Yesterday, I wrote a piece where I listed the three categories that my investments typically fall into: Franchises, Cheap and Good Stocks, and Cheap Asset Stocks. I also described a 4th category called Special Situations that I occasionally participate in when I find an interesting idea. The vast majority of my investments fall into the first three categories, but recently, I've looked at two interesting special situations that have a few similarities.
Dell (DELL) and Ebix (EBIX) are two stocks that I've been following for some time. Both have shown up in Joel Greenblatt's screen for months, and I've considered both to be potential investment candidates. Both have CEO's with large ownership stakes, both have negative sentiment surrounding the stock (for different reasons), both look cheap using basic value metrics, and both have traded above their deal price, signaling the market might expect a higher bid.
I own Dell, but unfortunately let Ebix pass by after not being comfortable with their accounting. (This is a lesson in and of itself: when bad news causes a stock to drop dramatically, the market often over discounts the news. The market has a hard time efficiently pricing these types of scenarios, and in my experience, the initial reaction is often the worst (BP during the oil spill, HLF after the Ackman short announcement, etc...). The market tends to price things toward the worst case scenario end of the spectrum, but the worst case often does not materialize.
Here is a very brief background on EBIX, which has been a short seller battleground stock for a couple years ever since this article came out. That article was written by an anonymous short seller 2 years ago, causing the stock to lose around a third of its value in one day. Then, more recently, another anonymous short seller named Gotham City Research wrote this scathing research piece in February, again causing a big one day drop in the share price, this time from 19 to 14.
At that point, the stock was beaten down to single digit earnings multiples including an EV/FCF ratio of about 7. This is despite the fact that the company has grown free cash flow at around 40% per year over the past decade. I noticed this stock showing up in Greenblatt's scan around that point, but never really spent any amount of time looking at it. Although it looked incredibly cheap on the surface, I felt that the short sellers knew much more than I did, so I simply stayed away.
This turned out to be a missed opportunity, as the market quickly revalued the company from a low of $12 a share all the way back to about $18 per share in just a few weeks. It pays to pay attention to situations where there is controversy or uncertainty. That's where the market is most inefficient.
Then, this past week Goldman Sachs announced a bid for EBIX at $20 per share. This private takeover includes management participation and CEO Robin Raina will maintain his ownership stake of about 19% of the company. This was a catalyst that made me take another look at the stock, and I noticed some similarities to the DELL situation, which I am currently participating in.
Summary of EBIX Situation
After the buyout was announced, I re-read the negative pieces written by those two short sellers, and I also read through the comment sections on Seeking Alpha. There are some insightful comments on both sides, including numerous bullish arguments written by accountants who know a lot more about EBIX than most of us, including one accountant who has been a shareholder and a consultant to the company for over 10 years. He commented on this piece which was a rebuttal to the short sellers piece. (By the way, as an interesting side note: I am always skeptical of anonymous short sellers who write these research reports. It's one thing for Bill Ackman to publicly trash HLF, it's another for someone who doesn't disclose their identity to do so. Anonymity doesn't mean that the thesis is less accurate, just less convincing, at least in my opinion. But it is beneficial to read the short's arguments in this case.)
I started compiling a short list of general thoughts on this EBIX situation:
- Goldman Sachs is interested in buying the company alongside the management at $20 per share.
- The stock initially jumped about 3% above $20, implying that the market believes that a higher bid might come in.
- This article came out summarizing the same arguments, causing the stock to drop back to about $19.50, which is where I am now interested.
- At $19.50, there is a 2.5% arbitrage opportunity, but there is the potential upside of another deal coming in.
- There is a $45 million breakup fee that Goldman has to pay Ebix if Goldman terminates the deal.
- Robin Raina, the CEO, has about a 19% ownership interest in EBIX, and he will maintain that ownership after the company goes private.
So we now have an interesting arbitrage opportunity. The stock has a lot of controversy, but you have a major investment bank interested at $20. The CEO has a 19% ownership interest, and he is not selling out at $20, which tells me he thinks it's worth at least that. The stock still is incredibly cheap relative to the earnings and free cash flow.
Here is a quick look at the 10 year numbers:
Final Thoughts and Comparison to DELL Buyout
I wasn't interested when EBIX had a negative spread between the buyout and the current price, just as I wasn't interested in DELL when it traded above $13.65. The market was betting on a higher bid in both situations, and I think both stocks might still get a better bid. But here is the main reason I'm interested in both arbitrage opportunities:
I am interested in the arbitrage play because I would still want to own the stock even if the deal falls through. This to me represents a low risk opportunity. Let's take DELL for example. The buyout represents only limited upside at these prices. But we have an alternative to cash (we get paid a small premium if the deal goes through), and we get the upside potential of another deal coming in 10, 15, 20% higher. But the main protection is that even without the deal, I'd own DELL shares at this price. If you believe Southeastern's thesis, DELL is worth $24 per share. I'm not sure if it's worth that or not, but I think it's worth a lot more than $13.65. So if the deal goes through, we don't make much, but we preserve our capital. If the deal doesn't go through, the stock would likely drop some and I'd be able to buy more.
So the following three scenarios could play out, and any of these would be favorable to me, just in different time frames:
- The deal closes and I get paid a small premium to my cost.
- A higher bid comes in and I'm able to realize a larger gain in a short period of time.
- The deal falls apart, likely causing the stock to drop, but allowing me to maintain a long term position (and even buy more) in a stock I believe is undervalued. (It's worth noting that many large shareholders like Icahn, Southeastern, Pzena and others would probably prefer this outcome as well).
So when you participate in an arbitrage situation where you believe the stock is undervalued even at the deal price, there is little that can go wrong (assuming your valuation assumptions are correct: that of course is the key).
EBIX is a similar situation. After getting more comfortable with the fact of insider ownership and interest from a major bank, along with the publicly available data, I think EBIX is an undervalued stock at $19.50. I don't own shares yet, and I'm not as convinced on EBIX as I am with DELL, but I still think it's an attractive risk reward opportunity.
To Sum it Up
Dell and Ebix have a few key similarities:
- Both stocks have had negative sentiment (for different reasons)
- Both stocks have dynamic CEO's with large ownership stakes in the business
- Both stocks initially traded above their proposed deal price, signaling that the market believes a higher bid might materialize
- Most importantly for me, both stocks represent good value at the current prices, which allows me to be comfortable knowing that if the deal doesn't materialize, I can maintain or increase my position.
The only arbitrage plays that I'm ever interested in are the ones where I think the stock is undervalued at the deal price. In most cases, I don't like the risk-reward that merger arb offers (limited upside, big downside). But when I'd own the shares at the current price, even without the catalyst of a pending buyout, I am interested. I get to own shares in an undervalued stock, with little long term downside, and with the upside of another deal presenting itself, allowing me to make a quick gain. I like these types of risk-reward scenarios... Heads I win now, tails I win later.