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Equities

Professors Philip Baird and Thomas McCue of Duquesne University explain why purchasing call options on your own stock can help preserve financial benefits for your shareholders.

Did Cephalon Gamble with Call Options?

Is purchasing call options on your own stock a risky bet or a legitimate way to protect shareholder value?

In a May 22, 1997, article in the Wall Street Journal entitled "More Firms Use Options To Gamble on Their Own Stock,” reporters E.S. Browning and Aaron Lucchetti claimed that a growing number of companies in recent years have used options to "gamble” on their own shares. By the Journal's count, the list already exceeds 100 and includes such household names as Intel, Microsoft, IBM, Boeing, Adobe Systems, Dell Computer, Dow Chemical, General Mills, Maytag and McDonalds.

In a frequently used strategy, corporate managers make bullish bets on their shares by selling put warrants, which give the holder the right but not the obligation to sell the shares back to the firm at a preset price during a fixed time period. If the bet pays off, the firm pockets the option premium as the stock price rises and the puts expire worthless. Because these transactions have rarely backfired in the prolonged bull market of recent years, selling puts has become popular with corporate managers. Microsoft, for example, has made more than $300 million according to the Journal and has never made a losing bet. The company currently has outstanding put warrants on more than $2 billion of its common stock. Intel has also made extensive use of the strategy. It has received $423 million in premium income and is currently exposed to puts on $1 billion of its shares.

Critics point out that, to some extent, the strategy's popularity may reflect poor judgment by corporate managers who seem increasingly to underestimate the risks associated with selling options. When a firm issues puts, for example, it does so in the belief that the stock price will rise, or at least not decline. Hence, the market interprets the announcement as a bullish signal of management's confidence in the firm's prospects.

Even managers can be wrong, however, and a bull market in no way guarantees higher stock prices. Selling puts exposes the firm to the risk of buying shares at above-market prices. Moreover, in the face of a declining stock price rising equity costs may combine with the expenditure of precious cash resources to strain the firm's financial flexibility.

Nevertheless, issuing puts can be an effective way to provide insurance for stockholders. Intel, for example, issued puts in 1992 while involved in a patent infringement lawsuit with Advanced Micro Devices. A negative outcome would have had a substantial impact on Intel's future profitability as well as its stock price. Some of the institutions that held Intel shares purchased put warrants for protection. The puts, in effect, enabled shareholders to establish a floor under the stock price.

Many other firms have issued puts to reduce the costs of ongoing stock buyback programs in a bull market and to hedge convertible debt securities. Still, in the wake of recent events at Procter and Gamble, Gibson Greetings and Orange County, many boards of directors have grown uncomfortable with virtually all types of derivative securities. Fearing shareholder suits, many firms have stopped using them altogether or have restricted their use solely to the issuance of put warrants.

Was Cephalon wrong?

The Journal article cited an innovative transaction undertaken by a pharmaceutical company, Cephalon, as an example of a risky derivative strategy gone bad. In anticipation of FDA approval of a new drug, Cephalon purchased $10 million worth of call options on its own shares. Had approval been obtained, the proceeds from the option's subsequent gain in value would have been used to fund the drug's commercialization. The FDA's denial, however, sent the stock price plummeting by more than one-third, and although the call options still have time to run, Cephalon is unlikely to fully recoup its investment. Critics argue that the firm "bet the farm and lost” in an unwise and exceedingly risky derivative deal.

But Cephalon's decision to purchase call options on its stock was not as foolhardy as critics have charged. Indeed, the transaction can be viewed as a financing strategy that would have minimized potential dilution and thus preserved the new drug's financial benefits for existing shareholders. Moreover, by virtue of the unique method by which the option purchase was financed—with shares as opposed to cash—the transaction did not impair Cephalon's financial flexibility nor did it increase the risk of the firm's shares.

The transaction clearly was a play on the FDA's review of MYOTROPHIN. Indeed, the bet was placed only the day before the FDA's announcement of its decision on the drug's commercialization. While Cephalon management surely hoped to capture the appreciation in its stock price that would have followed FDA approval, it appears, after some reflection, that Cephalon's motives went beyond foolish speculation and were based in fact on sound financial considerations.

The agreement can be seen as a prudent, albeit risky, strategy, and much of the criticism it has received has been unwarranted. Cephalon planned to use the funds to finance the commercialization of MYOTROPHIN. Management certainly understood the risk that the FDA would not approve the drug, making the calls potentially worthless. This risk, however, is unsystematic in nature and has little impact, in theory, on shareholders with well-diversified portfolios. Moreover, the strategy minimized the expected dilution of existing shareholders and would have avoided the possibility of selling equity below its true value.

Background

Cephalon is a pharmaceutical company that uses its technical expertise in biology and biochemistry to discover and develop new drug products relating to neurodegenerative disorders such as Alzheimer's disease. Founded in 1987, it has yet to develop a commercially viable product. The firm has produced no revenues during its entire history, and as of September 1996 had an accumulated deficit exceeding $150 million.

Cephalon's motives went beyond foolish speculation and were based in fact on sound financial considerations.

Cephalon funds its operations with external equity financing and with payments from other firms to conduct research and development. As a formal business strategy, the firm seeks strategic alliances with other pharmaceutical firms when management believes that such alliances can provide Cephalon with important technical, financial, marketing or manufacturing benefits. These agreements are typically structured with option-like features giving Cephalon the right to commercialize and copromote new products in exchange for "milestone payments.” These payments are required at various points in the development process—in particular, following the attainment of necessary regulatory approvals.

Cephalon thus holds real options to exploit various technologies that management believes may eventually become commercially viable. When the future benefits of a particular line of research appear smaller than the required milestone payment, management simply forgoes the payment and thereby allows the option used to develop that research to expire worthless.

Cephalon's 10-K and other reports indicate that some cash is invested in repurchase agreements and that the company has in the past issued call warrants and convertible securities. In view of this information and the option-like features found in their partnership agreements, it appears that Cephalon management has an above-average level of financial sophistication with regard to derivative securities in general and options in particular.

The company has never earned a profit or paid a dividend. In early April 1997, the stock was trading near $18 per share, down from its high of $40.75 reached in late 1995. With 24 million shares outstanding, Cephalon's market capitalization was roughly $440 million and, according to Morningstar Equities, institutions held 75 percent of the shares.

The spring of 1997 was an eventful time for Cephalon. On May 8 of last year the Peripheral and Central Nervous System Drugs Advisory Committee of the Food and Drug Administration met to consider Cephalon's application for MYOTROPHIN (rhIGF-I). Cephalon developed this drug in collaboration with Chiron Corp. for use in the treatment of amyotrophic lateral sclerosis (Lou Gehrig's disease.)

On April 9, 1997, Cephalon announced that an agreement had been reached with the Swiss Bank Corp. (SBC), London Branch, by which Cephalon would purchase capped call options on 2.5 million of its own shares.

Management hoped to benefit from appreciation of the firm's stock price following the FDA's expected approval of MYOTROPHIN. Although options on Cephalon stock trade on the American Stock Exchange, this was an over-the-counter, primary market transaction that allowed Cephalon to tailor the deal to its specific needs.

In particular, the option was purchased not with cash but with 490,000 shares of Cephalon stock issued to SBC, an amount equal to about 2 percent of the 24 million shares outstanding. This is perhaps the deal's most interesting feature, since both the ultimate cost of the option to Cephalon and its ultimate payoff depended directly on the FDA's decision. Based on a $20.25 closing price on May 6, 1997, the day before the trade, the "premium shares” had a value of $9,922,500, representing a premium of roughly $3.97 per option on one share. The additional shares raised SBC's holdings of Cephalon to 750,000 shares, or approximately 3 percent of the total outstanding.

The capped calls were set to expire on October 31, 1997, and give Cephalon the right to purchase 2.5 million shares of its own stock at a strike price of $21.50 per share. Since the options were capped at $39.50 per share (the cap price), the maximum potential gain is $18 per option, calculated as the cap price less the strike price. If the stock price traded at or above $39.50 at expiration, Cephalon stood to make $45 million, or as much as $91.84 on each of the 490,000 premium shares. The transaction was to be settled in cash, although the bank may opt to deliver shares by providing 30 days' notice of its intent to do so. These are European-style options, which can be exercised only on the expiration date. Finally, it should be noted that since the strike price exceeded the stock price on the day of the trade, the options were out of the money when purchased.

Analysis

MYOTROPHIN was developed in partnership with Chiron Inc. under an agreement that required a $16 million milestone payment from Cephalon to Cephalon Clinical Partners L.P., contingent on FDA approval. At a specified time following commercialization, Cephalon was obligated to purchase the outstanding limited partnership interests for approximately $40 million plus royalties in order to retain its rights to commercialize MYOTROPHIN in the United States and Europe. Hence, Cephalon held a real option on the drug with a strike price of at least $56 million and with a value that depended critically on the FDA's decision. Had the drug been approved, the option would have been extremely valuable and Ceph-alon would have needed a substantial cash infusion to exercise it. As it turned out, however, the drug was not approved, so the option's exercise and the need for cash became moot.

Cephalon's purchase of the stock option can be seen as a mechanism for financing the exercise of its real option on MYOTROPHIN. Had approval been obtained, Cephalon's stock price would have risen substantially, perhaps to a level exceeding the cap price of $39.50. The option's payoff of as much as $45 million would have provided a substantial portion of the cash infusion needed for the milestone payment, for expenses that were likely to have been incurred in the subsequent development and marketing of the drug, and for the purchase of outstanding partnership interests. Unfortunately for Cephalon stockholders, however, both the real option and the financial option now appear likely to expire worthless.

In evaluating the stock option as a funding mechanism, it is necessary to consider alternatives that might have been pursued by Cephalon management. One possibility would have been simply to wait for the FDA's decision and then raise the necessary funds externally through a debt or equity offering. Since Cephalon had recently sold $30 million of convertible debt, an equity issue would appear to have been the only feasible source of external funding. The costs of issuing equity consist of underwriting fees and the market impact on the price of outstanding shares. Theoretically, this market impact depends largely on the degree of information asymmetry between managers and outside investors, or, in other words, on the extent to which management has better information on the firm's prospects than do shareholders. When this asymmetry exists, the stock price, which reflects investors' opinions of value, can be above or below management's estimate of the firm's true value.

Investors recognize that managers acting in the best interests of existing stockholders tend to issue shares when the stock price is too high. Consequently, an announcement of a new equity offering tends to be interpreted, rightly or wrongly, as a negative signal that the stock is overvalued. The stock price therefore declines, perhaps even to a level below its true value. This negative market impact, along with underwriting fees, increases the number of shares that must be issued in order to raise a given dollar amount, and it contributes to a dilution of existing shareholders' interest. Firms therefore overwhelmingly prefer to finance their operations with internally generated funds. In the pecking order, a new equity issue is the last resort.

Suppose, for example, that following FDA approval Cephalon's stock price had risen to $40 per share. Assuming conservatively that the total costs of an equity issue amount to 10 percent of the stock price, Cephalon would have received a net amount of $36 for each new share issued. In order to raise $45 million, an amount equal to the option's payoff, 1.25 million shares would have needed to be issued, resulting in a dilution of 5.2 percent. This compares unfavorably with the 2 percent dilution associated with the call option strategy.

Table 1 shows the dilution of an equity offering at stock prices ranging from $30 to $40 assuming issue costs of 10 percent of the stock price. In each case, the equity issue would have had the greater dilutive effect, and the call option would have preserved to a greater extent the drug's financial benefits for existing stockholders. Consequently, before the FDA announcement, the expected total cost of funding the real option on MYOTROPHIN could easily have been lower with the stock option than by waiting to issue shares until after the announcement.

TABLE 1

Stock Price Option Payoff
($millions)
New Shares
(000s)
Dilution
30.00 21.25 787.0 3.28%
35.00 33.75 1071.4 4.46%
40.00 45.00 1250.0 5.21%
The table shows the percentage dilution of equity offerings at various stock prices. Total equity issuance costs are assumed to be 10 percent of the stock price. The total amount raised by an equity issue is assumed to be equal to the payoff of the call option at the given stock price.

As a funding mechanism, the option strategy was not without risk. The call options now appear likely to expire worthless, and, as the firm acknowledged in its SEC filings, the transaction could expose the firm to potential litigation by shareholders who perceive the move as being too risky. Following the FDA's announcement on May 8, 1997, Cephalon's market capitalization plummeted by $168 million as the stock price closed that day at $13 per share, down seven points on heavy volume of 8.3 million shares.

It seems apparent, however, that the precipitous decline in the stock price was almost exclusively a result of the FDA's rejection of MYOTROPHIN and the subsequent decline in value of the real option. In all likelihood, investors would have responded in such a manner even in the absence of the financial option. Because the option's premium was financed with shares rather than cash, its cost was limited to the 2 percent dilution, which had a value that in one day declined from $9.9 million to about $6.4 million. In addition, from a corporate finance perspective, the deal had no impact on either Cephalon's need for or ability to obtain external financing. On balance, while the option strategy was indeed risky, it nonetheless appears to have been the most defensible financing alternative.

The transaction can also be viewed in the context of capital market theory, particularly with respect to the nature of the risks faced by Cephalon's shareholders. As noted earlier, approximately 75 percent of the shares were held by institutions. Thus, one could readily assume that a majority of the shareholders were well diversified and faced only "systematic risk.” Theoretically, systematic risk, sometimes called market risk, stems from unexpected changes in the macroeconomic environment that affect all firms simultaneously and more or less in the same direction. Moreover, because it drives the volatility in the overall stock market, systematic risk cannot be eliminated through diversification.

Shareholders also face another kind of risk, often called unsystematic or firm-specific risk. Because this risk is unique to individual firms it can be diversified away by holding portfolios of stocks. According to financial market theory, if the portfolio is large enough, decreases in value in some stocks are offset by increases in others so long as the individual stocks are spread across different industries. The typical investor in Cephalon purchased the stock as a play on its research and development capabilities and its expertise in biochemistry. The returns ultimately depend to a large degree on FDA actions, a perfect example of an unsystematic risk factor. Since the call option's payoff is tied closely to the FDA as well, its risk is primarily unsystematic. Consequently, even though the stock's unsystematic risk might have increased, the option strategy probably has had little impact on the majority of Cephalon's investors who hold well-diversified portfolios.

It is apparent from the SEC filings and press releases that Cephalon management were well aware of the systematic and unsystematic risks involved. They had previous experience with option-like securities—convertible debt in particular—and their partnership agreements were structured to provide the firm with real options. Cephalon's agreement involved derivative securities, but the real risk was that the drug might not have been approved. Its use of derivatives involved a simple transaction that was relatively easy to value. Moreover, given that the stock's volatility has been reported by U.S. Options Focus at 77 percent, the chance still exists that Cephalon may recover something from this so-called gamble.

Adapted with permission from Philip L. Baird III and Thomas E. McCue, "Should Firms Purchase Call Options on Their Own Stock: The Case of Cephalon,” in G. Timothy Haight, ed., Derivatives Risk Management Service, copyright 1997, Warren, Gorham & Lamont Banking/A.S. Pratt & Sons Group.

Philip L. Baird III, assistant professor of finance at the A. J. Palumbo School of Business Administration at Duquesne University, can be reached at bairdp@duq2.cc.duq.edu. Thomas E. McCue, associate professor of finance at Duquesne, can be reached at mccue@duq2.cc.duq.edu.

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