Playing Consolidation in the Bulk Shipping Industry

by: Value Research

Despite analyst comments, it is better to be the target of an acquisition than the acquirer. In business combinations the target company shareholders usually receive more than the current share price from the acquiring company. When the news of an acquisition is released, the market price of the target company usually shoots up while the market price of the acquirer goes down. Events unfold as follows:

  1. The target firm trades at a market price $T and the acquirer trades at $A before the acquisition is announced
  2. The firms announce the acquisition of the target for price of $T+$P to be paid by the acquirer in the future. The takeover price is higher than the market price $T by a premium $P. When this announcement happens, the shares of the acquirer drop below $A and the shares of the target raise to some price between $T and $T+$P. On average, the net effect on the market capitalizations of the target and acquirer is negative.
  3. If the deal goes through, the acquiring firm pays $T+$P to shareholders of the target company.
  4. Historically, business combinations tend to underperform post-merger. This is presented in a wonderful lecture by Aswath Damodaran. Watch

You would never learn this from listening to the financial media. Many analysts recommend companies with excess cash based on the possibility of acquiring a target company at discount prices. This is not sage advice! They recommend buying stocks that would likely go down in price after announcing an acquisition. This is terrible, since that drop typically occurs quickly upon the announcement. Moreover, in the long term, business combinations have performed poorly historically.

What if an investor is determined, despite historical underperformance, to buy a particular acquiring company? Rational investors who want to invest in potential acquirers could play possible future business combinations in one of three ways:

  1. Wait for a stock-for-stock acquisition announcement and buy the target company. This strategy bets that the deal will go through, and that you are buying shares that will be worth $T+$P for a lower price. If the deal does not go through, the price of your shares in the target will likely drop to a value closer to $T.
  2. Wait for an acquisition announcement and buy the acquiring company. The shares of the acquirer were trading at $A before they dropped. You were paid to wait for the news since you can buy the shares at a lower price.
  3. Attempt to identify target companies and buy them before their acquisition is announced. This is tough! Potential target companies are often distressed value firms, sometimes on the verge of bankruptcy. If there is no deal, an investor betting on an imagined acquisition would have bought the wrong shares.

Activity and commentary in the shipping sector has fit this pattern. Analysts have recommended Diana Shipping Inc. (NYSE:DSX) and DryShips, Inc. (NASDAQ:DRYS) as investments because they are poised to make acquisitions. Don’t buy them on the basis of acquisitions; buy them only if your analysis of them as independent companies is compelling. And no, the shipping industry isn’t different from the bulk of merger and acquisition history. Consider two recent acquisition announcements:

  • The announcement of DRYS acquiring OceanFreight, Inc. (OCNFD) sent shares of OCNFD up 79.2%, from $9.47 to $16.97, while DRYS dropped 1.6% from $3.83 to $3.77 in one day. It is better to own the target company than the acquiring company.
  • The announcement of Kirby Corporation (NYSE:KEX) acquiring K-Sea Transportation Partners L.P. (NYSE:KSP) sent shares of KSP up 26.3% from $6.47 to $8.17 while KEX only went up 1.8% in one day. Again it is better to be the target company than the acquiring company. Shares of KEX could have been purchased with as much as a 5% discount to pre-announcement prices between announcement and completion of the acquisition, given subsequent price movements.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.