Abbott Labs and Alza

Group Case Report 3

Abbott Labs and Alza

1.        Use the stock prices of Abbot and Alza and plot the deal spread from June 22 till December 31, 1999. Pay attention to the dates listed on page 6-9 under “Tracking the Deal” section. What factors were affecting the fluctuation of deal spread?

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Factors which caused decrease in share price:

It seems like lawsuit filed by some shareholders as an effort to reject the deal has impact on the share price, as it can be seen as a signal the market that there are shareholders with strong will to go against merger (July 2 and October 14).

Alza’s shareholders vote to approve the company’s proposed merger with Abbott. Those who are unhappy of merger would have sold its shares, leading to decrease in share price (September 21).

Abbott had issue with FDA. Abbott argued that their facility and manufacturing procedures are in compliance with FDA regulations. However, FDA stated that they are concerned about Abbott, taking action only if it is revisited after a long period. This could lead Abbott to be unable to sell some of the products which could substantially affect company’s sales and eventually, the breach of merger.

Factors which results in increase in share price:

FDA approvals of drugs show positive impact on its share price. It gives the market an impression that approvals would lead to commercialization of products which is directly related to potential increase in sales and market share. Increase in profit highly likely represent the greater amount of returns to investors. Therefore, it can be said that share price has positive relationship with FDA approvals.

Another noticeable factor would be company’s announcement of its performance. Whenever the quarterly reports with increase in profits were released, share price increased. Market might have interpreted this information as company is growing consistently and possessing efficient business structure.

2.        Exhibit 11 provides the potential annualized return assuming the deal would be completed on December 31, 1999. In fact, the deal was cancelled on December 16, 1999. Calculate the actual annualized return on Green Circle’s Abbott-Alza investment.

Net spread, potential ROI and annualized potential ROI will change when the deal was cancelled before the expected day.

Gross spread (Total) =Value of Abbott Shares to be received – Price of Alza

                     = (43.50 × 312,000shs) – (48.00 × 260,000shs)

                     = 13,572,000 – 12,480,000

                     = $ 1,092,000

Net Spread = Gross Spread – Margin Interest + Short Sale Rebate

         = 1,092,000 – ((6.2% × 50% × 12,480,000 × (176/365))

                       + (5.6% × 13,572,000 × (176/365))

         = 1,092,000 – 186,550 + 366,481

         = $ 1,271,931

Potential ROI = Net Spread / Total Capital Employed

           = 1,271,931/ ((50% × 13,572,000) + (50% × 12,480,000))

           = 1,271,931/ 13,026,000

           = 9.76%

Annualized Potential ROI = Potential ROI × (365/Number of Days Until Completion)

= 9.76% × (365/176)

= 20.25%

Actual annualized return on Green Circle’s Abbott-Alza investment was finally 5% larger than they expected.

3.        Smith was considering buying put options to hedge against deal failure risk, as described on page 9 of the case. Suppose he decides to buy one put option for every Alza share he holds (using money additional to the $12.5 million already invested), then what is the potential annualized return if the deal were completed on December 18th? What is the actual annualized return when the deal was cancelled on December 16th? Does the use of options decrease or increase his returns? What about risks? What do you think of this option-based hedging strategy?

 Smith is contemplating using put options on Alza shares in order to hedge his position. In order to assess the impact of this option, let us say that we purchase the put options on Alza, at the strike price of $40 at a premium of $3.25 as mentioned in the case. In case the merger is successful, the put is not exercised and relative to the current position, Green Circle loses the premium paid. In case the merger is unsuccessful, the payoff depends on whether the Alza share ends up above or below $40. If the price of the Alza share is x dollars below $40, the put is exercised and saves $(x – 3.25) as compared to the current unhedged position. We see from the table that the returns have decreased significantly. The following calculation makes it very clear:

No. of Options bought             = 260,000

Total cost of options                = 260,000 x $3.25= $845,000

Net Spread                          = $1,287,265-$845,000 = $442,265

Potential ROI                           = 442,265/(13,026,000+845,000)

                                                 = 3.188%

Annualized Potential ROI                = 3.188% x (365/191)

                                                     = 6.09%

The put option reduces the risk to a slight extent since it protects from an adverse movement in the price of Alza in the event of the failure of the merger. However, the corresponding reduction in returns seems to be too high. This is because of two reasons:

The put option gives a positive payoff only in the case when the merger is unsuccessful and the price of Alza falls below (40 – 3.25) or $36.75. Given the fact that the price of Alza has not fallen to this level in the recent past and the news relating to the company has been generally positive, this scenario looks unlikely.While the put option prevents the downside in case of the Alza shares, the position is still vulnerable to adverse movements in the price of Abbott. Also, given the recent news relating to Abbott, the adverse movements in Abbott shares may be a possible scenario.