Friday, September 23, 2016 0 comments

Purchase (Special Situation): Lexmark (LXK)

After a very long absence...

I decided to invest in the Lexmark (LXK) takeover by Chinese parties. The deal is expected to close this year and has an expected return (based on my assumptions) of around 8%. Although the company is somewhat different now, I did a lot of research about 5 years ago on Lexmark so I am somewhat familiar with it (it isn't a terrible business but it is definitely in a declining industry).

The main risk with this deal is the uncertainty over the CFIUS government agency approval.

Takeover price: $40.50
Deal closing: 2nd half 2016

Purchase price: $36.03

Prob (success) = 90%
Return  (success) = 12% (@ $36.03)
Prob (failure) = 10%
Return  (failure) = -31% <<< assume it drops to $25

Expected Return = 8%

Overall expected return isn't that high--I like to aim for at least 12% return--but given that the deal is likely to close within an year, the 8% return is good enough for me. The stock may decline 1-2% so if one can time it (and are lucky), they may hit 10%.

Risk arbitrage is uncorrelated with the market and that is one reason it interests me. Ideally, one should invest in numerous similar transactions for it to work well (but it's hard to find too many with 5%+ expected return without catastrophic deal failure scenarios).

Anyway, onto Buffett's classic questions on risk arbitrage...

Buffett's Four Key Questions

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

I would say 90% chance of going through. The buyout consortium (Apex Technology and PAG Asia Capital) consists of a printer manufacturer whose business is in the same industry as Lexmark, and apparently one of the largest private equity firms in Asia. Closure is not contingent on obtaining financing and the private equity investor likely has capital lined up; funding appears secured. Risk lies with CFIUS, which is the American government agency that evaluates foreign takeover where national security is a concern. This entity is politically motivated and it is impossible to be certain of any outcome (their decisions are generally not consistent). However, most of Lexmark's business is straightforward business products and services with little national security issues. The only concerns are products sold to government agencies and I think Lexmark could structure the deal to avoid those issues if they arise.

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

Deal is expected to close by 2nd half of 2016. As soon as CFIUS ruling comes out, I expect the deal to close immediately. Based on a July 25 note to Chinese authorities by Apex, it appears that the CFIUS will respond 30 days after the initial submission (which seems to be July 15 (not sure?)) and complete a full investigation 45 days thereafter (source). A reasonable worst case might be 2Q 2017 (annualized returns will still be around 10%).

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

Zero chance of something better. Lexmark is struggling somewhat with downward revenue trajectory and not many parties interested in the printing business.

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

Stock will likely drop to around $25 (about -31%), which is the low for the last few years. Given the somewhat low valuation--admittedly in a declining industry so it is to be expected--I will be content to hold it if the deal fails. According to Morningstar, LXK is trading around $2.3B market cap and a forward P/E of 10.2 (trailing P/E negative), P/B of 2.2 and P/S of 0.6. Long-time readers of the blog may recall that I closely evaluated Lexmark about 7 years ago and am familiar with it. It has changed somewhat in the last few years and wasted(?) billions of dollars on questionable software-oriented business documentation process acquisitions (including a little under $1B for Kofax and $0.25B for ReadSoft). Company still looks ok if it can manage its costs as revenues decline (and hopefully its software businesses increase their revenue).

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