Chris DeMuth's State of the Markets December 2023

Episode Summary

Executive Summary: In this year-end podcast, Andrew Walker and Chris Demuth discuss several investment topics including Roivant Sciences' complex structure and litigation value, the Spirit Airlines/JetBlue merger antitrust trial, and broader market themes for 2024. They analyze the government's weak antitrust case against JetBlue/Spirit, critique corporate capital allocation decisions favoring M&A over buybacks, and highlight opportunities in biotech and financials. Key insights include Roivant's IP litigation against Pfizer/Moderna, the potential for demutualizations in thrifts, and the importance of CVR analysis in biotech deals.

Main Topics: Roivant Sciences (ROIV) Analysis (Priority: 5/5): Discussion of Roivant's complex structure of public/private subsidiaries, net cash valuation, successful Immunivant (IMVT) investment, and valuable litigation against Pfizer/Moderna over COVID vaccine IP. The stock trades near net cash despite having billions in cash and valuable pipeline assets. Spirit Airlines (SAVE) / JetBlue Antitrust Trial (Priority: 5/5): Detailed analysis of the DOJ's case to block the merger. Critics argue the government failed to prove harm, relied on weak theories, and the judge may still rule against due to pricing concerns. The outcome will set precedents for future airline consolidation and antitrust enforcement. Biotech Investment Opportunities (CVRs & Activism) (Priority: 4/5): Discussion of broken biotech companies trading below cash value, potential for activist-driven deals with CVRs, and the importance of reading background sections of fairness opinions to understand true CVR probabilities. Examples include recent deals like Theseus (THRX). Bank & Thrift Merger/Remutualization Outlook (Priority: 3/5): Expectation for more bank/thrift mergers in 2024, particularly remutualizations of orphaned mutual holding companies that trade at big discounts to tangible book value. This offers an arbitrage opportunity to take them private again. Corporate Capital Allocation Critique (Priority: 4/5): Criticism of companies buying other companies at multiples above their own stock valuation instead of buying back shares. Examples include fiber companies building at $2500/home pass when stock trades at $1800/home pass, and management-led buyouts at discounts to book value. Merger Arbitrage & Antitrust Environment (Priority: 3/5): Review of weak deal volume in 2023 due to interest rate volatility, and outlook for 2024 with hopes for more deals, especially in biotech and financials. The Spirit decision will impact how other mergers like Albertsons and iRobot are viewed.

Key Arguments: Roivant's SPAC structure trades near net cash but has a massive IP litigation overhang against Pfizer/Moderna that could double/triple the stock for a small relative cost to the defendants. The litigation is strategic because it creates cross-licensing pain points. The DOJ's antitrust case against JetBlue/Spirit is weak because they did not prove actual harm, relied on out-of-context quotes from precedents, and all industry witnesses (United, Frontier CEOs) testified the merger would not harm competition due to easy route substitution. Companies routinely destroy value by acquiring at multiples above their own stock valuation instead of buying back stock. Management entrenchment and desire for growth at any cost override shareholder value creation. Contingent value rights (CVRs) in biotech deals are often structured to benefit the buyer, not the seller, because the party paying the CVR controls whether the milestone is achieved. Reading the background section of fairness opinions reveals who truly advocated for the CVR and their incentives. Demutualizations of orphaned mutual holding companies offer a near-arbitrage opportunity: take them private again at a fraction of tangible book value by buying out the public minority at a discount. The Spirit case outcome will set a dangerous precedent if the government wins, allowing them to block any deal that could raise nominal prices, even if the target's business model was unsustainable. This would protect business models rather than competition.

Data Points: Roivant stock price vs net cash: Trades below net cash - Roivant has billions in cash but stock trades near net cash, implying the rest of the portfolio and IP litigation are valued at zero by the market. Immunivant (IMVT) secondary price: Secondary after moonrocket - Roivant participated in Immunivant's secondary offering after a positive drug trial result caused the stock to surge, despite Roivant itself trading below net cash. Pfizer market cap: $162 billion - Pfizer is 400x larger than Arbutus (ABUS), which holds IP that could be strategic for Pfizer against Moderna. Moderna market cap: $38 billion - Moderna is also a potential defendant in the IP litigation, and a royalty could be valuable cross-licensing leverage. Roivant drug sale to Pfizer: $7.1 billion - Roivant bought a drug from Pfizer for effectively nothing and sold it back to a different entity for $7.1 billion, showing capital allocation skill but also raising questions about the transaction's nature. JetBlue/Spirit market-implied probability: 40% for JetBlue, 60% for government - The stock price of Spirit implies the market sees a higher probability of the government winning, contrary to Chris's view that the government's case is weak. Number of antitrust cases for judge: Second antitrust case in his career - The 80-year-old judge hearing the Spirit case has limited antitrust experience, which adds uncertainty to the outcome despite the legal merits. Roivant secondary price (Nov 2022): $5 per share - Roivant did a secondary at $5, well below net cash, diluting shareholders despite having billions in cash, highlighting the disconnect between capital allocation and market valuation.

Pivotal Quotes: "I don't believe the government proved their case. I don't believe that they proved that there was harm. You might, for the sake of a decision, stipulate enough harm to construct a divesture package. But I think there's some shot that you would actually have a blowout for the companies that would even undermine the divestiture package that they proposed." — Chris Demuth: Analysis of the JetBlue/Spirit antitrust trial, arguing the government failed to meet its burden of proof. "And then saying it's a ratchet effect that if you ever do something, you may not raise prices as a result of a transaction. You can think of all sorts of perverse consequences. What if an airline was discounted because of lax safety standards, separate from any kind of regulatory issue? They just hired pilots that were only moderately successful in sobriety... And then the buyers came in and said, we're going to have safer commercial air travel and we're going to hire more sober pilots... And we have to raise the ticket price by 5%. And the government says, No, you can't do that. We have sanctified whatever business model has the lowest nominal price." — Chris Demuth: Illustrating the absurdity of the government's antitrust theory that any price increase resulting from a merger, even for legitimate improvements, can be blocked. "How can all those things be true? Either you should get a 90% pay cut or you should get a massive increase to what you're offering, but it can't both be right." — Chris Demuth: Critique of a founder-led buyout at a discount to tangible book value, where management has consistently destroyed value but continues to pay themselves highly.

Implications: If the DOJ wins the Spirit case, it will embolden aggressive antitrust enforcement against any deal that could raise nominal prices, even if justified by quality improvements. This would chill airline consolidation and may spill into other industries. Conversely, if JetBlue wins, merger activity in airlines and beyond could increase. Biotech and financials are likely to see more deals in 2024 due to valuation disconnects and activist pressure.