CDS / Equity Spreads Leading Up to Recent M&A Activity

This “is not a bet on next month or next year. We’re going to own it forever.”

Now we all know forever is a long time but then given that it seems as if Warren Buffett has been around for that long, he’s probably qualified to make that statement.

The other reasons stated by WB for Berkshire (BRK.A) acquiring the 77% of Burlington Northern Santa Fe (BNI) that he did not already own included a bet that rails will prove to be “the” lowest cost way to ship as the U.S. economy grinds its way out of its current malaise and one that is relatively immune to “competitive pressures from low-wage overseas economies,” as it was described in yesterday’s WSJ.

Matthew Troy, a Citigroup analyst, might have captured it best when he said: “The reason Warren Buffett is buying BNSF is a 10- to 20-year trend. For us near-term investors, it may seem curious. For him, the trajectory of the recovery over the next one or two years is irrelevant.”

Once again Mr. Buffett has proven that he lives by his stated credo of “getting greedy when everyone is scared and scared when everyone is greedy.”

Warren wasn’t the only CEO with the checkbook out this week as John F. Lundgren, CEO of Stanley Works (SWK), will also be the CEO of Stanley Black and Decker, when the merger of the aforementioned and Black and Decker (BDK) merge. The motivation for this combination is less a bet on the “recovery” and more the traditional rationalization of business lines and cost savings which are supposed to total something on the order of $350MM or $1/share according to various pundit’s projections.

I bring both of these examples up not only as a sign that corporate management, having hoarded cash through the darkest days of the downturn, is now poking its head up and trying to figure out what to do since the scheduled apocalypse never arrived, and having survived, the goal is now to thrive. But also because the CEC Strategy has seen and survived a similar period of acquisition while the bubble now hanging on the face of the world was still a bright pink orb.

The CEC Strategy was short SWK and BNI before the announcements were made. Of the three, BNI, SWK, BDK, I would have wished the shorts were in the two tool makers and not the railroad as Warren’s enthusiasm cost the Strategy more than the other two would have but hey, that’s trading.

More important here is what the CDS/equity combo looked liked for all of the names involved prior to the announcements and how that relates to late 2005 through early 2007 when easy money made buying things more of a sport than a business decision.

All three names had declining stock prices and rising CDS spread levels going into last weekend. This is the signal for the CEC Strategy to be short the name in question and so it was, at least in two out of three of the cases.

The comparison to the days when private equity firms started acquiring in earnest is that they started the same way. Buying beaten down companies that were good turnaround candidates, going through the whole revamp process and then reselling them once they were all spit and polished.

During this period shorting companies in the CEC Portfolio was a bit like walking across a mine field as names that were clearly in trouble, as designated by a rising CDS level and falling stock price, could at a moment’s notice become stars whose stock price just rose close enough to the 20% bid premium to make life very uncomfortable for the short sellers.

Right around the pre-prick period (late 2006 to early 2007) the PE firms figured out the revamp process was a lot of work, a lot of risk and that it was much easier to buy companies that had a ton of cash on their balance sheets. They issued boat loads of debt, paid themselves the cash as an “upfront dividend” and took the risk out of how the turn-around turned out.

The benefit here to the CEC Strategy was that the companies being acquired in the latter stages of leverage bubble looked attractive to the Strategy as well as they had falling CDS spreads and rising stock prices which put many of those names in the Portfolio before the deals were announced but, more importantly, in the right direction.

With corporations now doing the acquiring, it would seem a stretch to have the same cash rich targets being acquired but with all of the liquidity sloshing around the world at the moment, there is definitely the potential for silliness to reassert itself.