AGI Therapeutics, binary outcomes, Gross IRR, Gross Return, intangibles, intrinsic value, John Paulson, junior resource stocks, Risk Arbitrage, Warner Chilcott, Warren Buffett
Continued from here. OK, we’ve run through the key components of the AGI Therapeutics (AGI:ID/LN) offer. You now have a pretty good idea of the terms, attractiveness, timeline and likely success of this deal. But how does it stack up from an investment perspective? Well, as I said, let’s not approach this backwards – as with any investment, no matter your excitement or conviction about the company/stock story, intrinsic valuation comes first:
AGI’s most recent balance sheet (Jun-11) is pretty simple – they’ve $9.251 mio of Cash on hand, while Net Payables of about $0.3 mio are offset by a subsequent sale of patents to Warner Chilcott (WCRX:US) for about $0.3 mio also. This sale probably wiped out some/all of the $0.241 mio in recorded Intangibles, and there’s really nothing else to the B/S. btw I tend to ignore balance sheet Goodwill/Intangibles/etc. anyway when calculating Intrinsic Value. You should be able to confirm/calculate the value of intangibles from other sources – like reserve reports, industry comps, superior/sustainable earnings etc. – if you can’t, it’s usually best to ignore these ‘assets‘ (try tell this to your average junior resource company investor, sigh…).
Yes, of course, there’s probably still value (possibly substantial) in AGI’s intellectual property. But an industry buyer, particularly one that can engage with management/perform due diligence, is in a far better position to put a value on this. From my perspective, the best I can estimate it’s worth (as Buffett once said) is ‘somewhere between zero and a whole lot‘. This is another pearl from Buffett, presented in his inimitable folksy manner. What’s he really pointing out is that he’s happy to wait for the right pitch & refuses to pay up for ‘blue sky‘ promises – because if you’re patient, the right stock will come along at the right price…AND it will have some/lots of blue sky thrown in for free!
This is especially important to remember when you’re dealing in small biotech and oil & gas exploration stocks, for example, where outcomes are so binary… That’s the problem with binary or individual outcomes – some nutter always pops up to tell you about his 100 year old smoking/drinking/whoring grandfather, or that junior oil share he bought that promptly tripled – but so f**king what?!
They’re completely ignoring the relevant underlying/average outcomes..! My (value investing) approach to this type of stock, as I’ve written about regularly, may well mean I miss an occasional winner, but ensures I avoid the frequent & far more likely disasters...
And AGI’s one of those stocks where blue sky is thrown in for free. If we fast forward to Jan 9th, 2012, we can estimate a cash-burn of about $933 K (based on a $890 K semi-annual cash-burn) mitigated by expected share option proceeds of EUR 338 K. That pegs Cash around $8.747 mio. Based on 67.413 mio issued shares & 4.2 mio of in-the-money share options, that’s an intrinsic valuation of $0.122 or EUR 0.096 per share, vs. a EUR 0.08 share price.
As you can see, no value’s being assigned to intellectual property in this particular takeover offer. But in other instances, these intangible assets can capture a significant premium. Stocks like this, trading at/below cash with potentially valuable intangible assets, do come along now and again if you’re patient. Obviously, you have to be cognizant of/and adjust for a likely cash-burn, but these stocks can present v interesting investment opportunities.
So, is this a bad deal for AGI shareholders? Perhaps..!? But I’ve no vested interest here, I’m simply looking at a Recommended Cash Offer, which I think has a v high probability of success, and where my calculated Intrinsic Valuation exceeds the Offer. This is a v attractive deal to invest in, even if deal returns on offer are low. If my intrinsic value’s below the current share price/takeover offer, I’d be reluctant to invest, even in a reasonably certain deal – there will be plenty of better deals to come. On the other hand, if intrinsic value’s far higher, this might well encourage me to invest in a far earlier stage/lower certainty deal and/or I believe it raises the odds of a second bidder showing up at the dinner party. Yes, to put it another way…it’s a cheap value stock, but with a v obvious catalyst!
OK, the deal looks good, the intrinsic valuation’s very supportive, now what kind of return’s on offer? I think about this in 3 different (but related) ways. Note I’m going to focus on Gross figures from here on, as readers have v different broker service, commission costs, tax statuses, base currencies etc. You should, of course, factor all of this in when evaluating your own potential/actual returns. Let’s use AGI’s numbers to walk through these – let’s assume the share price is trading at EUR 0.08 or $0.102 per share. With a Takeover Offer of $0.1171, the Gross Return is 14.7%. This is actually quite extraordinary for a deal of this nature! People are wary of/criticize smaller and less liquid stocks/markets, but in reality this is where market inefficiencies show up best if you have the time, patience and stomach for them.
Next we have Gross IRR. If we’re optimistic (which I think is warranted here), this deal will likely be declared unconditional on Feb 3rd, with settlement due 2 weeks after. That’s only 39 days away, to realize a 14.7% Gross Return! Now, let’s imagine Risk Arb nirvana – assume for the next year we always have another equally good deal lined up whenever we exit a deal – our actual Gross Return for that year would compound up to about 261%..! This is the definition of Gross IRR – it’s just Gross Return presented on an annualized basis. The big driver here will always be time, rather than return – even a v small Gross Return looks extraordinary on a Gross IRR basis if the timeline involved is v short.
I look at both of these return measures together, as they tend to be a little deceptive on an individual basis. Gross Returns (for well advanced deals) are usually much lower than we see with AGI, and can often seem downright unattractive vs. other investment choices. But this ignores the much shorter/more certain timeline involved to value realization – the much larger Gross IRR highlights this nicely. On the other hand, a short timeline can make even a 1% Gross Return look seductive on a Gross IRR basis. For example, a measly 1% Gross Return to be realized in 1 week actually has a Gross IRR of 67.8%! I think there’s a happy medium, I’ll usually pass on even a ‘safe‘ deal if it doesn’t offer say at least a 3% Net Return – even though this can mean I’m missing out on some v attractive Gross IRR deals.
Of course, neither of these returns captures the downside risk that’s involved. That’s why I use a third return measure – probably the most important, and the most difficult, return to calculate & focus on…
To be continued…
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