Saturday, July 12, 2008 0 comments ++[ CLICK TO COMMENT ]++

An M&A Deal to Consider: Energy East Acquisition by Iberdrola

One of the few strategies that can do well during bear markets is risk arbitrage. If my understanding of Warren Buffett is correct, he made a big chunk of his gains in his partnership days during bear markets from risk arbitrage or similar specialist tactics (generally they are known as 'workouts'.) Deals can blow up--the Penn National (PENN) deal comes to mind--but if one can side step the failures, they should be able to post positive returns in a tough market. The only holding in my concentrated portfolio showing positive returns so far is the BCE M&A position. One of the deals I have been thinking about over the last few weeks is the Iberdrola acquisition of Energy East (EAS).

Energy East is a utility operating in the Northeast (New York and Maine.) Iberdrola is a Spanish utility that is one of the largest utilities in the world. The Energy East friendly takeover was announced last year and all the requirements have been met (shareholder approval, financing (finally a deal without financing risk :)), most government approvals) except for one issue. The New York regulator is yet to rule on the takeover and a non-binding suggestion by a judge was for the deal to be rejected. The stock is trading 14.6% below the buyout price due to the risk of the deal being rejected.

In an attempt to placate the regulator, Iberdrola has suggested that it will invest up to $2 billion in wind energy in New York. Charles Schumer, a key politician (US Senator) in New York, along with other government bodies seem to be in favour of the deal if the wind investment is made. But Iberdrola needs to make a firm committment on the wind investment, rather than suggesting it is a possibility. The deal will come down to this investment (or a similar investment plan for New York) in my opinion.

One thing to point out is that Iberdrola can walk away if it doesn't like the terms. Although Energy East is benefitial to own, they have a million other options and have no need to compromise much. There are many other utilities, some rumoured deals in Australia and New Zealand, that it can buy. Iberdrola is already the second largest wind energy producer in the US (if I'm not mistaken; not entirely sure about this) and has a presence in the US already so the Energy East deal is not critical to their future.

The deal is well past the initial projected closing date. It can close as soon as the regulator gives approval. Press articles seem to imply that a ruling will come before mid-August.

I still haven't made up my mind but I find this deal attractive given the quick pending decision. The scenario is easy to understand; but pegging the downside seems tricky. Even an arbitrage specialist wouldn't be able to hedge this given that it is a cash offer. Even if you attempt to hedge by shorting Iberdrola in Spain, the deal is very tiny compared to the rest of Iberdrola (Iberdrola stock price will move largely on other events.) Having said all that, I think cash offers are the best risk arbitrage plays for small investors (you can't hedge but you have no worry on the upside other than currency risk.)

One of the things one should consider is whether to hold a stock if an M&A fails. This is where the difficulty with this deal comes (at least for me.) I don't know much about the utility sector so I don't know if Energy East's TTM P/E of 16 and forward P/E of 17 is high; or if its debt/equity ratio of 1.2 is risky; or if its price-to-book of around 1.2 is high for utilities.

Buyout price: US$28.50
Current price: $24.87

Return upon success: 14.6%
Probability of success (guess): 75% (need to think more about this)
Return upon failure (guess): -26.1% (I need to do more work on this. I'm assuming the stock drops to $22 given the stock price low over the last 3 or 4 years)
Probability of failure (guess): 25% (need to think more about this)

Expected return: 4.4% (14.6*.75-26.1*.25)

Return looks low but remember that we should know the outcome of the deal within a few months. Also note that this is not an annualized return. Risk arbitrage investors always annualize their returns but I don't for a few reason

Anyone like me thinking about taking a risk arbitrage position in this really needs to be confident of the downside. One of the big reasons I'm still thinking about this deal, even with seemingly low returns and big regulatory risk, is due to the fact that utilities typically do fine even if the economy slows. So holding the stock if the deal fails may be acceptable. Your risk is not decreasing sales and profits, but rising interest rates and/or the market placing a lower multiple on the company. As for interest rates, I think the probability of them going up significantly over the next year are low (I think inflationary threats are overblown and is really an issue in developing countries rather than here.) The market lowering the valuation placed on the company is something I have to research more. P/E of 17 is not extremely high for a relatively "safe" utility paying a stable 5% dividend, but it may not be cheap either. Utilities did very well a few years ago and I want to be sure that they are not in a "bubble" of some sort. I'm bearish on most of the sectors that have performed well over the last 5 years (foremost bearish on energy and materials sector) and when the market chops them down, I don't want to be anywhere near them--are utitlities going to be priced down?


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