But it’s my take on what Mr. Market might be thinking (do your own homework! Don’t rely on my flights of fancy!). But for me, I’ve given myself a much higher hurdle rate, 25% (see my blog What’s wrong with my Portfolio). If Mr. Market is willing to accept $2.50 for a 15% expected return, what should I be willing to pay for a CVR? Not more than $1.87 according to my calculations in Table 2.
|3||Sales tgt 1||12/31/15||$2.00||50%||$1.00||$0.52||$0.35|
|4||Sales tgt 2||12/30/16||$3.00||30%||$0.90||$0.41||$0.25|
|5||Sales tgt 3||12/30/17||$4.00||15%||$0.60||$0.24||$0.14|
|6||Sales tgt 4||12/30/18||$3.00||5%||$0.15||$0.05||$0.03|
We’re almost a year away from the first milestone (which, by the way, won’t give us any insight into whether the next milestones will be achieved), so there’s a good chance that with a market decline we might wring some of the current market optimism out of the CVR price at some point over the next year. If so, I may have a chance to pick up the CVRs at or below my buy target. If not, well, we just won’t swing at this pitch!
Any reader thoughts on this would be very welcome.