Dacha Strategic Metals (OTCPK:DCHAF) was discussed here as a potential value opportunity just 3.5 months ago. While the company had been a destroyer of capital for several years, it came under new management with a history of good capital allocation. I'm pleased to report that shareholders have seen a share price increase of 30% since that article. Annualized, that return comes out to a cartoon-y 150%.
Most of that increase has come in the last two days or so, as the company announced it has signed a deal to invest the vast majority of its assets into Merus Labs International (NASDAQ:MSLI). Merus is a specialized pharmaceutical company that looks to acquire mature drugs, and increase each new drug's profits through improved sales and marketing.
Merus is trying to carve out a niche where it can operate with a competitive advantage. It seeks drugs that are too small to move the needle for the large pharma companies as well as products that have been "under-promoted" and yet are still covered by patent.
Merus claims to have a competitive advantage as follows. Its competitors in the acquisition of products are mostly regional or focus on certain therapeutic niches. In the company's own words:
"Merus believes it has a unique strategy in seeking to acquire legacy products primarily for the purpose of generating a stream of stable revenues and cash flow. Merus believes that this strategy will provide it with the flexibility to consider a broad range of acquisition targets from a variety of therapeutic areas. Therefore, the potential number of product acquisition candidates may be much larger for Merus than for its competitors. Management believes that its approach to product acquisition and its return objectives provide Merus with a competitive advantage..."
Maybe I lack imagination, but I'm not sure I see a structural advantage here. I'm not sure why a more focused and specialized pharma group (from a specific therapeutic area) isn't in a better position to understand what a drug is worth and how to effectively sell/market it.
Looking at Merus' financials is of no help here. The company lost $1.5 million on revenue of $6.7 million. Maybe the company just needs scale. But if it does have a competitive advantage, it's out of my circle of competence.
For that reason, I took my quick profit in Dacha and ran for the hills. For more enterprising investors, however, there remains an arbitrage opportunity.
Dacha plans to distribute its shares in Merus and subsequently de-list and cease its own operations. But it has a deal to purchase shares of Merus at a discount to Merus' market price. So while Dacha, which still trades at a slight discount to its net assets, is going to buy $11+ million worth of Merus shares at $1.70/share, Merus trades for $2/share. Merus has also agreed to provide Dacha a fee of 3.5% for this deal, which will be paid in Merus shares (as explained here).
An investor could arbitrage this difference by shorting Merus shares, and going long an equal dollar amount of Dacha. When the deal closes (for which the current goal is August 15th, 2014) and the Merus shares are distributed to Dacha shareholders, investors should have a positive number of Merus shares, which represents the profit of approximately 18%.
Of course, there are risks here. Even if the deal doesn't fall through (which is always risk #1 in any merger arbitrage), it's not clear how much cash Dacha will have available to invest, making it difficult to know how many shares it would take to offset a Merus short position. While Dacha is investing $5 million cash into Merus right now, much of the remainder of the $11+ million promise was tied up in other assets such as inventory as of Dacha's latest financial statements. How much the company can get in the sale of these assets is unclear, and as such the company's net assets may be subject to some writedown.
While Dacha does trade at a discount to its net assets, there may be other costs involved with dissolving the company and de-listing and distributing Merus' shares. Investors seeking to arbitrage the spread here should be sure to understand all of these costs.
Either way, the lesson here for me is clear. Don't own companies with capital destroyers at the helm, even though they may trade at large discounts to net assets. But do own these companies when they are run by good capital allocators, as the odds are firmly in your favor in such cases.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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