Earlier this year, Starboard LLP’s CEO Jeff Smith sent off a public letter to Depomed (NASDAQ:DEPO) asking for a special shareholder meeting to discuss a complete overhaul in management, and a possible sale of the company. After a lot of back and forth between the company and the fund manager, they decided on a date for the meeting after the Nucynta patent infringement lawsuit was settled. However, Starboard, which has a 10% stake in Depomed, opted not to hold the shareholder meeting and settled for a 3-member seat on Depomed’s board.

What does Smith achieve by putting his people on 3 seats on the Depomed board? As he says, “Replacing board’s isn’t how Starboard likes to roll, he says, but directors are usually more cooperative than Depomed’s (or Darden’s).” Cooperative to what? With an ultimate goal to releasing immediate shareholder value, even if that means a potential sale of the company, including a complete replacement of management.

Jeff Smith discussed Depomed at length at the Ira Sohn hedge fund conference held in May this year. As reported on Marketwatch:

Smith is concerned that Depomed’s lack of scale is leading it to poor decisions on acquisitions and other areas. The company is highly leveraged and intent on pursuing other acquisitions, which Smith sees as troubling given its “uncompetitive tax rate.”

That said, the company should be extremely attractive to a strategic buyer, Smith says. “Easy synergies could more than double earnings per share,” he said. It’s no surprise an acquirer offered a 60% premium but Depomed rejected it and put in place a poison pill.

Smith clearly thinks this is all wrong.

Jeff Smith is a much-feared name on Wall Street ever since his successful takeover of the $10bn market cap Darden Restaurants (NYSE:DRI) in 2014. This feat was even more startling considering that Smith’s own fund is valued only at $3bn, he held only a small percentage of shares of DRI at that time, there were much bigger shareholders including Vanguard at 7% and Capital Research and Management at 11.5%, he was pitted against a very strong team of the old Board of DRI and their advisors including Goldman Sachs and Morgan Stanley, and nobody had heard of the young, 42-year old hedge fund manager at that time. Despite all that, Jeff Smith managed to take over the company, and replace the entire Board of Directors. In about 5 years since he began burnishing his activist investor image, Smith had replaced more than 80 board members at 30 companies (as of 2014).

What’s in it for him? Well, when he started going after AOL CEO Tim Armstrong, he accumulated a 5.6% stake in AOL, which went up 250% as his campaign against AOL took form. Smith had made money from 84% of his target companies.

Now that Jeff Smith has 3 members on Depomed’s board, what does he plan to do with the company?

To understand that, we have to consider a number of factors:

  1. Depomed received a $3 billion buyout bid from Horizon Pharma (NASDAQ:HZNP) last year, valuing the company at around $30 per share. This bid was rejected.
  2. Depomed is trading at a 30% discount to those numbers at present.
  3. Depomed had very poor numbers this earnings season; not only did it miss estimates by a large factor, but it also drastically reduced guidance.
  4. However, the Nucynta patent infringement lawsuit was settled in Depomed’s favor, meaning it gets more life out of Nucynta, the opoid drug that makes for 64% of its sales.

The lowered guidance is interesting. We need to ask not whether management is wrong with the guidance, as some have done here on Seeking Alpha, but why management guided so pessimistically. And in my opinion, Depomed’s existing, original section of the board – minus the 3 people Starboard put on there – is trying to fight Jeff Smith’s endeavor to sell out the company by making itself unattractive to any potential bidder. What they are doing is, they are telling the bidder that a $3bn bid is too high, and then they are going back to the shareholder and telling them they have a very low bid and should not sell. The pessimistic guidance is a way for Depomed to attract low bids which will be clearly unpalatable to shareholders. There are already unconfirmed rumors of a $2.6bn bid for the company. This values the company at a price less than the old HZNP bid, and there’s no way it can be sold to shareholders given the patent win.

If this is true, it is an interesting little game that’s being played out here, and I am interested to see how this plays out. The Nucynta win has clearly increased the company’s value, and shareholders will not be okay with Smith’s plans to sell the company for anything lower than last year’s $3bn bid. It is now Smith’s turn to find such a prospective bidder, maybe not directly, but through his 3-member mini-board in Depomed. If he is unable to find a proper buyout offer, Depomed’s existing board members are safe. That, perhaps, is the idea behind the terribly low guidance.

Author: Kyle Dennis

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