Merger-Arbitrage Shakedown For The Third Quarter

by: Activist Stocks

We love special situation investing, and merger-arb (arbitrage) falls in this category. By definition, arbitrage is riskless, but don't be fooled, merger-arbitrage can be anything but. However, it can also provide low-risk returns. In looking at merger arb deals quantifying risk is a very different process than normal investing. The risk is that the deal will fall apart, versus the many other systematic and unsystematic risks involved in investing in equities during normal investing conditions. Merger-arb is a type of event driven strategy, hence the risk is known as event risk.

Merger-arb involves buying the stocks of companies that are involved in mergers and acquisitions. Shares of the target company generally trade below the acquisition price due to uncertainties over the deal and time to complete the acquisition.

An additional layer of merger-arb includes shorting the acquirer, where if the deal goes through the acquirer's stock will fall to reflect the price paid. Now this doesn't always happen, in some cases the price of both companies will rise, assuming the deal is extremely favorable to the acquirer.

With all that said, outlined below are some of the most notable deals still in the works for the 2nd half of 2013 ...

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The key takeaways from the table above include the fact that both Cooper Tire (NYSE:CTB) and Dell (NASDAQ:DELL) are offering investors the most upside. Harris Teeter (NYSE:HTSI) is trading right at the offer price.

The first on the list is BMC Software (NASDAQ:BMC). Billionaire investor Paul Singer of Elliott Associates orchestrated the deal to take the company private in a $6.9 billion buyout by Bain Capital and Golden Gate Capital.

The key takeaway for investors, as Value Investors presents here, is that although the jump in its share price is minimal following the announcement, it is indeed a large premium for investors who owned the stock when Singer first started pushing for a buyout of BMC back in 2012. Thus, for investors considering the fact that the deal might be unfair, they should look again.

The PC market is deteriorating and this would only further pressure the company should it remain public. BMC offers IT solutions, including cloud management. BMC CEO Bob Beauchamp had this to say about the deal:

After a thorough review of strategic alternatives, the BMC board of directors is pleased to reach this agreement, which provides shareholders with immediate and substantial cash value, as well as a premium to our unaffected share price. BMC believes the opportunity to become a private company will provide additional flexibility and position us to invest more strategically to drive powerful innovation and deliver cutting edge customer solutions.

BMC shares traded as high as $70 during the dot com bubble, before falling to $15. The company did roar back to above $55 back in 2011, but poor performance really began weighing on the company in 2012, where it traded in the $30s. The buyout could be considered a blessing to investors.

Smithfield Farms (NYSE:SFD) is the next stock on the M&A list. The company is the subject of a $7.1 billion proposed buyout from China's largest pork producer, Shuanghui. Smithfield is trading below its target price, presenting 2.6% upside, enough to intrigue us. However, we do note that this the stock is trading much closer to the target price than would be expected considering the political implications related to a Chinese company buying the world's leading pork producer. Smithfield CEO Larry Pope testified at a Senate Agriculture Committee hearing earlier this month to alleviate any concerns.

Activist fund Starboard Value owns 6% owner of Smithfield and opposes the deal, believing that a breakup of the company would unlock more value for shareholders. On a sum of the parts valuation, Starboard has pegged Smithfield's valuation at over $10 billion, or $54 per share, compared to the current $34 offer.

While the stock is trading nearly 30% higher than pre-announcement, helping support the company should the buyout fall apart, is the potential for another buyer to come in. Contributor George Rho also makes a good point for downside protection, noting that:

The termination penalty of $275 million, or about $2 a share, which is in escrow, would provide a cushion, though. That said, we think the probability of Smithfield still being an independent concern at year-end is very low. All in all, we fully expect investors in the stock to earn a minimum of 3.3%, and perhaps considerably more.

The Cooper Tire (CTB)-Apollo Tyre deal will make the combined company the 7th largest tire maker in the world, still leaving plenty of room for future growth and leading to monopolistic concerns that could threaten the deal. The Value Investor has a solid piece, where they note that at the buyout price, "everyone is a winner."

Only back in 1993 shares traded a bit higher in the high-thirties. Shares have seen quite a bit of volatility over the past decade trading in a wide $5-$25 trading range. After peaking at $25 in 2007 shares fell all the way back to $5 during the crisis in 2009. Shares recovered toward $25 in 2011 and have traded around those levels during spring, before Apollo came with a knockout premium of $10 per share. Between 2009 and 2012, Cooper expanded its annual revenues by a cumulative 50% to $4.2 billion. Earnings tripled to $220 million in the meantime.

As we noted previously, Cooper's revenues were down 2% in 2012, but EPS was a whopping $0.87, compared to $0.34 a year ago, while also smashing through analysts' expectations of $0.69. Back when the stock first came on our radar it was trading at a mere 6x earnings, and even with the buyout premium now only trades at 8.4x, which is well below its 6x to 26x five year range.

There is no short of data and opinions surrounding the Dell (DELL), founder Michael Dell and activist Carl Icahn saga. Michael Dell wants to take Dell private for $13.65, whereas, and it appears to change on the daily, Icahn wants to do a hybrid deal by offering to buy up the majority of shares and also offering warrants. This would give shareholders $15.50 to $18 per share.

The FactSet data shows of the eighteen deals announced so far this year (in excess of $2 billion), Dell's is the largest. Thus, it's no surprise there has been some concerns that Icahn can put together the necessary capital to complete the deal.

Without getting into the fundamentals, we still believe that the buyout is a solid "out" for investors. There's no denying the PC decline, and we can debate all day about the ultimate fallout for Dell, but it comes down to either taking $13.65 that Michael and Silverlake are offering or betting that Icahn can turn the company around.

Charles Zhang has an interesting take on the Dell saga, and one we don't disagree with. He notes that investors can choose to:

1) make a small profit early, 2) make a bigger profit slightly later, or 3) go all the way and split profits proportionally with him down the line.

The 3.8% upside (from the table above) for the stock is if investors take the $13.65 Michael offer. The upside is impressive, but the risk appears to be growing. If investors reject the deal at the shareholder vote, there is a chance that shares fall, question is how low - in part depending on and if Icahn is ready to step in and provide support for the stock via buying.

Last but not least, the Kroger (NYSE:KR)-Harris Teeter (HTSI) acquisition is offering investors virtually no return. This is in part due to the fact that many in the market believe either Kroger will have to up its bid or that a rival bid might come in. Kroger is snatching up Harris Teeter for $2.5 billion. The deal is a 33% premium to Harris Teeter's closing price back in January, and so it's not too likely a better offer will come in, especially considering Kroger was one of the only two leading companies in the running.

Kroger CEO, David Dillon, had this to say about Harris Teeter:

Harris Teeter is an exceptional company with a great brand, friendly and talented associates, and attractive store formats in vibrant markets run by a first-class management team. They share our customer-centric approach to everything we do - from store format and merchandising to innovative loyalty programs. This is a financially and strategically compelling transaction and a unique opportunity for our shareholders and associates. We look forward to bringing together the best of Kroger and Harris Teeter while continuing to operate and grow the Harris Teeter brands. Together, we can continue to deepen our connections with customers across all of our markets.

A few key mergers mentioned earlier this year include:

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The Thermo Fisher (NYSE:TMO), Life Tech (NASDAQ:LIFE), deal is one of those deals that's great for the acquirer and acquiree. The market is still offering investors decent upside, at 3.8% annualized. But the real draw is that we'd be interested in owning Thermo after the buyout.

Back in May, WMS Industries (NYSE:WMS-OLD) approved the takeover by Scientific Games (NASDAQ:SGMS) for $1.42 billion in cash and debt. This is a deal that we're not overly excited about. Scientific Games is the only suitor, but some of the speculation is that another buyer might come in and offer a higher price. This in part is overshadowing the potential that the deal might fall apart. Other players in the market, i.e. Bally and International Game, carry little cash and are unlikely to make a play for WMS.

Earlier this month, shareholders approved the deal between OfficeMax (NYSE:OMX) and Office Depot (NYSE:ODP). The deal involves Office Depot buying OfficeMax for $1.17 billion, which would help the two better compete with major peer Stables. The deal will be a plus for the entire industry, helping stabilize and increase prices.

The deal is not without risks, which include the FTC stepping in and denying the deal all together. This is a big risk, where the deal could be seen as anti-competitive. However, the OfficeMax stock is trading very close to deal value.

Longer-term, we think fellow contributor Benedict Tubuo sums it up nicely:

While this deal works for Staples in the short term it is a story of a sector whose business model has evolved faster than the incumbents. The ultimate winners are Amazon (for online businesses) and Wal-Mart (for mass retail).


Merger-arb can be a great way to add some percentage points to your portfolio's return with little (calculated) risk. The five recently announced mergers/buyouts don't all offer investors great deals, where the upside to the buyout price for BMC is too small to get in for the time being (although we own at much lower levels). I don't like the stock at current levels, In part, because if the deal falls through, I would not be interested in owning the company.

For risk reward, we like the Dell deal the best. The stock could pullback some if shareholders reject Michael's deal, which could provide a further buying opportunity. While the Cooper Tire deal also has inherent risks, including a large fall in the stock if the deal falls through, but we think the upside justifies this risk, given the deal still is in the best interest of both companies.

Meanwhile, the Smithfield deal has "national security risks", but the company's stock is being buoyed by the potential for a higher offer. While that would be nice, we believe investor's best hope is the materialization of the Shuanghui bid.

Disclosure: I am long CTB, SFD, DELL, BMC. 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.

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