S&P (NYSEARCA:SPY) has remained essentially flat in the last one and a half year. In addition, as the corporate earnings per share have declined for 4 consecutive quarters and minimal growth is expected in the second half of the year, it is obvious that the market has limited upside, at least in the short term. Therefore, under the current circumstances, a great way to achieve satisfactory returns with limited downside is to profit from the deal arbitrage spreads that have a favorable risk/reward profile. In this way, the free cash of a portfolio, which earns nothing if it sits idle, can significantly boost the return of a portfolio if it is invested in the right deal arbitrage spread.
Last week, Lexmark (NYSE:LXK) announced that it had entered into a definite merger agreement with a consortium of investors led by Apex Technology and PAG Asia Capital, under which Lexmark would be acquired for $40.50 per share. The transaction includes only cash and is expected to be complete during the second half of the year. As Lexmark is now trading at $37.95 and is expected to make two more dividend distributions of $0.36 each, investors can earn an approximate profit 8.5% if and when the deal materializes. As the deal is expected to close during the second half of the year, investors can earn the above return in about 6 months.
Of course the deal should first get the approval of the shareholders of Lexmark and the regulatory authorities of US and China. First of all, it is important to note that the approval of the shareholders of Lexmark should be taken as granted. More specifically, the management has made its best efforts to sell the company in the most rewarding way for the shareholders in the last 6 months. Moreover, the stock has gained about 25% since last October, when the management first announced its plan to pursue a takeover by a suitable candidate. The stock has also gained almost 10% since the announcement of the takeover last week.
Furthermore, Lexmark has been going through a major transformation in the last few years, which may be rewarding in the long term but has greatly tortured its shareholders. More specifically, its conventional business has been experiencing a secular decline due to the heated competition and the boom of the online and mobile photo/document viewing. The company has made some acquisitions in its software segment but these investments have not paid off yet while they have greatly increased the debt load of the company. Therefore, most shareholders will be totally relieved to sell their shares at an approximate 30% premium over the price of the stock before the announcement of October.
In reference to the regulatory approval of the deal, there should not be much of a concern over competitive issues, as the sector of printing hardware and supplies is characterized by intense competition. In addition, the merger is not subject to a financing condition. It will be financed through equity contributions by the Consortium and debt financing. Therefore, there are no significant potential deal breakers on the horizon.
Nevertheless, while the deal is most likely to materialize, investors should always ask themselves what will happen to the stock in the unlikely event of the cancellation of the deal. While I always try to select deals in which the acquired stock is reasonably valued even as a standalone, this cannot be claimed for this deal. To be sure, if the deal falls apart, the stock of Lexmark is likely to plunge towards the low 30s, where it was trading before the first announcement, in October. Investors should take this downside risk into account before investing in the deal arbitrage spread. On the other hand, even if the deal is cancelled, the stock is likely to rebound after its initially plunge, given the persistence of the management to pursue any takeover or spin-off endeavor that will enhance shareholder value. All in all, if the deal is cancelled, the stock will almost certainly plunge by about 25% on the announcement but will probably retrieve about half of its losses when the dust settles. This is a tolerable downside, particularly given the low chances of a deal cancellation
To sum up, the takeover of Lexmark seems to have a favorable risk/reward profile. The deal will almost certainly materialize and will thus offer an 8.5% return in 6 months to those who purchase Lexmark at its current price. If the deal is cancelled, the stock is likely to fall by about 10%. Therefore, the risk/reward profile should be quite attractive to most investors, particularly given the lack of short-term upside potential of the market and the minimal interest rates, which render cash a drag on every portfolio.
Disclosure: I am/we are long LXK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.