BCE Merger Arbitrage Situation Very Attractive

The BCE merger situation is quite attractive right now. You are looking at around 17% return by the end of the 2nd quarter (I'm primarily looking at the Canadian stock price; US$ returns will differ based on currency fluctuations). The downside risk has been significantly reduced.

Andrew Willis of The Globe & Mail points out that the stock market is pricing in zero chance of the closure of the deal:

BCE shares touched lows of $33.30 yesterday. At that price, the company is changing hands at a price that reflects fundamentals, not the $42.75-a-share that the Teachers' consortium promised in July. It is now possible to play the world's biggest pending takeover with next to no downside.

There is still some downside risk since the stock ran up before the merger announcement. I would say the downside is around 5% while the upside is 17%.

Analysts figure that based on projected earnings, plus the $3.2-billion of cash coming from the Telesat sale, plus a scheduled dividend, plus the $1-billion break fee that the Ontario Teachers' consortium forks over if the buyout doesn't close, BCE should be valued at $32 to $33 a share (includes $5.20 per share in cash). That's the worst-case scenario.

Scotia Capital telecom analyst John Henderson took this view last week. He also argued that if Mr. Leech and Teachers leave the dance floor, Darren Entwistle from Telus will move deftly to take his place.

Joseph MacKay at Desjardins Securities crunched the numbers yesterday and arrived at the same fundamental price.

These analysts peg the value of the firm close to the current price. Do note that BCE is a stable business (telecom) with good cash flow. It won't be impacted as severely during an economic slowdown (it's also in Canada and the economic slowdown here is projected to be more mild). So it is unlikely that the BCE stock price will collapse if the deal falls apart.

Here is another story (a blog entry actually) by Boyd Erman pointing out that the credit markets still believe the deal will close (whereas the stock market doesn't think it will):

The stock market continues to bet against BCE Inc. actually being bought out at the agreed-upon $42.75 price by Ontario Teachers' Pension Plan and its partners. That's evident in BCE's market price: $35 today. One of the concerns is that a bondholder lawsuit underway in a Montreal court will succeed, scuttling the deal or forcing a renegotiation. The other major fear is that Citigroup and other lenders will pull the funding for the deal because the terms are no longer economical in today's market.

The bond crowd, however, doesn't seem to agree that the deal is in trouble. Spreads on credit default swaps remain stubbornly wide on BCE, well into LBO-target territory...

"We're still talking about spreads at levels that are all-time highs for BCE bonds, which is indicative of the fact that the credit market still expects that BCE will be a highly leveraged entity and therefore the deal will be consummated," said Dan Barrett, an analyst in New York at Tradition Group, a broker of credit default swaps and other derivatives products. CDS spreads would have to come in by about 50 per cent if the credit market thought the deal would be scuttled or renegotiated, he argues.

I think one of the factors that is causing the big takeover spread is the problem faced by merger arbitrage firms. As I mentioned in a prior post, some merger arbitrage specialists may have lost $1 billion on some of the failed takeovers late last year. With the huge sell-off in the markets in January, cash may be tight at many firms that simply dabble in merger arbitrage. It's very risky out there (since banks are having a hard time selling high yield debt) but it provides an opportunity for small investors to take advantage of unusually large spreads.