WMS Industries (WMS) is the defendant in a pending lawsuit that could de-rail its takeover offer by Scientific Games (SGMS). WMS shareholders should immediately consider a hedge to protect themselves from this lawsuit. In this article, I explain why every WMS shareholder should consult a financial advisor as to whether buying a small amount of MGT Capital (MGT) might be an appropriate hedging strategy.
As publicly announced on Thursday, Scientific Games intends to acquire WMS Industries in cash for $26.00 per share. Directors at both companies have approved the deal, but closing is nevertheless subject to U.S. anti-trust approval, gaming regulatory approval, customary closing conditions and WMS shareholder approval.
The $1.5 billion acquisition represents a generous 60% premium to WMS' prior trading range in the $16s. Valuing WMS at a lofty 28x estimated 2013 EPS, the generosity of the offer was affirmed by top analysts across Wall Street including CLSA, Wells Fargo, JPMorgan, Morgan Stanley and BMO Capital. JP Morgan explained the shared sentiment in its research report,
We think it is unlikely another bidder for WMS will emerge given the premium valuation Scientific Games is paying for WMS.
According to Scientific Games, the acquisition is scheduled to close by the end of 2013, leaving many interim months for WMS shares to freely trade on the open market. Although shares will likely trade in a narrow range for the remainder of the year, I believe WMS shareholders would be negligent to believe that nothing could cause their shares to suddenly drop in price. To propose just one scenario that would send WMS shares plummeting: a multi-hundred-million dollar loss in court to MGT.
WMS Depends on Substantial Revenue from Patent-Contested Machines
As has been publicly announced and thoroughly explained, MGT's majority-owned subsidiary has filed a lawsuit claiming patent infringement against WMS Gaming, a subsidiary of the public company WMS. MGT alleges that certain gaming machines infringe on its "Gaming Device Having a Second Separate Bonusing Event" patent that was issued in February 2011.
MGT names six slot machines in its lawsuit, of which WMS Gaming manufactures five.
- Battleship -WMS
Pirate Battle -WMS
Reel'em In Compete to Win -WMS
Great and Powerful Oz -WMS
Paradise Fishing -Aruze
This makes WMS the primary defendant in the lawsuit and, if it loses, the company with the largest financial burden. Some estimates of the money at stake in this lawsuit go into the billions. Of course, no one can know precisely how much money WMS could be ordered to pay, if anything at all, but we do know that MGT's primary mission is to monetize intellectual property and thus is happy to relentlessly pursue WMS.
Doubts Corroborated by Goldman Sachs, Sterne, Agee & Leach and CLSA
The plot thickens when you look at the curious actions of top tier analysts following Scientific Games' offer. Before nightfall on the day of the buyout offer, Goldman Sachs (GS) raised its WMS price target from $13 to $24 and maintained a "Cautious" coverage view.
Most other major analysts (Wells Fargo, JPMorgan, Morgan Stanley and BMO Capital) immediately raised their price targets to Scientific Games' full offer price of $26.
Why only a $24 price target for Goldman Sachs, and why its cautious view? Could it have been that its analysis factored in the likelihood of complications (or outright failure) of the buyout? Whatever the reason, by Friday morning, Goldman Sachs had succumbed to peer pressure and raised its price target to $26.
However, David Bain at Sterne, Agee & Leach was not so easily convinced. On Thursday, Bain maintained his Neutral rating and $17 price target, noting inevitable "growing pains" and "vastly differing cultures between the two companies."
Analysts at CLSA of Credit Agricole shared this pessimism. In a research report on Friday morning, they rated WMS an immediate Sell and explained,
We could not have possibly envisioned any form of sex appeal in WMS to warrant an acquisition, let alone one with a 59% premium. Let's be clear, WMS is not just a turnaround story but a complete fixer-upper.
Like analysts at Wells Fargo, JPMorgan, Morgan Stanley and BMO Capital, CLSA doubts any other firm besides Scientific Games will bid for WMS.
Scientific Games Could Back Out of the Deal
When a major public company like Scientific Games offers to buy a company, it has already performed exhaustive due diligence and specified particular conditions under which its offer will no longer be valid. Because Scientific Games' offer letter is not public, I cannot say with certainty which conditions are specified. It would surprise me, however, if Scientific Games did not leave an "out" for itself in the event of a sudden legal liability arising at WMS.
Morgan Stanley noted this risk in its research report in the section Potential Downside Catalysts: "SGMS deal to purchase the Company is delayed/cancelled."
To date, WMS has not commented on its pending lawsuit with MGT, nor has Scientific Games so much as acknowledged the lawsuit. This despite the fact that MGT alleges that there are up to 10,000 infringing machines in operation today generating wagered revenues of up to $3,000 per machine per day. Lest we forget that WMS manufactures five out of the six allegedly infringing machine types, we see how WMS' legal liability could be truly enormous.
Any of 10 Investigations Could Complicate or De-Rail WMS' Buyout
Although customary to see legal investigations following buyout offers, 10 law firms have already announced investigations against WMS for possible breaches of fiduciary duty and other violations of law in connection with the buyout. Any of these law firms could discover additional problems with the buyout during their investigations.
Levi & Korsinsky
Glancy Binkow & Goldberg
Ademi & O'Reilly
Ryan & Maniskas
Bronstein, Gewirtz & Grossman
Faruqi & Faruqi
Pomerantz Grossman Hufford Dahlstrom & Gross
Rigrodsky & Long
A Cheap Hedge to Reduce Risk
WMS shareholders cannot know the full terms and conditions of Scientific Games' buyout offer. They do know, however, that the buyout is not certain until it closes in approximately 11 months. What will happen between now and then? Will MGT prevail against WMS in court?
No one can know for sure, but this lawsuit is an undeniable risk for any WMS shareholder. Again, I suggest that all WMS shareholders mitigate this risk simply by hedging their position by considering a small amount of MGT for their portfolio.
There are many reasons why this hedge is attractive, not the least of which is that 2/3rds of MGT is cash. Yes, MGT's paltry $9 million market capitalization includes no debt, a conservative cash burn rate, and approximately $6 million in cash.
So it is not as though we are looking at an expensive business with significant operational or market-related risks. The entire risk of MGT--its total enterprise value--is $3 million. Contrast $3 million with the $900 million in market capitalization that WMS gained after its buyout offer on Thursday--$900 million that is resting, in part, on WMS not losing its lawsuit with MGT--and you see why this hedge might be a good idea.
Another reason this hedge is attractive is because it is leveraged in WMS shareholders' favor. If MGT prevails against WMS, MGT's share price could rally by hundreds of percentage points, whereas WMS' share price would only fall incrementally. (Recall that Vringo rallied hundreds of percentage points while prevailing against Google, yet Google barely declined a few percentage points during the same period.) In the same way, WMS shareholders would expect a small company winning a big lawsuit to have a massive share price improvement, while the big company would only decline slightly. Therefore, the hedge I suggest is in some sense "leveraged" and does not require very many shares to be effective.
As with any trade, there are risks. Although more fully described in SEC filings, here are a few.
1. WMS Itself as a Long-Term Investment
Nowhere in this article have I discussed WMS as a standalone investment. I have no opinion whatsoever as to the attractiveness of WMS as an investment, neither at the present time nor before its buyout offer. WMS has risks independent of anything discussed in this article. This article only discusses a hedging strategy for shareholders who already wish to own shares of WMS yet also want a way to mitigate litigation risk.
2. Limited Supply of MGT Shares
As discussed above, MGT is a small company with a market capitalization of just $9 million. As such, it is obviously not possible for every WMS shareholder to buy shares of MGT at its current market price of $3.01. If MGT shares rally, downside risks will proportionally increase.
3. Limited Operations at MGT
MGT prominently discloses on its homepage that its primary business is the monetization of intellectual property. That is to say, MGT is not a diversified investment vehicle with multiple revenue streams. Investors in MGT are investing in patents- pure and simple. As I explained above, this makes MGT an ideal candidate for a hedge, but it also adds a layer of risk that should be analyzed when making comparisons to a typical business.
4. Payment Delays
MGT shareholders must consider the timeline for receiving payments from a legal victory, if one occurs at all. If MGT does prevail against WMS this year, collecting payment will require additional months and could involve negotiated settlements that reduce the total award. Likewise, MGT will be obligated to pay attorney fees and pre-arranged splits, such as minor incentive payments to the patent inventor.
Again, the trade I propose is simple and involves only common stock. WMS shareholders hoping for the closing of Scientific Games' buyout should consult a financial advisor to discuss buying MGT as a hedge for the WMS shares that they own.
Personally, I like MGT as a standalone investment, independent of WMS. For WMS shareholders, however, I think MGT is a cheap, attractive opportunity to reduce the risk of WMS' pending lawsuit.