Project Description

Summary

The LLY/ELAN exchange offer represents a very low risk way to make $626 in two weeks. My expected return works out to a 5.1% return and 301% IRR. This is not an official recommendation as it is really only appropriate for odd lot holders (99 shares or fewer). But I made this trade today and wanted to share it in case others want to participate. It’s obviously not a game changer for institutional investors but may be meaningful for smaller investors.

I created a tool in google sheets to help you monitor the trade as the returns will vary depending on the price of ELAN and LLY.

Overview

Eli Lilly (LLY) recently announced that it would spin off its remaining stake in Elanco (ELAN), its animal health business. As a reminder, LLY originally IPO’d a 19.8% stake in ELAN in September 2018. The IPO was oversubscribed. The IPO priced at $24 (up from original target of $21.50) and performed very well peaking at ~$35 shortly after the IPO. Here’s what I originally published about the IPO.

LLY has decided to spin-off its remaining stake in ELAN through a share exchange. LLY shareholders will be able to exchange their shares for shares of ELAN. For each $100 of LLY stock accepted in the tender offer, shareholders will receive $107.53 of ELAN. The one caveat is the maximum share exchange ratio (ELAN for LLY) is 4.5262. So if ELAN sells off significantly before the exchange is finalized, it may be less compelling. However, to me it looks attractive.

The exchange option will expire on March 8, 2019. The exchange is subject to proration (Pfizer’s only accepted 24% of shares tendered in its ZTS exchange), however, LLY has included an odd lot provision such that shareholders with 99 or fewer shares will not be subject to proration. Thus, it appears like an *almost* risk free way to make $626 by my math.

How to Execute the Trade

LLY is currently trading at $124.67 per share. ELAN is currently trading at $29.05 per share.

Here’s how the math works at current price levels.

Step 1: Buy 99 shares of LLY for $124.67 per share. Total cost of $12,342.

Step 2: Per the exchange offer, shareholders will receive $12,276 x 1.0752 = $13,200 of ELAN shares. $13,200 / $29.05 = 456.9 shares of ELAN. However, in this scenario, the exchange ratio ELAN shares / LLY shares is 4.615. The maximum exchange offer that LLY is allowing is 4.5262. So instead of receiving 456.9 shares of ELAN, shareholders who exchange will receive 448 (4.5262 x 99) shares of ELAN. 448 x $29.19 = $13,079.

Step 3: Sell ELAN shares that are received.

This works out to profit of ~$675 profit not excluding commission (Schwab charges $4.95 per trade). Schwab also charges $39 to execute the exchange. So my net profit decreases from $675 to $626 (assuming two trades). On a percentage basis, it’s a 5.1% return and a ~301% IRR.

Not too bad!

The share exchange is scheduled to expire on March 8, 2019. Investors can withdraw their tendered shares at any time until midnight on the expiration date (March 8, 2019 unless LLY changes it).

To tender your shares, just call your broker (after you’ve bought the LLY shares) and inform them that you would like to tender your shares. I did it with Schwab and it was very easy.

What are the risks?

LLY Sells Off

If you buy LLY and it sells off prior to the exchange, you could lose money on LLY. I’m not particularly worried about this risk, as investors have been bidding LLY shares up to take advantage of the share exchange.

However, if LLY does sell off, it would have to sell off by over 5.1% for you to lose money. Also, if LLY falls but ELAN rises, your loss will be offset by receiving more ELAN value (exchange is currently capped at 4.5262).

The Exchange Is Cancelled

The two conditions for the share exchange to proceed are as follows:

  1. At least 146.645MM shares of Elanco need to be distributed in exchange for shares of LLY stock. LLY currently owns 293.29MM shares of ELAN. Judging from the appreciation in LLY stock since the exchange announcement was made, I would expect the exchange offer to be oversubscribed. The ZTS/PFE exchange offer was ~4x oversubscribed as only ~24% of shares that were tendered were accepted.
  2. The receipt of an opinion of counsel that the exchange offer will qualify for tax-free treatment to Lilly. I’m 99.9% certain that LLY has already received assurances from counsel that it will qualify as tax free. However, counsel cannot give its official blessing until LLY the transaction is imminent. I’m not worried about this risk.

Elanco Stock is Weak After the Share Exchange Closes

If the share exchange closes and investors who’ve exchanged their LLY shares for ELAN shares make 5.07%, but then ELAN shares immediately depreciate by more than 5.07%, this trade will lose money.

However, I think this risk is low. ELAN is already trading at an attractive EV/EBITDA multiple versus ZTS.

Also, Elanco also has a great opportunity to increase margins (ELAN is already executing on this) and pay down debt over the long term. This will drive upside to ELAN equity holders

Further, investors are likely buying LLY and shorting ELAN in order to lock in their profit. This is an option that I considered too, but I fundamentally like ELAN so I decided not to. The selling/shorting pressure should subside once the exchange offer has been finalized. If Elanco is weak after the exchange offer is finalized, I would NOT sell as I like the company’s long term fundamentals and current valuation.

Should you buy more than 99 shares of LLY?

Unless you really like LLY on its own merits, I don’t think so.

I don’t have a strong fundamental opinion on LLY one way or another, and I think it’s highly likely this exchange offer is pro-rated (again, PFE only accepted 24% of shares that were tendered in the ZTS exchange offer).

So your gain from the share exchange could be negated by share price weakness from the LLY shares that were not accepted in the tender.

If you like LLY, then feel free to own more than 99 shares. In that case, it would make sense to exchange as many shares of LLY as possible to take advantage of the “free money” because you are happy owning whatever LLY shares aren’t accepted.

Thoughts on ELAN Longer Term

I like the set up of the stock a lot. It’s defensive which is nice in the current stage of the economic cycle. Also, ELAN has ample opportunity to increase margins and pay down debt which should drive long term value for equity holders. Finally, despite these opportunities, it trades at a discount to Zoetis, its closest comparable.

However, I need to do a additional analysis prior to making it an official recommendation.