How to invest

Guest Post by

plc90210

The original version of this article can be found in the forum under back-testing spinoffs.

Successful Spinoff Investments

In Joel Greenblatt’s first book, “You Can be a Stock Market Genius”, he stated two points that make a spinoff worth analyzing.

1. Insiders are buying
2. Institutional investors are selling (without regard to the investment merits)

Spinoff Performance with Heavy Insider Buying

I decided to do some experimenting with this. I looked back at all the Form 10-12Bs I could find within the past 10 years, and made a list of all the spinoffs. Then I took all the spinoffs that had heavy insider buying within a week of being spunoff (from secwatch.com). I then checked the 1st year performance of those stocks. Here  are the results.

As you can see, the results are pretty impressive, all but one spinoff that had heavy insider buying within a week of being spun off outperformed the S&P 500.

Also, a recent spinoff, HHC, also had heavy insider buying within a week of being spunoff, and has outperformed the market since then, so might as well add that one to this list too.

Performance of Spinoffs Smaller Than Parents

It was hard to find the spinoffs that were indiscriminately sold by institutional investors, but since these are usually micro cap spinoffs that have mid-large cap parents, I decided to create a list of those spinoffs that were small compared to their parents.

It was hard to find all the information on the parent companies because there were many that were acquired or went private, so there were many spinoffs that were not included.

Still, I managed to get information on about 25 of them and checked their 1st year performance and here is what I found.

(click to enlarge)

As you can see, the results are quite satisfactory. For some spinoffs, I included the performance for a period shorter than 1 year because only looking at the 1-year performance can be limiting.

For one of the spinoffs, ALC, I couldn’t find what the market cap of the parent company was but I found out that it traded on a different exchange than ALC, and since that can be a reason for indiscriminate institutional selling, I decided to include it.

Of course, it would be best to do research on spinoffs before investing in them rather than just buying every spinoff that gets sold off by institutional investors or has heavy insider buying, but still, this data proves that spinoffs can make great investments.

The author of Value Uncovered is a long time reader of OSV and has graciously allowed me to repost his latest article and special situation idea on FIS.

I only read blogs that offer high quality information and ideas, and Value Uncovered is a new blog that I am glad to read and would recommend to all value investors.

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Fidelity National Information Services, Inc (FIS) is a financial services company with over $3.7 billion in annual sales, focused on credit card and mortgage processing.

Background

On May 6, 2010, the Wall Street Journal reported that FIS was in talks with the Blackstone Group and THL Partners, two private equity firms, about a leveraged buyout in the $10-11 billion range.

The stock jumped on the announcement, and moved even higher after rumors surfaced that another private equity firm wanted in on the deal as well. News organizations increased their estimates to more than $15 billion, making it potentially the largest leveraged buyout since the start of the credit crisis.

However, on May 18, the deal fell through and the Company decided to pursue a leveraged recapitalization plan and substantial share repurchase instead.

Announcement

On May 25, the Company released a statement outlining the terms of the recapitalization plan:

As stated in the news release, our Board of Directors has authorized a plan under which our Company will repurchase up to $2.5 billion of its common stock at a price range of between $29.00 – $31.00 per share through a modified “Dutch auction” tender offer. In order to effect the proposed recapitalization, we intend to borrow approximately $2.5 billion of incremental debt. FIS is in a strong financial position and generates significant free cash flow, so we are very comfortable with the proposed debt levels that we will incur in repurchasing the company stock.

Odd-Lot Provision

Although the final price level and number of shares purchased will be determined by the dutch auction, the tender offer provides priority to ‘odd lot’ shareholders of less than 100 shares.

Even if the offering is oversubscribed, this provision ensures small shareholders will receive a full cash-out without any proration, a great opportunity for the average investor.

Timeline

May 25: FIS announces details about the proposed recapitalization plan and self-tender offer.

July 6:  The Company sells $1.1 billion in Notes to qualified institutional buyers, the main condition for the share repurchase

July 6: FIS commences the tender offer.

July 16: Proposed closing of $1.1 billion Note offering

August 3: Conclusion of the tender offer

Late August: Shareholders who validly tender their shares will be cashed out at the final auction price, with priority for the ‘odd lot’ shareholders defined above.

Return Scenarios

As of July 9, I’m adding FIS to my ValueUncovered portfolio using the latest closing price of $27.70.

Final Tender Price

TBD

Conclusion

The deal offers attractive annualized returns for a month long trade.  Although there is always risks with such a large transaction, FIS is very well capitalized and I don’t forsee any problems with the offer going through.

I think Frank Martire, the Company’s President & CEO, says it best:

The recapitalization plan is consistent with our commitment to doing what is in the best interests of our company, our clients and our shareholders. Our strong financial position, combined with appropriate market conditions and our excellent relationships with lenders, make this the right move at the right time.

Disclosure

Value Uncovered & Old School Value is long FIS

Lately, I’ve been focusing on trying to take advantage of the volatility by picking up shares of companies undergoing merger agreements. You may recall that I made passing mentions of purchasing EMMS. If not, it’s probably because I forgot to post my June portfolio update.

Well, I bought a good size position at the end of June at $2.17 but sold out completely at $2.20. Break even after you include fees.

Disappointing result but it was a decision that I had to make in order to stay disciplined.

Emmis Corporation Merger Arbitrage Details

• Type: Going private acquisition via tender offer
• Acquirer: JS Acquisition & Alden Global Capital
• Target: Emmis Corporation
• Announced date: April 26, 2010
• Closing date: September 30, 2010
• Closing value: $2.40
• Last price: $2.20 at time of writing
• Profit: 9% upside excluding fees

EMMS originally announced plans to be taken private by JS Acquisition which is a company formed by the CEO of EMMS himself.

Completion Conditions

A majority of common A, B and 6.25% Series A Cumulative Convertible Preferred Stock stock must be validly tendered.

Herein lies the problem.

Merger Events

Seeing as how the CEO, Jeff Smulyan, holds most of the common shares, votes for the common isn’t a worry. The issue is the preferred stock.

One of the rules of merger investing is to make sure that opposing parties with sizable positions are not in a position where they can block the transaction.

In this merger arbitrage, there is no single preferred stock holder that can do this, but a group of holders acting together is a different story.

This group has sign a lock up agreement where each will vote against the exchage of preferred stock for a new debt issue.

The activist group in the lock up agreement hold a total of 969,858 preferred stock. Some funds could have easily bought more without the total being updated on the documents yet. This is more than a third of preferred stock, which is enough to block the transaction from being completed.

A good summary of the situation can be read from this article.

Activists

The preferred stock are  selling in the open market for just under $22 but under the deal, holders are expected to receive 60% of face value.

This current situation with the lock up agreement is a fight to get Smulyan to raise the price. Smulyan already tried to take the company private before 2006 at a higher price and the activists must believe that they have the cards to get Smulyan to up his bid.

Probabilities

You can obviously see two sides here.

• 1. Activists can force Smulyan to increase the buyout offer and reward both commons and preferred stock holders.
• 2. Smulyan could easily walk away and live to fight another day.

Number 2 is why I sold out. I’ve made plenty of mistakes before, and before the lock up agreement was formed, EMMS was looking like sweet 10% gain with very high chances of closing.

Now, the closing probability has decreased, in my opinion, considerably. Gain potential “could” increase but the downside has gone up way too high for my liking.

With the tender deadline set for August 2, there is still a couple of weeks to keep an eye on the developments in case talks are positive.

The optimist and “gambler” in me wants to hold a small position but I wont be making any bets based solely on who I think will win.

Unlike a bankruptcy situation, there is no equity committee to lay out fundamental analysis or a judge to rule objectively in favor of the winner. Smulyan can easily withdraw the bid and walk away.

But what about you? Do you think that the parties involved make a good case for the bid being increased?

Disclosure

No holdings at time of writing.

As noted in my 2010 Q1 portfolio update, I purchased common shares of RGCIQ.

Regent Communications Inc is currently under Chapter 11 bankruptcy and is working to reorganize the company under a prepackaged plan.

RGCIQ is an interesting situation because under the proposed plan, common shareholders will be “gifted” 12.8c for every common share they hold.

The market offered multiple days of mispriced action when RGCIQ was being sold for 10c which would have been a guaranteed return of 28%. Not bad odds at all.

I was going to write up a whole summary of the situation, the players and the odds, but just the other day, a case summary of RGCIQ popped up. The information contained within is very well documented and the author is obviously well experienced in the world of investing in distressed companies.

Analyzing bankrupt companies will be new to many of you, myself included, but don’t be turned off. Take your time to read over it. It can only help you get better and increase your circle of competence.

For distressed opportunities, my opinion is that you perform less number crunching than you would normally do when finding a company to go long on. However, the difference is that you have to simulate multiple scenarios and play your hand to the best odds.

Much like merger arbitrage, you have to keep up with the situation and how the bankruptcy is progressing.

From what I can see, there is a considerable amount of work involved in reading the lengthy documents, which can easily exceed 100 pages, keeping up with news and analyzing the situation.

Cases where equity holders receive something is rare, but it does exist and the upside is enormous. You can expect returns over 100% easily if things work out well. On the other hand, the risk is that you could lose it all as well.

A home run example is Visteon Corporation (VSTNQ). With management incentivized and pieces of the puzzle falling into place, common shareholders were able to capture over 2000% gains within one month! (Although it does looks like irrational exuberance is setting in)

No doubt a rare case, but a fine example of what could happen.

With that said, enjoy the document below. If you are reading from email, follow the link to the document.
Regent Communications Inc Case Summary

Disclosure

I hold RGCIQ at the time of writing

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

Disclosure

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

Recent Merger Developments

It’s been a while since I last wrote about any special situation.

But in case you haven’t noticed, merger and acquisition activity have been steadily increasing.

Disney recently bid for Marvel, Kraft got rejected by Cadbury and the deadline for AT&T to acquire Centennial Communications is approaching.

So those are the big guns flexing some muscle and most likely to go through.

AT&T still have to get an approval from the FCC though which is one of the biggest hurdles and there is still a 7% spread with AT&T and CYCL. The deal was announced back in Nov of 2008 which also means that many people have forgotten about it while new names have cropped up in the  media. May become a buying opportunity if the spread remains even after FCC approval.

Smaller Special Situation Plays

I was involved in a going private transaction with Zabera Systems where the management of the company voluntarily opted to delist the company due to high costs in maintaining its compliance with the SEC. It’s somewhat similar to a stock tender.

ZRBA is a micro cap with a market value of $9.5m with virtually no trading volume, so it made sense for the company to delist.

What the company proposed was to reduce the number of stockholders by 1-for-250 reverse splitting the shares outstanding. Then for any shareholders that hold less than 1 share of ZRBA after the reverse split, the company would then pay out in cash $5.20 in cash per share for the number of pre-split shares held.

To put it simply, all I would have to do is buy 249 shares of ZRBA, which will become 99.6% of 1 share which entitles me to receive 249 x $5.20=$1294.80

Sadly, the company came out today saying they’ve changed their minds.

Obviously this is another form of risk arbitrage. In this case, the risk wasn’t the ability of the company to obtain financing. Go through their financial statements and you’ll see that they were capable of going through with the de-registration.

The risk is that small companies tend to change their minds more regularly.

So while the opportunity and profit of small-micro cap risk arbitrage is only viable for small investors,  there is higher uncertainty in how management will pursue their intended course of action.

Luckily I managed to sell and came out with a tiny $12.95 profit. Need to thank ZRBA for giving me a free lunch at least

Kid Castle Educational Corporation (KDCE)

KDCE is another going private situation. It’s basically the same as ZRBA except it’s even smaller.

Shareholders of less than 5000 shares are entitled to receive $0.18 in cash.

KDCE is going through with their plan. They even scanned their letter of transmittal they mailed out.

A nice opportunity for a small portfolio.

Discount Broker

I just opened up an account with Tradeking and they want to charge me $55 in fees just to buy 4999 shares. Absolutely ridiculous. Tradeking is definitely not a broker you should use for stocks under $1.

Anyone know of a good cheap one that doesn’t slam you with absurd prices?

I’ve deposited $1000 of liquid cash into this account and plan to use this to try and pull the trigger on my best ideas.

Currently I manage my own 401k so it’s impossible to withdraw but I’m hoping that I can grow this $1000 to something much bigger to help pay for a down deposit on a home in a couple of years or so.

Disclosure

Trying to fill my order on KDCE. I really hope this post doesn’t pump up the price…