If you are familiar with merger arbitrage, please feel free to skip straight down to the deal metricssection below. Merger arbitrage is a process akin to picking up a few pennies and nickels along the way while panning the river for the big prize, gold. You are basically trying to pick up a few short-term and hopefully low risk dollars in your journey to your long-term investment goals. To explain merger arbitrage, I am going to borrow from a blog entry I wrote on January 11, 2007 titled A Merger Arbitrage Opportunity, where I wrote,
2006 proved to be a banner year for global mergers & acquisitions with $3.79 trillion worth of deals, which even surpassed the deals made during the height of the dot com boom in 2000. As you may have noticed, when a merger or acquisition is announced, the stock of the company getting acquired usually jumps up and closes the day at a price very close to the acquisition price but often a little lower. For example when private equity firm Genstar Capital announced the acquisition of International Aluminum Corp yesterday, the stock jumped up more than 4% to close the day at $52.08. This is almost a dollar less than the acquisition price of $53 per share in cash that Genstar is offering. Here are a few reasons why this occurs.
- Unless there is a possibility of a rival bid, the stock of the company getting acquired will stay stagnant and tie up capital until the acquisition is completed.
- The acquisition may not go through due to antitrust issues or breach of conditions mentioned in the deal.
- The deal may be an all stock or stock plus cash deal and there is a risk that the stock of the acquisitor may drop in value before the acquisition is complete.
- If it is a very large deal, there is a risk that the acquisitor may not be able to raise the required capital to complete the deal.
Investors can profit from mergers and acquisition in a variety of ways. One of these methods is called merger arbitrage where investors purchase the stock of the company getting acquired while simultaneously shorting the stock of the acquisitor (I like this word and have already used it thrice since it saves me from typing “the company making the acquisition” or something to that effect). This is best done as soon as the news of the merger or acquisition is released but is often the hardest to achieve in this era of universal and instant access to news. Another method to benefit from mergers is called risk arbitrage and is described in detail in this excellent FocusInvestor.comarticle called Introduction To Risk Arbitrage: Rainy Day Returns? (PDF).
In case you are wondering, risk arbitrage is not just for hedge fund managers and as mentioned in the article above, has been used by both Warren Buffett of Berkshire Hathaway (BRK-A) and his guru Benjamin Graham.
Deal Metrics:
On Monday January 26, 2009, Pfizer (PFE) made a definitive announcement to acquire Wyeth (WYE) in a deal estimated at nearly $68 billion or $50.19/share at the time of announcement. Since Dow Jones had already reported on the deal the previous Friday, the stock appreciated from Thursday’s close of $38.83 to $43.74 on Friday, January 23, 2009. Hence I am going to use $38.83 as a pre-deal price.
Pfizer is offering $33 in cash plus 0.985 of a Pfizer share in exchange for each share of Wyeth. With the 0.985 share of Pfizer working out to $17.19 at the time of announcement, the cash component of the deal worked out to $44.7 billion. Pfizer ended 2008 with nearly $24 billion in cash and short-term investments on its balance sheet and has decided to raise $22.5 billion in debt for the deal from a consortium of banks. Since this is a friendly acquisition, the key risk appears to be Pfizer’s ability to raise this debt. The deal is expected to close by the end of the third quarter of 2009 or in the fourth quarter.
Based on the Feb 27, 2009 close of $12.31 for Pfizer, the 0.985 share component works out to $12.12. Combining that with $33 in cash, the deal is worth $45.12 to Wyeth shareholders right now. Wyeth shares closed at $40.82 last Friday, representing a discount of $4.30 or 9.5% to the value of the deal.
Some of the analysis I have come across for this deal, tends to ignore the impact of Wyeth’s dividend on the overall return. Wyeth pays a $0.30 dividend per share each quarter. The first quarter dividend will be paid on March 2nd for shareholders on record Feb 13, 2009 and hence I have not included it while computing the total payment in the table below. The table below looks at actual returns and annualized returns for the arbitrage opportunity for two scenarios. The first scenario assumes the acquisition will close by the end of the third quarter, translating into a 7-month holding period (0.58 years). The second scenario assumes an end of fourth quarter close or a 10-month holding period.
| Acquisition Timeline | Total Payment | Actual Return | Annualized Return |
| Closes End of Q3 | $45.72 | 12% | 20.58% |
| Closes End of Q4 | $46.02 | 12.74% | 15.29% |
| Total Payment = $33 cash + 0.985 of a Pfizer share ($12.12) + Wyeth dividends | |||
In an environment where cash is yielding just 2 to 3%, a 12% actual return appears to be an attractive bet. Please keep in mind that the above returns are not taking into account the probability of success or failure of the deal. If you want to arrive at the estimated annualized returns based on the probability of success or failure of this deal, you can use the formula discussed in the Introduction To Risk Arbitrage article mentioned above,
Expected return = (GC – L(100%-C))/YP
G: Expected gain in dollars in the event of success
L: Expected loss in dollars in the event of failure
C: Expected probability of success in percentage
Y: Holding period in years
P: Price of stock at the time of purchase
L: Expected loss in dollars in the event of failure
C: Expected probability of success in percentage
Y: Holding period in years
P: Price of stock at the time of purchase
Assuming the first scenario where the deal closes by the end of Q3, a 70% chance of success that the deal will go through and Wyeth falling $2 to return to the pre-deal announcement price if the deal does not succeed, the expected return works out to,
Expected return = (($4.9 * 0.70) – ($2 * 0.30))/(0.58*$40.82) = 11.95%
Pfizer generated $18.24 in operating cash flow in 2008 and paid out $8.5 billion in dividends. Starting in the second quarter of 2009, Pfizer plans to cut its 32 cent quarterly dividend in half, potentially conserving as much as $3 billion in cash for the company pre-dilution. With Wyeth generating $5.27 billion in operating cash flow in 2008 and the credit markets thawing, I believe the probability of Pfizer raising the capital required to complete this deal is quite high. Even with a 70% probability of success, the expected annualized return of 11.95% is decent given current market conditions.
Please note that I am only going to start a long position in Wyeth and am not taking a corresponding short position in Pfizer. Pfizer has dropped precipitously over the last few months, first on worries related to patent expirations on some of its blockbuster drugs, then on account of dilution from this deal and finally because of the new administrations proposed health care reforms. Shorting Pfizer does not seem to make much sense from a risk/reward trade-off at this point.
I plan on starting a position in Wyeth for my personal portfolio after this newsletter is sent out to subscribers. Since this is a high conviction idea and the SINLetter model portfolio is fully invested at this time, I plan on adding Wyeth to the Special Reports Portfolio.
Deal Website: For additional details including the original press release or subsequent developments, check out the deal website at www.premierbiopharma.com.
Model Portfolio – February 28, 2009
Long Stocks
| Stock | Symbol | Number of Shares* | Cost | Current Value | Diff ($) | Diff (%) | Date Added |
| PICO Holdings | PICO | 150@$25.42 | $3,812 | $3,276 | $-537 | -14.08% | 1/31/2009 |
| Precision Castparts | PCP | 200@$51.13 | $10,226 | $11,086 | $860 | 8.41% | 12/5/2008 |
| Sterlite Industries | SLT | 2000@$4.71 | $9,430 | $9,200 | $-220 | -2.34% | 11/6/2008 |
| Intel | INTC | 500@$15.60 | $7,800 | $6,370 | $-1,430 | -18.33% | 8/29/2008 |
| Activision | ATVI | 1,200@$12.635 | $15,162 | $12,036 | $-3,126 | -20.62% | 8/29/2008 |
| Towerstream | TWER | 13,000@$1.1361 | $14,769 | $11,700 | $-3,069 | -20.78% | 6/30/2008 |
| Textron | TXT | 150@62.55/share | $9,382.5 | $848 | $-8,535 | -90.97% | 5/31/2008 |
| Companhia Siderurgica Nacional | SID | 200@43.15/share | $8,630 | $2,642 | -$5,988 | -69.39% | 4/30/2008 |
| Lionsgate Entertainment | LGF | 1,000@9.41/share | $9,410 | $5,060 | $-4,350 | -46.23% | 2/29/2008 |
| Tata Motors | TTM | 500@17.52/share | $8,760 | $1,755 | $-7,005 | -79.97% | 2/29/2008 |
| Barclays PLC | BCS | 400@32.435/share | $12,974 | $2,056 | $-10,918 | -84.15% | 11/20/2007 |
| Powershares Water Resources | PHO | 400@22.10/share | $8,840 | $4,496 | $-4,344 | -49.14% | 10/31/2007 |
| Blockbuster | BBI | 3,000@3.925/share | $11,775 | $3,000 | $-8,775 | -74.52% | 7/9/2007 |
| Unilever Plc | UL | 200@32.53/share | $6,506 | $3,856 | $-2,650 | -40.73% | 5/11/2007 |
| EMC Corp | EMC | 600@13.85/share | $8,310 | $6,300 | $-2,010 | -24.19% | 3/31/2007 |
| ICON Plc | ICLR | 300@18.65/share | $5,595 | $6,156 | $561 | 10.03% | 1/31/2007 |
| Diamond Offshore Drilling | DO | 80@76.65/share | $6,132 | $5,011 | $-1,121 | -18.28% | 1/3/2007 |
| Alvarion | ALVR | 1000@6.87/share | $6,870 | $3,090 | $-3,780 | -55.02% | 1/3/2007 |
| WisdomTree Investments | WSDT.PK | 1000@7.40/share | $7,400 | $640 | $-6,760 | -91.35% | 11/30/2006 |
| Teva Pharmaceutical | TEVA | 300@35.05/share | $10,515 | $13,374 | $2,859 | 27.19% | 9/1/2006 |
| Suntech Power | STP | 250@25.93/share | $6,483 | $1,522 | $-4,960 | -76.51% | 7/31/2006 |
| Procter & Gamble | PG | 180@55.60/share | $10,008 | $8,671 | $-1,337 | -13.36% | 6/30/2006 |
| Cash | $670 | ||||||
| Total | $122,814 | $22,814 | 22.81% |
* Price and number of shares adjusted for Activision Blizzard (ATVI) and ICON plc (ICLR) to reflect splits on September 8, 2008 and August 13, 2008 respectively.
Voluntary Disclosure: From the stocks that are currently in the model portfolio, I own shares of PICO Holdings (PICO), Sterlite Industries (SLT), Intel (INTC), Activision Blizzard (ATVI), Towerstream (TWER), Lionsgate Entertainment (LGF), Tata Motors (TTM), PowerShares Water Resources (PHO), Barclays (BCS), Suntech Power (STP), Teva (TEVA), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), and BlockBuster (BBI).
DISCLAIMERS :
- Suria Investments, Inc. does not warrant the completeness or accuracy of the content or data provided in this newsletter.
- Suria Investments, Inc. does not comprise any solicitation to buy or sell securities.
- Suria Investments, Inc. will not be liable for any investment decision made or action taken based upon the information in this newsletter.
- We suggest you check with a broker or financial advisor before making any investment decisions.
