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Why Shire plc & Royal Bank Of Scotland Group plc Could Plunge Much Further

Shire (LSE: SHP) stock was a pretty straightforward investment until Tuesday 4 August, but has become a less obvious call following the British group’s hostile approach for US biotech rival Baxalta, which values the target at $30bn. 

Elsewhere, Royal Bank of Scotland (LSE: RBS) has always been an attractive restructuring story but has never been an obvious equity investment, to be honest, and now becomes even less appealing to me following the sale of a 5% stake by the UK government. 

The “Shaxalta” Risk

Baxalta has declined to engage in substantive discussions regarding the proposal, Shire said on 4 August — and this is a big headache. 

At $45.23 per Baxalta share, Shire’s offer is fair but will have to go up by 10%, 20% or more if Shire, which needs to bulk up to support its rich trading multiples, is serious about securing these assets. Its R&D pipeline is strong, but inorganic growth is essential to boost value, while becoming a more enticing takeover target itself. 

Investors have sold Shire stock since 4 August because any $30bn+ tie-up will likely bring dilution to its shareholders due to the deal’s financing mix, even though dilution risk could be mitigated by share buybacks that Shire plans to launch at a later stage: earnings per share are expected to “breakeven in year one, with accretion thereafter, supported by a share buyback program,” Shire said. 

Unsurprisingly, Shire’s share price dropped 6% on the day the proposed deal was announced, and hasn’t recovered since. Yet its stock could fall a lot more if recent news, according to which Shire will have to bid over $50 a share to buy Baxalta, is to be trusted. 

This week’s drop was because of an all-stock move, and that could mean hefty dilution if the take-out price sky-rockets, given that Shire can’t use cash because of tax-free distribution of Baxalta,” Jacob Plieth at London-based EP Vantage told me. “Well, ‘Shaxalta’ is a rather strange story,” Mr Plieth concluded. 

What Does This Mean? 

In other words, following the recent spin-off of Baxalta from Baxter, Baxalta shareholders won’t have to pay the taxman for the stock they received from the holding company, but they would have to pay a rather large tax bill if they were to receive cash — any cash — from Shire.

Hence, if a cash offer emerges then Shire’s premium for Baxalta, currently at 36%, will likely go through the roof, simply because part of that cash being offered will have to be used by Baxalta shareholders to pay their tax bill. 

The proposed transaction would be structured as an all-stock transaction to maintain the tax-free nature of Baxalta’s July 1, 2015, spinoff from Baxter. Baxalta shareholders would own approximately 37% of the combined Shire group.”

Given the peculiar nature of the deal, Shire is unlikely to lever up, which could prevent hefty dilution if the price tag goes north of $30bn, although its balance sheet could carry much more debt.

So, Shire will likely have to finance the deal issuing new stock, and lots of it. Then, Baxalta’s shareholders may even end up owning more than 37% of the combined entity, if Shire, as it seems likely, pays over the odds, one way or another. 

While the shares of Shire remain a great investment for the long term in my opinion, short-term volatility is likely to continue to push down their valuation, which would render the acquisition of Baxalta even more expensive than it currently is. 

It’s hard not to share bad feelings about the short-term outlook for RBS, too, which also came under the spotlight this week. 

Pressure Mounts On Royal Bank Of Scotland 

The UK government has decided to cut its losses on the RBS investment, selling a portion of its holding earlier this week at a price that is below the level that was required to recoup the money that it borrowed from the taxpayer in the wake of the credit crunch in 2008. 

RBS is not a bad restructuring story in the UK banking universe, but now that the government has started to sell down stock, its shares look fully priced indeed. In fact, I doubt that the benefit of future private ownership will outweigh the downwards pressure on the stock during the entire divestment process, which will take years — unless private investors smell the opportunity to sneak in. 

Consider that Lloyds, whose financials are stronger, has struggled to deliver meaningful capital appreciation for a long time, and will continue to have problems on this front at least until the UK’s government residual 15% stake isn’t sold. The Treasury now owns more than 70% of RBS’s equity, which says a lot about the risk involved in holding RBS stock over the next three or four years. Meanwhile, legal risk is still alive and well, as recent results showed. 

Considering all this, I'd avoid RBS and other banks for the time being, while in the pharma world I'd consider another pharmaceutical company, whose stock is on a roll and is up 5% this week: this defensive value play has been under pressure, true, with its shares trading around their 52-week lows, but could surely offer upside if its management team gets its strategy right. 

Its name is included in a free report, which explains why its dividend yield at 6% is incredibly attractive. Ultimately it's your call, but our Fool research will surely help you determine what kind of risk is involved. Do your research, but do it now -- our FREE report is available only for a limited amount of time!

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.