3Com Merger Arbitrage Idea

Since I don’t see much appreciation in the market this year, now is a  good time to look into merger arbitrage again. It’s been a while since the failure with DISK and now may be the time to get back on an easier to ride horse.

3Com Corporation Merger Arbitrage Details

  • Acquirer: HP
  • Target: 3Com Corporation
  • Announced date: Nov 11, 2009
  • Closing date: April 30, 2010
  • Closing value: $7.90
  • Last price: $7.48 at time of writing
  • Profit: 5.3% excluding fees

This merger is a cash deal so 3Com shareholders will receive $7.90 per share in cash if the merger is successful.

Cash deals are much easier to analyze and calculate whereas profits can fluctuate with stock mergers. It’s one less variable and the key point of merger arbitrage is to remove as many variables and risk as possible.

Recent Events

On Jan 26th, the shareholders approved the merger by 77% which clears most but not all the hurdles to finalize the deal. The Chinese Ministry of Commerce (“MOFCOM”) now has to formally ok the deal.

“Under the Anti-Monopoly Law of the People’s Republic of China, the parties are required to submit a filing to the Ministry of Commerce (“MOFCOM”). The parties made a joint filing on December 4, 2009. MOFCOM formally accepted the filing on December 28, 2009, commencing the 30-day Phase I review process. On January 25, 2010, MOFCOM notified the parties it would not complete its review by January 27, 2010, the end of the Phase I review period, and that a Phase II review would be initiated. The initial Phase II review period is up to 90 days and can be extended by MOFCOM by up to an additional 60 days.”

You can read all this from the latest SEC filing.

Merger Arbitrage Checklist

1. Due diligence by both parties

I immediately concluded that both have performed their due diligence. HP and 3Com want this merger badly. How do I know this?

“The Merger Agreement provides that, upon termination under specified circumstances, 3Com would be required to pay HP a termination fee of $99,000,000.”

$99 million break up fee? These two desperately want to get married.

2. Financing and regulator approval

Financing for HP isn’t going to be a problem. The tricky part is the regulator approvals. I’m am not aware of how the MOFCOM acts and approves decisions when it comes to mergers, but it seems like the Chinese antitrust approval will be the final hurdle. Will have to wait for news on any European and US antitrust laws but looks good so far.

3. Get preliminary shareholder sentiment (or controlling shareholder approval)

Not required

4. Obtain regulator (SEC, FCC, any and all) approval

Same as (2) above.

5. Get final shareholder approval

Shareholder approved by 77%

3Com Valuation

With a merger, knowing the downside level is also just as important should something go wrong and you are left holding the company.

Quickly running through COMS on the stock valuation calculator, I see that the company’s fundamental history isn’t great. A few things I immediately see.

  • The net income was inflated because the company didn’t have to pay much taxes from all the losses over the years.
  • FCF has been negative for most part of the past 10 years.
  • Management has done a terrible job of using it’s cash.

With the following valuation, I’ve kept it slightly optimistic.

DCF: $6.70

Graham’s Formula: $5.87

EPV: $4.94

Looks like COMS is a $5 company. No need to be exact, just take the average and COMS valuation is $5.84 which is what it was trading at before the merger announcement.

Probability Calculation

  • Potential Upside: About 5% (based on closing value of $7.90)
  • Potential Downside: 26% (based on a stock valuation of $5.84)
  • Time: 3 months but has to be completed within 1 year, i.e. Nov 11, 2010.
  • Probability of success: 85%

I then plug the numbers in a Kelly formula calculator with the above stats and the result is a Kelly Percentage of 27%. Meaning, you can allocate up to 27% of your portfolio to this particular investment. I’m not 100% convinced with the Kelly formula but in this case, I would have to agree.
COMS Fundamental Stock Valuation Overview


No position at the time of writing. Need to free up some cash to make it worthwhile.

  • Old School Bro

    Sicne when is $99,000,000 equal to 1/2 of $1,000,000,000?

  • thanks for pointing that out. I misread it as 990,000,000. Fixed.

  • Chris

    The spread on this transaction is huge–much larger than just about any other deal currently in the works–due solely to the fact that MOFCOM is a black hole of information. There is absolutely zero transparency, so gauging the likelihood of regulatory approval is extremely difficult. Additionally, the size termination fee is standard (about 3.5-4% of the total deal value) so do not put any stock (pun intended) into its size as a determinant of the transaction being completed. Investing in the deal may turn out to produce some great returns (as stated, the spread is HUGE for a merger arb transaction–the small spreads that are the current standard and are why merger arb funds are generally leveraged to the hilt), but the potential risks from the lack of regulatory transparency is inherent in size of the spread.

  • Alex MacKinnon

    “I then plug the numbers in a Kelly formula calculator with the above stats and the result is a Kelly Percentage of 27%. Meaning, you can allocate up to 27% of your portfolio to this particular investment. I’m not 100% convinced with the Kelly formula but in this case, I would have to agree.”

    You be confident putting 27% of your portfolio into this position ?

    That’s seem quite high.

  • @ Chris,

    I disagree that the spread is huge. Definitely more work required to learn about MOFCOM but for the small guys, there is no point in dealing with arbs where the spread is less than 1%. The only factor here between a 0.1% arb and 5% arb is MOFCOM.

    Will do some more digging around though as I’m sure it isn’t the first time MOFCOM had to approve something, and since it is for anti-monopoly purposes, I dont think it’s as big a threat as you state. There are far many and bigger companies with bigger market share that HP has to be concerned about monopolizing the industry.

    @ Alex MacKinnon,
    It all depends on your asset allocation. Remember it says allocate “up to 27%”.

  • Paul

    Hi Jae, just wondering how you arrived to an 85% probability?

  • Chris

    Hi Jae, I agree with 100% you that that MOFCOM is the sole reason behind the 5% premium for the reasons you listed above. The terms seem straightforward enough and the potential synergies are readily apparent; it is, however, a very high profile transaction–anybody who has ever dabbled in risk arb has heard about this deal. Given that (at least on the surface) the numbers are simple to crunch, I find the 5% premium a bit troubling. I am no specialist in international law, nor do I believe in totally efficient markets (as no value investor does), but 5% is a very significant figure for a transaction that is on everyone’s radar and with such simple deal terms. This would imply to me that there is something askew with the uncertainty surrounding Chinese regulatory approval, and it is the breakdown of this uncertainty (risk, for lack of a better term) where the profit lies in successfully investing in this transaction. Personally, given that I am not a lawyer (helpful in breaking down and quantifying all regulatory risks) nor a soothsayer (helpful in breaking down and quantifying all risks related to dealing with the Chinese government), I will leave this transaction to those rocking both aforementioned feathers in their cap. Long story short, anything that seems too good to be true (and a 5% premium in a widely-followed acquisition is most certainly that) usually is. Just my $.02.

    As an aside, I do very much enjoy your site/spreadsheets/blog. Keep it coming.

  • Nice article Jae and I like your use of Scribd. Those who use Kelly criteria in the stock market often use half Kelly for position size.

    I tried to leave you a request on your contact page the other day and wasn’t sure if it worked. Can you reply to this or my email, just so I know either way. Thanks – Dean
    .-= Dean´s last blog ..Day Eight: Ten of the Biggest Mistakes in Option Trading =-.

  • @ Chris,
    I didn’t think about that part. I clearly see where you are coming from. I’ll try to dig up some more stuff on MOFCOM and its history and share if it is useful. Appreciate your point of view.

    @ Dean,
    Thanks Dean. I did get your email. I’ll send you a reply.

  • @ Paul,

    No real mathematical formula to the 85%. I figured 90% is too high and 80% is too low. As simple (and flawed) as that haha

  • Paul

    Fair enough.
    I just see people who use a probability in their analysis of special situation investing and wonder how they come up with it.
    It seems to either be a highly complex formula, which reminds me of something either Buffett or Munger said (or both), that successful investing requires no more than basic math skills.
    Or it’s a gut thing, which you seem to use.
    Usually a gut feeling beats out a complex formula. Less variables. 🙂

  • I could have used the following formula
    An = 0.25 An-1 + 0.45 Bn-1 + 0.40 Cn-1 + 0.25 Dn-1 + 0.15 En-1

    But I don’t know what it is… 😛

  • Leslie Schwartz

    All of these comments seem to be correct. Except, did HP buy 3Com to run as is (e.g., the $5.50/per share company) – or for its potential, such as in China, organizationally (Chinese engineering / manufacturing, etc., and for whatever potential it may have for HP server and SAN clients?

    So, my guess is they must see some potential to put about 2.7 – 3 $B USD for the acquisition.

Ready to try Old School Value?