MTJ489

Merger Review: Puget Energy

The only thing you are doing by buying Jan'09 $25 calls is that you are paying a bit a of a premium for the calls (30c or 40c of premium as I write this.) So if the deal closes before Jan expiration, you will make 30c or 40c less than if you owned the stock. However, if the deal busts. you will obviously lose a lot less money. If deal doesn't close by Jan expiration, then you should simply exercise your option and yo are long the stock. All you lost is the premium, if that happens. The worst scenario is if on the expiration date, the stock closes right at the strike price of $25.00, and then on Monday morning, PSD announces that the deal has closed. In that case, you have lost the entire investment in the call options, whereas if you were long the stock, you would have received $30/shr. But that is the price you pay for downside protection.

If you were long the calls, and short the PSD stock, and if there is a binary outcome before the Jan expiration, you can make money if the deal closes, AND make money if the deal busts. This is possible because the risk/reward on the options is better than the stock. So if you get the "delta" right, you can profit in both scenarios. But this gets a bit tricky due to the short timing, etc...


On Jan 10 09:46 AM mwm711 wrote:

> Excellent analysis. If the deal is supposed to close by 1/22/09 is
> there a potential problem with buying January calls that expire on
> 1/17/09?

Merger Review: Puget Energy

Jae --

If PSD trades to $17/shr upon a deal bust, and you make $30 plus $0.25 in dividends if deal closes, that implies an 86% market-implied probability of this deal closing. (At the current PSD price of $28.45.) What that means is unless you have greater than 86% confidence level of deal completion, you should sell every share that you own. Are you greater than 86% confident?





On Jan 09 12:26 PM Jae Jun wrote:

> MTJ489
>
> thanks! I breezed through the WUTC filings and came to the same conclusion.
>
>
> Although I'm not singing at the moment, Im confident that the probability
> of the deal closing is much higher than it the case for it failing.

Merger Review: Puget Energy

The WUTC order provides a scathing commentary about how much the Public Counsel has been off the mark in its arguments. Apart from Commissioner Jones' dissent, WUTC's majority view was that the deal was entirely consistent with the public interest and will not harm ratepayers. Against this backdrop, I doubt that the PC will appeal the decision. I think the more likely scenario would be that the Acquirers (the investor consortium) will seek to clarify the WUTC's order by filing a petition. This will have the effect of delaying the closing by weeks or months. And, as everyone knows, pending mergers don't age like fine fine, so any delay beyond the normal 15 days following the "Final Order" (as defined in the merger agreement), which comes up on January 22nd, will not be viewed well by the market. I believe that this is one of the reasons that the spread is trading wide.

Another reason for the wide spread is the following: According to the merger agreement, the Acquirers' liability is capped at $130MM if they were to breach the agreement. This means that if the Acquirers did not feel like completing this deal -- for whatsoever reason -- they are liable to pay $130MM to Puget, but not a penny more. Recently, deals that have blown up frequently contained a similar clause, whereby the purchaser had an option to walk away by paying a nominal break-up fee. With the stock market having raced to the bottom, most deals that were cut months ago now appear highly overpriced. What have acquirers done to compensate for their ill-timed dealmaking? They have simply walked away because they were allowed to under the merger agreement. Were it not for this seemingly innocuous clause in the Puget merger agreement, I believe the spread would be much tighter.

Having said that, I believe that this deal is not only highly likely to close, but close by January 22nd 2009, for the following reasons. If you listened to the Commission hearings in Sepember/October as well as read the hundreds of pages of WUTC briefs filed by the Joint Petitioners (Puget and the Acquiers), which I did, you will see that the Acquirers were simply "pounding the table" on wanting to complete this acquisition. Keep in mind that this was as recently as October when the financial world seemed to come to a screeching halt. Even at the height of the financial market meltdown, the Acquirers were adamant that they had the financial flexibility to not only complete the acquisition, but also fund billions of dollars of capital expenditures for the next five years -- something that Puget, without this buyout, will find extremely difficult to to. Acquirers were also adamant that the terms of the "ring-fencing" provisions, which provide a margin of safety to the well-being of the "Opco" (the operating utility), are the best such provision of any similar transaction in modern history -- and the WUTC staff singularly agreed with this argument. Here we are -- less than 3 months after the hearings and the briefs and the financial world has gotten a little calmer -- I would argue that if the Acquirers were adamant on wanting to acquirer Puget in October, I think they would want to acquire Puget today.

To elaborate on this important point, I spoke with a respresentative of Macquarie who is close to this deal. He agreed that "nothing has changed" since the hearings were held and the briefs were filed in October.

So an obvious question that comes up on all of this: Why would the Acquirers want to acquire Puget for an inflated price of $30/shr? First of all, the Acquirers are infrastructure investors,. Not only do they own Duquesne Power & Light in PA, they own water utilities, highways, bridges and tunnels all over the world. Puget is a regulated business that they want to own for the long-term. Many people view Puget as a typical LBO. That is not entirely correct. The Acquirers are putting up $3.3 billion in equity capital for Puget, nearly 50% of the enterprise value of the company. That is a lot more equity than your garden variety LBO that has 20% equity. What that means is -- the Acquirers are willing to accept a lot lower internal rate of return on their equity than a typical LBO. I believe this is because regulated businesses such as Puget generate highly predictable cash flows, and therefore, the hurdle rate on such stable cash flow stream is correspondingly lower. The Macquarie representative confirmed that this was the case.

Without further rambling --- the point is, I believe Puget acquisition, although expensive by today's utility valuation standards -- fits the profile of what the Acquirers are looking for. If they walked away from this, it will take another 1 1/2 years for them to acquire another utility -- any utility --in the U.S. Is that worth it even though they would be able to buy the next one a bit cheaper? By the time they complete their next purchase, who knows, utility valuations may come back up...

By the way, there was nothing in the WUTC Order that anyone should be comcerned about. It's a long document, but there is nothing substantively different than the multi-party settlement that Puget signed along with the Staff back in July. I would be shocked if Macquarie tries to put a negative spin on the WUTC Order conditions. As far as I know, they should be giving each other high fives since they got pretty much everything they were looking for in the Order.

I hope this helps if you are wondering why the PSD spread is so wide. It is wide for the reasons I explained above. But it being wide presents a huge opportunity to make 10.5% in a week and a half.

One final point -- if you want to own PSD stock, you should look at PSD Jan $25 calls. They are much better risk/reward than the stock (for reasons I won't go into here..) If you want to be really technical, you should buy those options and short the stock. If you get the "delta" right, you will make money if the deal completes, AND you will make money if the deal falls apart and the stock goes to $17.00 as long as this binary event happens before the option expiration next Friday.. (What a beautiful arbitrage..!!) Because, as much as I think the deal will get done, what if I'm wrong? I wouldn't want to get carried out in a stretcher...

Now go and make some money........

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