Roche Healthcare

1
Roche Healthcare

• Presented By Andrew Bishop
• Risk Management Insurance
• February 10th, 2005

2
Agenda

• Theory Review
• Roche History
• Roche Financial Strategy
• Analyzing Returns
• Bond Holder
• Warrant Holder
• Bond Cum Warrant
• Costs
• Conclusions
• Questions

3
Theory
What is a warrant?
-rights can be in the form of call options, put
options or futures contracts (or any combination
of the three)
What is an option?
4
Theory
Options vs. Warrants

• Short term (lt 1 year)
• Issued by financial intermediary
• Issued independently from any other debt
  instrument
• Issued at a variety of strike prices
• Financial intermediaries meet the demand of
  investors exercising their options

• Long-term
• Issued by firms
• Usually issued in combination with debt issues
• Often issued considerably out of the money and at
  one strike price per embedded warrant
• Company meets the demand of investors exercising
  their options

5
Hybrid Securities
What is a hybrid security?


6
Hybrid Securities Cont.
Roche currently has three hybrid securities
outstanding

• Rodeo
• Sumo
• LYONs

Roche Outstanding Bond Listing
7
Roche - History

• Founded in 1896 as an entrepreneurial venture
  dedicated to manufacturing, for worldwide
  distribution, drugs with uniform strength and
  quality
• World leader in diagnostic instruments and
  reagents, vitamins and fine chemicals (divested)
  and flavors and fragrances (divested)

8
Roche - History

• Currently Roche has two major divisions
• Pharmaceuticals (view products)
• Diagnostics (view division)

9
Roche Capital Structure

• Voting shares owned by a small group of investors
• Group ensures majority voting power by
  restricting equity issues
• This also gives them power over key corporate
  decisions
• How could Roche raise capital at a low cost?

10
Roche Financial Strategy

• Build an acquisition war chest
• Borrowing was done at opportune time (low cost)
• Borrowing was targeted to specific investor
  groups

Targeted Investor Group- Roche held a high credit
rating with little outstanding debt -sought
institutional investors interested in hybrid
securities -investors sought a potential return
that would be taxed _at_ the capital gains rate
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Roche Cash Strapped
Roche issued hybrid securities as a method of
raising capital, which had several benefits

• lower cost (3.5 coupon) market rate _at_ time of
  issue 8.65
• attached warrants would not dilute shareholder
  earnings
• attached warrants would not dilute voting rights
  of majority share holders

12
Roche- Financial Strategy

• Minimize Cash Outflows
• Maximize initial sale price of debt instrument
• Minimize cash outflows from borrowing
• Increase the placement power of its investment
  banks

13
Roche- Financial Strategy

• Prune divisions and sell of dead wood
• Used to increase cash flows

• Reduce dividends to increase cash flows
• Dividends kept intentionally low
• Shareholders rewarded with non-cash benefits
  (derivatives structured to give capital gains)
• This directive has changed over the recent years
  (as per video conference)

14
Roche- Financial Strategy

• 5. Improve financial transparency and stock
  market profile.

Media Conference Financial Summary
250 -540
15
Roche- The Bull-Spread Issue
Hybrid Security Characteristics

• Entire Issue - Face Value 1 Billion
• Years to Maturity 10 yrs.
• Coupon Rate 3.5
• Individual Bond Face Value 10,000
• 73 Bull Spread Warrants
• Warrant Characteristics
• 3 yr. Maturity
• 100 Bull Spreads redeemed _at_ SFr7,000 (if lt SFr
  7,000)
• Or 1 share
• Or SFr10,000

16
Analyzing Bondholder Return
Market Rate _at_ time of issue 8.65 Coupon Rate
3.5 Present Value of Bond
See pg. 54 of Risk Takers Textbook
17
Analyzing Warrant Holder Return

• Value of Warrant _at_ time of issue
• 3,356 or SFr4,833.55
• Each note had 73 warrants so each individual
  warrant is worth SFr66.21

IndividualWarrant SFr 66.21
Warrant SFr 4,833.50
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Analyzing Warrant Holder Return
3 Possible Situations

• Share Price lt SFr7,000
• Investor has right to sell 100 warrants for
  SFr7,000
• Guaranteed Return of SFr379 (or 1.9 over 3 yrs.)
• Share Price gt SFr 10,000
• Roche has right to purchase 100 warrants for a
  maximum price of SFr10,000
• The most investors could earn was SFr3,379 or
  14.7 Annually
• Share Price gt SFr7,000 but lt SFr10,000
• Investors would receive one-for-one earnings
• Between SFr379 and SFr3,379

19
Analyzing Warrant Holder Return
Keep in mind that The warrants were paid for in
US, but return was in Swiss francs Therefore,
investors faced foreign exchange risk as a
result actual returns could be well above or
below those previously calculated!
OR
20
Analyzing Bond Cum Warrant Return
Two forms of returns

• Consistent bond returns
• PLUS
• Varying return on the warrant

Ignoring foreign exchange risk, investors earned
from
7.40
10.00
21
Analyzing Costs to Roche

• Costs to Roche are Dependent Upon
• Hedging Strategies
• Market Imperfections

Costs of bond coupons is fixed, however, it is
likely that the firm engaged in hedging
strategies for the warrants.
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Conclusion

• Although the text didnt disclose if the firm
  engaged in hedging strategies (which is highly
  likely given Meiers background), we were able to
  develop an understanding to the importance and
  usefulness of hybrid securities in reducing the
  cost of capital for a corporation. Hybrid
  securities combined with hedging strategies
  enable firms to reduce their cost structure.

23
Review Questions
24
Question 2-1

• Objectives of the changing the treasury into a
  profit center
• Borrow funds at the cheapest possible rates
• Actively manage debt throughout its maturity
• Aggressively invest excess funds

The benefits are obvious -lower cost of
capital -minimized cash flows -excess returns
that wouldnt have otherwise been realized The
general disadvantage would be that the firm is
taking on additional financial (non-operating)
risks. Unless the CFO and treasury team possess
a strong knowledge of such activities, it is not
a recommended practice.
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Question 2-2
By shorting the Roche shares, the hedge funds
would invest the proceeds at the current market
rate. This would hedge the downside exposure in
the event that the shares lost value. If in the
future the share price lies above the critical
value (SFr7,000) then when the warrants are
exercised, the amount received upon exercising
the warrant would cover the cost of the shorted
shares.
M.L.
26
Question 2-3
Roche was exposed to increasing interest rates as
a result of the short-term U.S. dollar bridge
loan. Roche would have to roll-over the loan on
a semi-annual or annual basis, thus exposing the
firm to the risk that interest rates could rise,
making the firm unable to lock in at the lower
rates for long periods of time. The natural
hedge their speaking of was setting up the
long-term liability in U.S. dollars. This
liability would be matched with the long-term
cash inflows from the acquisition of Genetech.
M.L.
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Question 2-4
The put options allowed investors to sell their
warrants at a price between SFr7,000 and
SFr10,000. The annualized return on the option
was between 1.9 and 14.7 over three years. The
put options give rise to Capital Gains income, as
opposed to ordinary income. In Canada, only 50
of capital gains are taxed, as opposed to 100 of
interest income received from fixed-income
securities. The Swiss government might object to
the issuance of such securities simply because
they lose out on valuable tax income.
M.J.
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Question 2-5
Hybrid securities give pension funds (with equity
restrictions) access to the equities markets
without direct investment. There arent (as
many) restrictions on hybrid securities, as they
are considered a fixed-income security. The
Bull-Spread offered pension funds access to
potential returns above those traditionally
earned from fixed-income securities.
M.J.
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Question 2-6

• Shareholders are weary of hybrid issues, because
  they generally result in the dilution of earnings
  and voting rights.
• Warrants are honored in three ways
• Issue New Shares
• Settle In Cash
• Purchase Shares on the Market
• Roche shareholders were unaffected but the
  Bull-Spread issue since Roche settled in cash,
  thus leaving the number of outstanding shares
  unaffected. Although settling in cash can cause
  large cash outflows, proper hedging can reduce
  the impacts of such outflows.

M.B.
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Question 2-7
a) Value of the bond
C.F.
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Question 2-7 cont.
c) Value of Warrant _at_ Issue 2,684.03 Assume
Spot Rate _at_ Issue SFr1.44/ Warrant Worth
SFr3,865.00 Individual Warrant Worth SFr52.95

• Share Price lt SFr7,000
• Investor has right to sell 100 warrants for
  SFr7,000
• Guaranteed Return of (7,000-5,295) SFr1,705 or
  approx. 10.73

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Question 2-7 cont.

• Share Price gt SFr 10,000
• Roche has right to purchase 100 warrants for a
  maximum price of SFr10,000
• The most investors could earn was SFr4,705 or
  29.62 Annually
• Share Price gt SFr7,000 but lt SFr10,000
• Investors would receive one-for-one earnings
• Between SFr1,705 and SFr4,705

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Question 2-7 cont.
d) Exchange rate fluctuations would not affect
bondholders. They would, however, impact the
returns of the warrant holders and bond cum
holders. Depending on the direction of the
fluctuations, returns can vary above or below
those calculated.
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Question 2-8

• One of the many ways which Roche could hedge its
  exposure would be to acquire shares now on the
  open market (could drive up the share price).
  Roche could also hedge the put options with call
  options with similar features.
• If arbitrage existed in the market, then Roche
  would take advantage of the opportunity, and
  hedge its warrant exposure. Initially, there
  would be a cost associated with the hedge, but
  perfect arbitrage would mean that once the
  warrants were exercised or expired, a cost
  savings would offset the initial expense.
• Total Interest Costs of the Transaction 200
  Million 35 Million
• Some sources of market imperfections outlined in
  the text include
• -warrant pricing
• -informational imperfections (information
  asymmetry)
• -government induced distortions

D.M.
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Question 2-9
Its always easy to make an ex-post comparison.
However, when preparing ex-ante costs, it is
difficult to anticipate what will happen with the
warrants. The costs associated with the warrant
can be approximated through the use of hedging
techniques. If several hedges are performed,
such costs are difficult to predict. As a
result, you cannot predict the precise cost
associated with a hybrid issue, and compare it to
a straight issue.
M.B.
36
Question 2-10
Please refer to Content Highlight 2.2 (pg.
62-63) for further discussion of the calculation
of the Bond Cum Warrant IRR