Saturday, July 15, 2017 0 comments ++[ CLICK TO COMMENT ]++

Bought: Monsanto (MON)

I bought Monsanto (MON) as a risk arbitrage position a few days ago. Potential return is pretty good if you believe the risk is low (spread of about 9%, my expected return of around 7.7%). Deal expected to close by end of this year (maybe worst case Q1 2018).

I find it really hard to invest in this environment. Everything just looks highly valued and there aren't too many areas that are beaten down or appears cheap. I have been researching some out-of-favour industries (like retail, radio broadcasting, oil & gas) but they are not good industries in the long run. I hope my impatience doesn't end up hurting me but I took a really large position in this deal.

I was researching the position for almost an year when the merger spread was much higher (18% as recently as January of 2017). In fact, it looked like an attractive position ever since Berkshire Hathaway took a small position late last year (likely as a risk arbitrage position but with spreads likely more than 20% at that time). However, I didn't take a position since I already had a position in the Syngenta (SYN) merger and this was highly correlated to that one (i.e. if regulators blocked that deal, chances are the Monsanto merger might have been blocked too).

The spread is largely due to regulatory risk as the companies are waiting for European and American regulators (others not expected to be an issue) to approve the deal. I also believe that the spread is a bit larger than what it should be because risk arbitrage funds can't fully participate in this deal (the size is way too big and given the blow-ups last year of some prominent funds, I suspect there is a shortage of capital).

Purchase price (MON): $116.64

Return Expectation

Takeover price: $128
Purchase price: $116.64

Probability of success (my estimate): 95%
Return on success: 10%
Probability of failure (my estimate): 5%
Return on failure (my estimate): -31% (assume it drops to $80 (P/E of 17 on 2017 consensus EPS of $4.70))
Expected Return: 7.7%

Buffett's Four Key Questions   
(1) How likely is it that the promised event will indeed occur?    
Given that regulators already approved the other two agricultural mega-mergers, Syngenta buyout and the Dow-Dupont merger, there is a very high likelihood of this deal closing. If the deal does run into problems, the companies have the option of divesting assets to satisfy regulators (although sometimes this causes the bidder to lower their buyout price). Furthermore, some analysts quoted in the press have suggested that there isn't that much overlap between the Monsanto and Bayer businesses so there shouldn't be as much concern regarding anti-competitive or monopoly power (I haven't done my own research so not sure how much the businesses overlap). There is additional risk this year from the Trump administration in USA which is more politically driven than past Obama or Bush administrations. The CEOs of both companies met the US president early this year and came out with positive views but Trump always flip-flops and gives a message to suit the audience so not sure how supportive the US presidency is for this deal (it results in a major American agricultural power disappearing and being run by Germans). 

(2) How long will your money be tied up?   
Companies expect deal to close by end of 2017. My worst case assumption is Q1 2018.  
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?    
Monsanto went through prior takeover offers and has been rumoured to be under takeover discussions for several years. Unlikely any better deal will materialize.   
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?    
I wouldn't mind owning this business if deal fails so I am taking a larger position than someone who doesn't care for the business would. Obviously there will be big short-term loss if the deal fails but the underlying business is very solid and I think it has a very large moat (but growth really low). Based on 2017 consensus EPS forecast ($4.70), Monsanto is trading at a P/E of 25. Given Monsanto's dominant position in the world and its intellectual property and history of continuous innovation, it has generally traded above a P/E of 20. Even if you assume the future is worse than the past--likely true given its size--I am assuming its long-term P/E is around 17 (versus S&P 500 long-term around 15). You are only looking at a short-term loss of around 30% if deal fails and the stock trades down to a P/E of 17.

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