Is this a fat Pitch?

Buffet has been frequently quoted on his strategy of swinging hard at a fat pitch (a juicy full toss for us Indian cricket lovers) when the right opportunity presents itself. Likewise, we have been swinging hard at two recent open offers where we believe the odds to be quite favorable. Needless to say that this post needs to be seen in light of our vested interests. 

The basics of open offer arbitrages have been covered in an excellent manner in Prof’s, Kiran’s and Neeraj’s blog. Over the past two weeks, the promoters of Orient Refractories (link) and Liberty Phosphates (Link) have cashed out of their businesses triggering an open offer for minority shareholders.

The broad specs of the opportunity are as follows:

	Orient Refractories	Liberty Phosphate
CMP - (A) - 30th Jan 2013	37.50	210.00
Offer Price - (B)	43.00	241.00
Gross Arb (%) - ( B/A-1 )	14.67	14.76
Acceptance Ratio (AR) %
Promotor holding - (C )	48.61	61.42
Public shareholding - (100 - C= D)	51.39	38.58
Offer for - (E)	26.00	26.00
Theoretical AR (E/D)	50.59	67.39
Manufactured luck AR %	70.00	80.00
Quantity returned out of 100 tendered shares	30.00	20.00
Effective cost price of returned shares (Rs.)	24.67	86.00

All above calculations are ignoring transaction costs and taxes

In other words, in the case of Orient, if one buys today at CMP and tenders 100 shares, we expect 70 to get accepted at a price of 43. Adjusted for the profit made on these 70 shares, the cost price for the residual 30 shares drops to Rs 24.67. Thus the trade will be in profit till one is able to sell the residual 30 shares at a price higher than Rs. 24.67. In other words, one can create shares in these companies at a substantial discount to current price.But is that good enough ? Lets see,

Orient Refractories at a adjusted cost of Rs 24.67, will be the Indian subsidiary of the world's largest refractories player ( RHI AG) available at a trailing 12 months PE of 7.8, PB of 3.1, Div.Yield of 4% and ROE of 40%.

Liberty Phosphate at an adjusted cost of Rs86, will be part of the Murugappa Group (largest market share in phosphor fertilizers) available at a trailing 12 months PE of 2.7, PB of 0.7, Div. Yield of 2.1% and ROE of 55%.

Juicy enough ? We think so !!!!

Quite obviously, these nos will vary depending upon the actual acceptance ratio which is the only variable. The Acceptance Ratio we have assumed is higher than the theoretical ratio explained above since we have observed that a large no. of retail/other shareholders do not tender shares in open offers, thereby improving the acceptance ratio for those who tender. 

For the numerically oriented and scenario analysis lovers, here is how the deals stack up.

Return Profiles of the deal:

ORIENT REFRACTORIES
Exit Price for residual shares Rs	27	29	31	33	35	37
Absolute % Returns	1.9	3.5	5.1	6.7	8.3	9.9
Annualised % Returns
2 months	11.2	20.8	30.4	40.0	49.6	59.2
4 months	5.6	10.4	15.2	20.0	24.8	29.6
6 months	3.7	6.9	10.1	13.3	16.5	19.7
LIBERTY PHOSPHATE
Exit Price for residual shares Rs	100	120	140	160	180	200
Absolute % Returns	1.3	3.2	5.1	7.0	9.0	10.9
Annualised % Returns
2 months	8.0	19.4	30.9	42.3	53.7	65.1
4 months	4.0	9.7	15.4	21.1	26.9	32.6
6 months	2.7	6.5	10.3	14.1	17.9	21.7

Fields in the red is the range of our expected return

Invisible Fielders

For us, it’s been a while since we are dabbling in special situations and both opportunities look quite attractive. In most cases generally the gross spreads hover in the range of 8-10%. We have tried to use the “Invert, Invert, Invert – Always invert “ framework to try and figure out what’s on the minds of Mr. Market. Beware again that we could be biased since we have already sized up our positions!!

•  Deal Risk: Maybe people are speculating that the deal won’t go through and hence the spread reflects that. Our understanding based on annual reports/ cash flows and existing valuations don’t seem to suggest that they are sham (Khoka) companies. The profile of the acquirers (RHI AG – world leader in refractories and Murugappa Group – one of the largest South India based conglomerates) also gives us comfort as to the pre-deal due diligence and sufficient financial muscle to fund the acquisitions. Regulatory approvals could in our view, at best delay the offer rather than lead to the deal failure.
•  Time Risk: SEBI recently has a track record of clearing clean deals normally in the time frame of roughly two months. Clean deals here should be construed as one where acquiring promoters have a clean track record of public market activities and where there are no controversial embedded clauses. Other regulators (RBI, CCI, FIPB etc.) may take their own time but in the current context they don’t seem to be a road block apart from the usual RBI approval for repatriation of open offer proceeds to NRI investors.

In cricketing analogy, we think that even if the fielders get a hand to the ball they might not be able to stop it  from crossing the ropes. Unless, we have missed noticing a fielder (risk) or two. Do let us know if you spot something not visible to us!!

Why is somebody selling it cheap??

The question still needs to be answered as to why sufficient volume is available at what we believe to be distorted prices. Here is our hypothesis.

Insiders/speculators generally buy into such counters at a rumor stage itself leading to a Pre deal run up in stock prices. Most of the liquidity after the announcement is provided by these people and we hear that most of the speculator community is on margin funding hence the need to liquidate ASAP, rather than wait for the 3 months of the open offer completion. 

Our guesswork in both cases suggests that there is a large proportion of shares disclosed as public shareholding which seem to be either related to promoters or preferential issue to corporate bodies (loosely we prefer to call them as friends of promoters shareholders).  The details of the shareholding are available in more than 1% categories on the exchanges. The shares have been acquired prior to one year at a fraction of the current cost and hence for these shareholders the gains would be significant. The taxability of the same can be very different for them depending on how they choose to sell their shares. They would be liable for a zero long term capital gains tax (after paying STT) if sold in the market OR if they choose to tender the shares in the open offer their incomes would be taxed at the normal marginal rates of taxation.  Hence it makes tremendous sense for them in our view to sell the shares in the open market even if it means at a discount to the offer price.  (In the case of Liberty Phosphate the bulk deals disclosures show Blue Deebaj Chemicals LLC holding roughly 14% of equity having sold nearly a third of their holding at Rs214 while the offer is at Rs241)

We have always had great difficulty in looking into the future, with or without the help of glasses. This explains why we normally do not try to emulate Sehwag and rarely swing hard at the ball, but when we do we also pray hard J. Given our weight exposure to both the stocks, we can only pray for luck and seek any disconfirming evidence if any, from your feedback.

This time, we seek the best of manufactured luck!!!