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Workouts Work Out In Down Markets - Part II

January 20, 2008 | About:
Joe Ponzio

Joe Ponzio

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So, you're sold on using arbitrage to enhance your portfolio. In fact, you've always known that arbitrage can offer virtually risk-free profits; still, it can be somewhat scary to jump in with both feet. Rather than getting into the theoretical aspects of arbitrage, let's take a look at some real life examples of when you can have a high degree of confidence...and when you should be leery.

First off, let me thank the visitors of F Wall Street. In the comments to Workouts Work Out In Down Markets — Part 1, Tim J, D, and Heterocedastico asked about specific opportunities. In addition, George from Fat Pitch Financials jumped in to confirm the value of arbitrage, and Kevin posted this free website that tracks various arbitrage opportunities.

I responded to Tim's comment about MGM here. So, let's look at Oracle's potential purchase of BEA Systems.

The Offer

Oracle is offering BEA Systems (BEAS) shareholders $19.375 per share in the merger agreement. At this point, Steps 1-4 have likely been completed as the companies have agreed on a price and have a general feel that this deal will go through. Buying BEAS today gives you the opportunity to earn roughly $0.90 per share on completion of the merger, or about 5%.

Management expects the merger to be completed by mid-2008.

The Obstacles

According to the 8-k ("Current Report") BEAS filed with the SEC:

Merger is subject to clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and the applicable merger control laws of the European Commission and other jurisdictions, as well as other customary closing conditions.

In addition, it must be cleared by a majority of the shareholders. This can be a major obstacle if management and other people on board don't control the majority — or a large part — of the outstanding shares.

A look at BEA's most recent annual report filed with the SEC, the directors and executive officers only control about 4.1% of the outstanding shares. That will have likely increased by the time the proxy to shareholders goes out (Step 6); still, it is unlikely that they will be able to control a majority unless the major institutions really love the deal. If these shareholders feel like they are getting a raw deal, it could fall through.

So, are Carl Icahn, Private Capital Management, and AMVESCAP — in total controlling 28+% of the company — on board? We don't know yet.

At this point, the transaction doesn't look nearly risk-free. If the merger falls through, BEAS stock will likely drop to (or through) its $16 level again, and you are out $2.50 a share (11%) or more.

There Is No Hurry

The deal is expected to close in mid-2008. More than likely, that's noise at this point. It could just as easily close in Q3 or Q4 of 2008. Without knowing how long it will take for regulatory approval (Step 5), "mid-2008" is a goal, not a plan.

The Rewards

Then, of course, you have to look at the potential rewards. At today's price, you have the opportunity to earn about 5% on the upside over the course of 6-12 months. You can earn nearly that much in a Certificate of Deposit (CD) over the next year — with virtually no risk!

The Goal of Arbitrage

In arbitrage, the goal is to earn high rates of return on an annualized basis in low-risk, high-certainty situations. I look for "done deals" that are mis-priced due to other peoples' fear. When would a 5% return satisfy me? When I can get it in a few weeks. If we have gotten past Step 5 and there are two or three months to go, I want to see a 10% spread between the current price and the merger or acquisition price.

If the merger or acquisition (or going private) transaction is more than three months out, it likely hasn't gotten past Step 4 or 5 and it is a purely speculative play.

When should we look at BEAS as an arbitrage play? I'll take a look in a few months, once I get the news that regulatory approval has passed and that the shareholders (who, in this case, control the majority) aren't going to revolt or upset the applecart.

New Motion's Merger With Traffix

I'm a fan of the 10-Q Detective. I love getting his blog feed to my Outlook because he really loves turning over rocks, particularly in smaller companies. On January 11, he posted an arbitrage play appearing to yield 42%. In short, New Motion (NWMO) is engaging in a stock for stock merger with Traffix (TRFX). With NWMO trading near $12 and TRFX just under $5, it appears to be a 40+% return.

If you head over to TRFX's proxy recently sent to shareholders, you'll see that Traffix shareholders will receive "approximately 0.681 shares of New Motion common stock for each share of Traffix, based on the currently anticipated capitalization of both companies as of the closing date of the merger." In short, buying 100 shares of TRFX at $4.90 today would cost $490 (plus broker fees) and, upon closing, you would end up with 68 shares of NWMO.

If NWMO were to hold its $11.95 price, this would seem like a sweet deal. Your $490 of TRFX stock is now worth $814 of NWMO.

The Problem

NWMO has 12,096,284 shares outstanding. To complete the merger, it will have to issue another 11,917,520 shares to TRFX stockholders, thereby changing NWMO's outstanding shares to 24,013,804. Combining the two market caps of the companies (perhaps not the best way to do it, but it gives us an idea), post-merger NWMO would trade at roughly $9.11.

Your $490 investment in TRFX is now worth $620 in NWMO. Still not a bad return, but let's continue.

NWMO is coming off the bulletin board to get quoted on the NASDAQ. As of right now, there is virtually no volume on the stock — a company that used to trade (split-adjusted) for more than $600 a share, went through bankruptcy, reverse split, and is back in operation. When it hits the NASDAQ and can be traded more freely, with long-term stockholders run — pushing the price down in the process?

TRFX is listed on NASDAQ. You can't really say it trades with an average volume of 29,000.

So, one company barely trades and has had a rough history (and, perhaps, a correspondingly desperate or indifferent shareholder base) and the other company is barely traded. What does this mean for you? Odds are, you are going to hold stock in a thinly traded stock. The price you see (i.e., roughly $9.11) may not be the price you get if you sell.

In addition, shareholders that didn't like the acquisition or that now have the opportunity to sell may push the price down. If it gets below $7.20 a share, your premium is gone.

The Solution

I don't like to put my faith in stock for stock acquisitions. When I commit money to an arbitrage position, I don't want my fate determined by a short-sighted market. That's why I like cash deals — going private transactions, cash buyouts, etc.

And that's it for now. I guess we'll have a Part 3 to this discussion next week.

About the author:

Joe Ponzio
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.8/5 (9 votes)

Comments

danielw
Danielw - 6 years ago
Arbitrage work-outs work out--until they don't. I think it's bad to call them risk-free.

I would only be involved in them given two conditions. Either the closing is a near certainty (which of course gives me lower returns) or the stock expected to be bought is a good buy at its current level irrespective of the deal, and I wouldn't mind adding more on a pullback.

Third Avenue wrote about these workouts in their most recent annual report, saying much the same thing.

--Daniel

http://danielwahl.blogspot.com/
equityguy
Equityguy - 6 years ago
I agree with Danielw. "Workouts" are, with rare exceptions, much riskier than they were when Buffett was young. In the 50s and 60s there weren't thousands of arbitrage hedge funds (whose sole purpose is, of course, to identify and exploit arbitrage situations). Now, with all these funds and computer models out to identify arb situations, the profit potential is drastically reduced and the risk is drastically increased. The spreads aren't what they used to be, and the "margin of safety" is nonexistant in most deals. There are exceptions and it is still possible to make decent returns on arb deals, but its very hard to do consistently.

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