Events Trader # 17: National Express revisited - and another risk arb strategy

I’d like to start with an apology. A few months ago I wrote about public transport group National Express. I thought the company was potentially interesting, following the loss of its East Coast rail franchise, but decided that the risks were too great to buy in at 270p.

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1st September 2009

National Express revisited and another risk arb strategy

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Welcome back.

I'd like to start with an apology. A few months ago I wrote about public transport group National Express. I thought the company was potentially interesting, following the loss of its East Coast rail franchise, but decided that the risks were too great to buy in at 270p.

It seems I was being too cautious. As you might have noticed, a bid offer this week has seen the share price shoot up over 40% compared to where they were then.

In my defence, the offer is conditional on National Express retaining its other rail franchises (by no means certain). And perhaps more importantly, the company alongside a couple of large institutional investors decided to reject the bid.

There may yet be a better time for us to buy in

The two main problems with National Express

On Thursday, National Express said it had received a preliminary and revised proposal to acquire 100% of the company's stock at 450p a share. The offer was made by private equity group CVC Partners and the Cosmen family (who already hold 19% of National Express's equity). The deal also had the outside support of Stagecoach, which could later acquire some of the assets.

But the offer was rejected on Friday after the board decided that there were too many conditions attached to the bid, and that the offer " undervalued the group and its prospects".

Conditions on the offer included having to come to an agreement with the pension trustees on pension funding and the change of control, and of course, the need to complete an extensive due diligence process. But the main condition was that National Express maintains its C2C and East Anglian rail franchises. As you may remember, the government was considering stripping the company of all its rail franchises, after National Express decided to hand back the keys to the East Coast main line, because the contract had become too onerous.

Indeed, this is the main sticking point in the whole saga as far as I'm concerned. Until the government makes its final decision, it will be hard to make sense of it all. Two months ago, when the East Coast affair first kicked off, the government sounded pretty hostile towards National Express, which led me to believe it would be stripped of the other franchises. But as yet, no one knows when the government will decide one way or the other.

A rights issue may be around the corner

Beyond the bid, the second main point in this saga, is the fact that the company needs to raise cash to reduce its level of indebtness. This continues to be a big problem for National Express, which holds nearly £1bn in debt (much of it in foreign currency, to reflect its foreign operations). It's a problem that has to be addressed soon.

The company statement rejecting the bid, also hinted that a rights issue might come soon. This also makes me think that the company was quite pleased to feed the rumour mill, so that the share price would rise, rendering the dilution of the rights issue less painful for the existing shareholders. As you know, a big rights issue might be badly received by the market and could push the share price significantly lower in fact, this was the other reason I advised caution on the stock.

All in all, I still think we should wait for developments coming from the government regarding the other rail franchises, and also on the rights issue front. Perhaps I am being too cautious, but I would rather preserve my capital than take unnecessary risks. Remember, opportunities will always be around, but the money might not.

A new risk arbitrage strategy

And speaking of opportunities a brand new one has just arisen. Fed up with overpaying for branded Disney and Spiderman toys for your children? Here's how you can make some of that money back

You'll probably have guessed by now that I am referring to the acquisition announced yesterday of Marvel Entertainment (US: MVL) by Disney (US: DIS). As usual, I will skip all the industrial logic behind the deal which will create an entertainment industry superhero - and I'll go straight into the details.

The deal

The deal is very simple. For each share of Marvel that you hold, you'll receive $30 in cash plus 0.745 shares of Disney. The mix of cash and shares may be adjusted so that the total consideration you receive in Disney shares will be no less than 40%. The deal is expected to close by the end of 2009 and is subject to the approval of Marvel shareholders; clearance under the Hart-Scott Rodino Antitrust Improvements Act; and certain non-US merger control regulations. Both boards have approved the deal.

The maths

Disney shares (US: DIS) closed yesterday at $26.04 each, while Marvel (US: MVL) closed at $48.37. Here's how the deal works:

0.745*DIS + $30 - MVL = profit

Therefore, plugging those figures in:

0.745*$26.04 + $30 $48.37 = $1.03, or 2.2%.

Which, for a merger expected to close in three months' time, equates to 8.8% (2.2% annualised).

This time we can ignore the dividend payouts (unlike our previous risk arb plays) as they will not change our profit by much.

The strategy

The strategy is a bit more complex this time than in previous plays. Because this deal was only announced yesterday, we can expect a certain amount of volatility in the target stock (Marvel) before things settle down. For this reason and because the spread is only 2.2% wide and can be eaten away by the commission, I would advise you to try and wait for the spread to open up a bit more, and set the trade up once the spread is above 3% (which gives an annualized return of 12%).

How can you work this out? Simple. The profit side in our equation needs to be higher than $1.45. So if Disney trades for $26.04 then Marvel needs to be at $47.95 before we buy in. You can see this by looking at the equation again:

26.04*0.745 +30 47.95 = 1.45

Clearly if Disney moves, you will have to recalculate the value of Marvel. To do that, you can use this equation:

DIS*0.745 + $30 - $1.45 = MVL

to work out the price at which you can buy Marvel to get a 3% spread.

You could of course, always wait for a larger spread to emerge and act accordingly. In my view 3% is quite attractive, because these types of strategies have very little risk, but if the market is volatile the spread could widen. Of course, it may not, which means you take the risk of missing out on the trade if you wait for the spread to go too far.

How to do the trade

For each 1,000 Marvel shares you buy (multiples or fraction can be used as well), you go short 745 Disney shares. This means that your portfolio is hedged, and your gain or loss will not be affected by movements in the wider market.

So far, I do not think the conditions relating to the payout consisting of a 40% minimum of shares are a problem. If the market moves you might have to slightly adjust the number of shares bought or sold, but for a position below $100,000 you can ignore it (unless the market moves by more than 20%).

As usual I think it is best to purchase the Marvel shares through a normal broker and to short Disney with a spread bet. So for each 1,000 shares of Marvel you buy, you sell Disney at $7.45 per point. Please do read the other articles I have written on risk arbitrage strategies where I have written in more detail about such trades and the risks involved - these area vailable in the Events Trader Archive (password: Traveller), please see issue 12.

The risks

This time I can start the risk section with some good news. In this case there is a small but positive risk that someone could come in with a higher bid. Companies such as NBC or Sony or Paramount Pictures could have an interest in trying to outbid Disney for Marvel, which owns more than 5,000 different characters. If this happens you would make more money than you planned as the bid would certainly be higher.

The other risk are the usual ones. The main risk is that the merger falls apart. If this happens, expect Marvel Entertainment to fall back to between $38 and $40 a share temporarily. I am saying temporarily because I suspect someone else could decide to buy the company.

Conditions relating to antitrust (competition) issues should not be a major problem, but there is a risk that this might delay the closure of the deal. Again, if this happens, I would expect a slight delay of a couple of months. This would mean the annualised return would be lower, although the absolute return wouldn't change.

The last risk as usual is currency risk, as this strategy is dollar denominated. Again, please do read the previous article I have written where I have discussed currency risk and how to hedge it.

One last thing before we go on the deal between Sun and Oracle , the European Commission needs to decide by 3 September whether to initiate proceedings under EC merger regulations or to clear the deal. We'll have an update on what happens next week.

Just to remind you the e-mail to get in contact with me is

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Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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