Compounding Life

I enjoy reading old finance and investing books for many reasons. Most of the time the enjoyment is derived from the history lesson or seeing folly from the past that we continue to repeat in the present. Ocassionally there are some very entertaining gems like the one I found in “The ABC of Options and Arbitrage” (free download from archive.org) by Samuel Armstrong Nelson, published in 1904.

As most of the readers probably know the main difference between American style and European style options contracts is when they can be exercised by the buyer. European style options can only be exercised on the expiration date where as American style options can be exercised any time before expiration.

Why might it be that this difference exists? Samuel proposes one answer:

The London buyer of options is accustomed to “trade
against his options” to a much greater extent than the
New Yorker, and trading of this character calls for quite
complicated calculations that would puzzle and confuse
the average American stock speculator who wants a sim-
ple, rather than a complicated proposition, and who prefer-
ably always demands a quick, rather than a slow decision.
The English stock speculator apparently is slower, more
patient and willing to work harder to secure a profit than
his American contemporary, who despises small profits, and has a world-wide reputation among financiers for his
failure to give proper regard to his interest account.

I have talked about risk arbitrage in the past but risk arbitrage in stocks is not true arbitrage. In my experience is very rare to come across a true arbitrage situation meaning there is a guaranteed profit, no risk and the transactions happen almost simultaneously. So I do find it fascinating when I come across one.

The Wall St. Journal and Make Magazine posted stories about frequent fliers who found a nifty arbitrage transaction. The US Mint was offering free shipping on $1 Native American and Presidential coins which are sold at face value. By charging this purchase on a credit card that provides frequent flier miles you are buying a dollar for a dollar and getting the miles for free. The Journal article states that one person claims to have purchased over $800,000 of the coins using multiple credit cards and bank accounts. People would order the coins in boxes of 250 and take them straight to the bank to deposit in their checking account and pay back their credit card company.

*note: Bristol-Myers Squibb’s ticker symbol is BMY, however the company refers to itself often as BMS, this can be confusing

I was reading this Fat Pitch Financials post and saw mention of Bristol Myers (BMY) offering their remaining ownership of Mead Johnson (MJN) in exchange for BMY shares.

Bristol Myers did a public offering of MJN earlier this year and the stock has risen nicely since then. Mead Johnson was started in 1905 and aqquired by Bristol Myers in the 1960s.

Quick info about MJN

From their website:

We are Mead Johnson Nutrition — a global leader in infant and children’s nutrition.
We are best known for our Enfamil® and Enfalac® families of infant formulas as well as for our regional children’s nutritional products, including Enfagrow®, Enfapro®, Enfakid®, EnfaSchool®, and Sustagen® in Asia, and Choco Milk® and Cal-C-Tose® in Mexico and Latin America.

I like Mead Johnson because its a boring steady business. Infant formula, while it will probably change in the future is not going away and families are likely to stick with known recognized brands for their children. I think brand recognition in infant formula is a good competive advantage.

The flip side of this of course is that something as serious as infant formula requires the company does not tarnish is brand by producing bad products. It is likely that a recovering from a massive problem with its product could put the company in dire straits. As an investor you should realize the potential risk of things like this regardless of how likely or unlikely they are. There has been one instance of Melamine being found in MJN and others infant formula.

Info about the deal

Bristol Myers owns the majority of MJN (they sold some in a public offering this year). There is a tender offer being made in which BMY will provide up to 0.6313 shares of MJN for each share of BMY tendered. The actual ratio will be determined by an average price over a couple of trading days, in which they will provide $1.11 worth of MJN for each share of BMY (not to exceed to the 0.6313 number). The original tender was supposed to expire Dec. 14th 2009 at midnight. A recent SEC filling indicates they have extended the offer:

From the filling:

Bristol-Myers Squibb and Mead Johnson Announce Amendment and Extension of Exchange Offer
(NEW YORK, December 4, 2009) — Bristol-Myers Squibb Company (NYSE: BMY) and Mead Johnson Nutrition Company (NYSE: MJN) today announced that Bristol-Myers Squibb Company (“BMS”) has amended and extended its offer to exchange up to 170.0 million shares of common stock of Mead Johnson Nutrition Company (“MJN”) for outstanding shares of BMS common stock that are validly tendered and not validly withdrawn at an exchange ratio determined by a formula described in a registration statement filed by MJN on Form S-4 (Reg No. 333-163126).
BMS is amending the offer by:

•Increasing the upper limit on the exchange ratio to 0.6313 shares of MJN common stock per share of BMS common stock from 0.6027 shares of MJN common stock per share of BMS common stock; however, the final exchange ratio may be less than the upper limit;

•Extending the exchange offer’s expiration to 12:00 midnight, New York City time, on December 17, 2009, unless extended or terminated, from December 14, 2009; and

•Amending the current expected three-day period over which the final exchange ratio will be determined to December 11, 14 and 15, 2009 (which previously was expected to be December 8, 9 and 10, 2009).

The final exchange ratio will be announced by press release by 9:00 a.m., New York City time, on the trading day immediately preceding the expiration date. BMS and MJN currently expect to issue that press release by December 16, 2009, unless the exchange offer is extended or terminated.
As of December 3, 2009, approximately 1,055,000 shares of BMS common stock have been tendered.

Some Risks

Potential Kicker for BMY holders

Value?

A quick look at the DCF valuation using the OldSchoolValue.com spreadsheet prices it at about $20 fair value assuming 5% growth and 9% discount rate. It currently trades somewhere around $41 a share. One thing to keep in mind here is that due to the fact that MJN is only recently public there is very much historical data about the their growth. If I was really interested in this situation I might research Bristol Myers annual reports for more information. For sake of argument I picked %5 as a somewhat conservative growth rate.

Overall it seems like MJN is still a bit overpriced even if you take into account that you could get %10 discount via the tender offer, unless there is something that can indicate they will grow free cash flow at a high rate.

However if you look at this from an arbitrage perspective it is a potential 10% profit with a very short time frame. This assumes the market continues to value MJN at current levels or higher. If you want more information on this deal I would suggest following the link at the bottom of this post for the online webcast of the conference call.

What about BMY?

On the flip side BMY appears to be undervalued. I pulled it up on the spreadsheet and with %25 MOS (good moat), 9% discount and 0% growth it shows a 27.87 per share value and buy price of $21 to get a margin of safety of %25. If you bump the growth up to 3% the numbers start looking reasonable. The question is will they grow FCF? Well here are some things to keep in mind:

1. They are divesting themselves of all non-core units (hence the MJN spin off) so they will be more focused on their biopharma products. This has been a long standing plan that they have been following through on.

2. Shares that will be retired in the MJN tender will reduce their dividend payout. In the conference call BMY said that the dividend reduction will be larger than loss of dividends they currently get on their MJN shares.

3. Over the past 10 years FCF has been a bit of a roller coaster, but from 2006 to 2008 it has been growing which might mean that management has their act together more and their plan for focusing on biopharma is working.

Useful Links:

Bristol Myers Investor Relations

Listen the to MJN split off conference call

Most recent related SEC filling at the time writing

Summary

I think MJN is overpriced and BMY could warrant further investigation. That being said I might take a small position in MJN to go through the exchange process as a learning experience so I know what to expect in future opportunities.

Disclosure

This is not a recommendation to buy or sell securities or a replacement for your own investment research and due diligence. I have no positions in MJN or BMY at the time of this writing.

Arbitrage in the purest sense exists when there are multiple markets for something and one of the markets prices said something lower than the other. For a real simple example lets say that a certain collectible baseball card sells for $30 in California over the counter. You can take the same baseball card to a card shop in Boston and sell it $50. There is a very low risk opportunity to make a $20 profit per card if you can buy them in California and sell them in Boston. So you buy a bunch of these cards in California and ship them to your old friend from High School who lives in Boston. The shipping averages out to $1 per card and you cut your friend in at $5 per card. 

  $50  Market price in Boston

- $30  Market price in California

______

  $20  Spread

  -$1  Shipping 

  -$5  Comission 

  $14  Total profit per card

What you are doing here is a form of arbitrage.

Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.

- Buffett in the 1988 Berkshire Letter to Shareholders

There are many different forms of arbitrage. People sometimes engage in arbitrage on sports betting, where they can place bets at different books at different odds in such a way that no matter what the outcome of the game or race they are guaranteed a profit. Casinos practice “statistical” arbitrage. All the games they offer have a statistical advantage in favor of the house that guarantees over time they will profit. 

Warren Buffet was engaged in a unique arbitrage situation involving cocao beans while working for Ben Graham’s Graham-Newman Corp. Buffett writes about in the 1988 Berkshire Letter to Shareholders:

 
Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corporation.  Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory – quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.  

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.”

 

Risk arbitrage is the most popular type of arbitrage when it comes to securities markets and involves “merger & aquisition” situations. For example Lester Floor Tiling announces it is attempting to buy out Smith Carpet Company (company names are made up) and offering $20 per share of Smith Carpet Company stock. If you purchase Smith Carpet Company stock for under $20 you can profit from this transaction when and if it happens. 

As the name implies there is risk involved in these situations. Smith Carpet shareholders may vote against the buyout, regulatory agencies might step in and say that this would create a flooring product monopoly that would not be in the interest of consumers. In M&A activities there are endless lists of things that can prevent deals from happening.

Take all of these risks and then factor in the current credit freeze and market volatility. Things can get hairy and do.  Mergers that seemed likely months ago can now fall apart quite easily.

Value investing blog Oldschoolvalue has been dilligently following a risk arbitrage opportunity regarding Emageon Inc. (symbol EMAG) and Health Systems Solutions Inc. (symbol HSSO). HSSO made an offer to purchase EMAG at 2.85 share. HSSO had a hard time meeting deadlines for the deal but ultimately ponied up $9 million in an escrow account to be paid to EMAG in the event that they could not follow through on the deal. $9 million may not seem like a lot, but put it in context HSSO’s market cap as of this writing is $8.3 million and the deal value of $69 million, its a fairly substantial deposit. So when news hit the deal was going to close February 11th the stock price started soaring up to $2.60 as people started getting in on the deal. The day before the deal was supposed to close the price started droping and investors were worried. Was there insider information about the deal falling through that was causing people to sell? The market in general was taking it in the pants so a lot of people (myself included) attributed the price drop to a combination of market volatility and people selling early to lock in their profits. 

The deal fell apart.Stanford International Bank in Antigua decided not to fund HSSO’s purchase and EMAG shot down to the $1 dollar level. To make it even more interesting, the decision to not fund the purchase has brought more attention to Stanford International and there is some speculation that the bank which has had abnormally high return rates on its certificates of deposits might be up to no good. In fact they are the subject of a probe.

I am left holding EMAG shares for quite a bit less than what I paid for them as are alot of other people. After doing a mental post mortem I have a couple of lessons learned.

1. Coming off of a successfull arbitrage with Puget Sound Energy I was probably not as critical of the EMAG deal as I should of been. Had the Puget Sound Energy deal fallen through I would have been content holding my position through the current market and collecting the dividends. In assessing the deal I did not put enough weight on the fact that EMAG is not a stock I would be content with holding an extended period of time. I think looking forward, my overall feelings about holding the secuirty in question should have a heavy weight on my decision. Even if the odds look like they are 90% or greater, the quality of the stocks in question should be paramount to my decision because I do not engage in enough arb situations to balance out the losses.

2. More due dilligence on Stanford International Bank may have set off some flags that I should steer clear of the deal. The fact that they offer abnormally high returns on CDs and are based in Antigua a place where I have little knowledge of the local financial regulations might have tipped me off. But of course hindsight is 20/20. 

3. I know very little about the industry that EMAG and HSSO are involved in. One nice thing about the Puget Sound Energy deal was that I live in Puget Sound and hence was close to the pulse. In addition I know a person that had been Puget Sound Energy shareholder for a long time who gave me some valuable insight as well.

Typically those who engage in arbitrage when faced with this type of situation sell their position, take their losses and move on. I was tempted to do this but I have decided not to for the following reasons:

1. Sell off. There are alot of people closing out their positions and driving down the price. I don’t believe the current price reflects the value of the stock and I do not have an existing opportunity waiting for the funds currently invested in EMAG. 

2. EMAG recieved 9 million in cash because the deal fell through. As of this writing EMAG is trading right around their book value and a little bit over their cash per share not including the 9 million in cash they just recieved. While the cash will not bring the book value up to my purchase price, I think they are better positioned or ride it out. 

While I understand the “cut your losses and move on” way of thinking, I believe the exit much like the entrance into the position requires some thought and in this case my thought is to hold on for a little while and not let the actions of the masses sway my judgement.

Some good arbitrage related reading:

1988 Berkshire Hathaway Letter

Buffett on Valuation: Risk Arbitrage Edition

Arbitrage: Emageon (EMAG)

Updates:

1.Turns out that the Stanford International is the focus of probe and key people are facing criminal charges.

2.I ended up selling my EMAG position because I feel I have found a good investment idea that will be a much better allocation of remaining funds instead of waiting for EMAG to recover.

So there has not been a lot of news on the PSD merger lately. This has some people thinking the deal will not go through, these thoughts are reflected in the stock price which has remained around $27.30-$27.50 for a couple of days now.

In my opinion no news is good news. There really should not be much to report unless something goes wrong, so they silence has me quite content that share holders will be getting their $30 per share sometime this month.

One interesting thing to note though is that PSD annouced its quarterly dividend to shareholders on record as of January 21st 2009.  This is a nice added bonus if we end up getting the dividend for this quarter and the buyout share price. 

For more details on the PSD deal read the posts at Oldschoolvalue.

I am not going to go into detail about the Puget Sound Energy deal, it has been covered in depth in many other places which I will list at the end of this post. 

But I wanted to bring it up because it was my first taste of risk arbitrage. I started my initial position in PSD (PSE’s ticker symbol is PSD, confusing) around a month ago.  The deal gives all share holders $30 a share cash in exchange for their shares. So the idea is quite simple buy it for less than $30, the deal goes through you get your cash and profit. The reason merger deals are called “risk” arbitrage is well… because there is risk. In true arbitrage you have two simultaneous markets with different prices and you have essentially a risk free profit. 

The risk is that the deal had to be approved by the Washington UTC and this had not happened a month ago. In fact it just happened this week. In addition some of the communities in WA are not in favor of the merger hence there was risk that this could prevent the UTC from approving it.

On the downside if the deal did not get approved I was quite content with holding the stock and collecting dividends in the event that I could not sell it for a profit in the short term. For someone who might not want their money tied up in the long term, the downside is different. 

Interestingly enough with news of the approval the stock traded Wednesday below the sale price so there was still an option to make a quick very low risk profit.  It will be interesting to see if it continiues to trade at this price tomorrow on Friday. 

Mucho thanks to the Old School Value Blog for consistently posting updates on this deal.

PSD Merger at OldSchoolValue

Puget Sound Energy Website