Friday, February 15, 2008 4 comments ++[ CLICK TO COMMENT ]++

Purchase: BCE

I decided to take a risk arbitrage position in BCE (TSX & NYSE: BCE). I was considering PENN but I feel it is better to go with a safer bet with a 10% lower return. As I quoted in a prior post, arbitrage deals work until they don't. I don't want to be the last one holding the bag when it fails.

Derek DeCloet of The Globe & Mail--one of the best business reporters in Canada--pretty much summarizes the situation in his latest article. Just to recap the risks...

The risks clouding this takeover are three: The bondholders could win their lawsuit in Quebec Superior Court; the buyers, led by the Ontario Teachers' Pension Plan, could walk away; or the banks, led by battered Citigroup, could break their agreement to fund the deal.

The way I see it, the bondholders are unlikely to win. I mean, how can you sue a company for taking on more debt when you never bought a bond that stipulated that they cannot do that?

I don't think the buyers will walk away. They seem committed, with the Ontario Teachers Pension Fund already owning a big chunk of BCE. They clearly like the company and think this will work.

The real risk is the bank financing. Since some of the funding is coming from Canadian banks like TD, which are not tainted by the subprime or LBO problems plaughing Wall Street, a failure seems low. Yes, there are US banks involved and the banks had a hard time selling the recent Harrah's deal. But of many of the deals out there, this is the type of deal that is attractive in the present climate. BCE is a leading, solid, telecom that pumps out cash and should weather an economic slowdown or other looming issues.

There is always the possibility of adverse government intervention but this seems like a remote chance given that nothing has been said for months. BCE is also getting beat by cable companies like Rogers, so I can't see much being made about the deal.

(you can get detailed documents from the official site here)

BCE takeover price: C$42.75
Closing Date: 2Q 2008 (likely May 2008)
Current price: C$35

Gain if deal closes: 22%
Loss if deal fails (guess): -11% (C$31)
Probability of success (guess): 75%
Probability of failure (guess): 25%

Expected Return = 0.75*0.22-0.25*0.11= 13.75%

This is a pretty good return if the deal closes by the second quarter. An attractive thing for me is the fact that it is in my local currency. After my returns being shaved off due to a declining US$ in a few of my situations, the currency situation will not impact me this time.

I think the stock price may drop a bit more if the stock market sells off. But who knows what will happen and I don't want to bank on that.

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

I would say 75% chance of going through. The lead takeover party, Teachers Pension Fund, is already a shareholder of BCE and hence likes the company.

(2) How long will your money be tied up?

This deal shows how things often take longer than initially forecast. Original deal was supposed to close in 1Q 2008 but now it looks like late 2Q 2008. Tying up my capital for that long is fine with me.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

Chance of something better is zero. All interested parties submitted a bid and this company is way too big for some unknown party to show up if the bid fails (however, one of the prior interested parties, like Telus, may make a lower bid.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

There is a big risk with financing. If financing causes the failure of the deal, the stock will likely drop 10% to 15% (my guess). There is a possbility that Telus, a competitor that dropped out of bidding, might bid at a lower price than the current takeover price. In the worst case, I think BCE is the type of company that one can hold given its stable operations that should not be impacted too much during an economic slowdown or recession (its yield of around 4% is pretty stable).

If the Deal Fails...

This is a stock that I may hold if the deal doesn't close. If the deal fails, you are looking at a company with the following stats:

Market Cap (approx): $28 billion
TTM P/E: 12.4
Forward P/E: 15.4
P/B: 2.2
Dividend yield: 4%
Debt/Equity: 0.8
ROE: 15.9%
Industry: Telecom Services

The stock may drop around 10% but it isn't expensive by any means. Valuation is similar to other telecom peers such as AT&T in USA. Also, during an economic slowdown, something like BCE may hold up better than the rest.

Purchase Price: $35.27

(I also purchased BCE for my mom's account. It's actually a pretty good long-term hold for her even if the deal doesn't close.)

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4 Response to Purchase: BCE

February 16, 2008 at 8:54 AM

I would not be so sure the banks are going to show up for the closing. The leveraged loan market is global and just because Canadian banks don't have a lot of subprime exposure does not mean they want to put an asset on the books that they are going to have to mark down below 90 cents the first day they own.

As well, TD, which you cited, has some significant exposure to the US commercial mortgage market which is deteriorating rapidly. Here's a little detail:

Every bank in the world is looking very hard at commitments and risk levels. The banks in the BCE transaction will be no different.

February 16, 2008 at 12:30 PM

I think practically all the outstanding LBO deals can fall apart. I am comfortable taking a position because, even if it fails and drops 10% to 20%, I am ok holding on to it. Unlike an arbitrage fund, I don't necessarily have to sell if the deal doesn't go through. I think telecoms are ok in an economic slowdown ( Marketwatch has an article on telecoms--nothing to do with BCE but it sort of aligns with my thinking).

As you point out, the banks will try their best to get out of the deal if they can but it won't be easy for them (they are more likely to renegotiate or get the buyers to put up more equity rather than debt). My feeling is that the buyers (Ontario Teachers Pension Fund and some private equity groups) are committed so there is a possibility of renegotiated deal at a lower price that may satisfy the banks.

June 5, 2008 at 2:51 PM

So who are you shorting, OTPP? TD?

This is a bet not risk arb.

June 9, 2008 at 10:01 AM

Nope... just a straight speculative bet... you can't hedge this position. Shorting TD or any other security doesn't do anything. Some arbitrage deals cannot be hedged. Cash offers from private parties cannot be generally hedged...

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