Events Trader #27: A potential trade on the Cadbury / Kraft situation

4th November 2009

A potential trade on the Cadbury / Kraft situation

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I know this isn't the usual day you get your Events Trader, but I spotted an interesting play in the news this morning and wanted to share it with you as quickly as I could.

Yesterday food group Kraft (US: KFT) reported third quarter results. Now, we don't really care about how the company is doing so I won't go into that. What we do care about is a statement made by CEO Irene Rosenfeld regarding the Cadbury bid, where she said that "[Kraft] is still interested but will maintain a disciplined approach." Kraft has also secured a $9bn loan that will be used to finance the bid if it decides to go ahead with it.

As you probably know, Cadbury has been trading at a premium to the Kraft bid since it was announced back in September, because nearly everyone thought that a bidding war for the company would break out, forcing Kraft to raise its bid. However, so far no one has come forward with a higher bid, and the Kraft offer needs to be formalized by 5pm on 9 November under rule 2.5 of the UK takeover code.

Cadbury's board has rejected the bid and still opposes it. So as it stands, Kraft has until this coming Monday to formalize the offer or let it expire. From the noises that are coming out of the market, it looks as though even if the offer is raised 10% (to around 780p), Cadbury's board might find it difficult to back it after saying that the original offer significantly undervalues' the company.

So, Kraft could go hostile and launch a bid without the backing of Cadbury's board. But I don't think it would be much higher than current price - maybe 800p.

Alternatively the offer could fall through. And I still don't think that another bidder will emerge. If that's the case, expect Cadbury's share price to fall to below 600p a share.

Strategy

The strategy in this case is going to be very simple. You can short the share at 773p and wait for next Monday. Or you can use options to gain downward exposure to the share price. You can buy December Puts with a strike price of 760p, trading at 24p; or December puts with strike 740p costing 17p, which are quite actively traded.

If you use options, then the premium you pay is the maximum amount that you can lose, but you could stand to make over 500% if the deal fails. If you use the naked short strategy (selling shares you don't own in the hope that the price falls) you can lose if the bid is formalized, but I think that this risk is outweighed by the potential gain you could make if it fails. But do bear in mind that with the short, the amount of money you could lose is potentially unlimited.

Also bear in mind that Kraft might be making these noises in order to force its hand with Cadbury`s management. It's possible that a deal might be reached at the 11th hour which could value the company above 800p, just to get the offer through. I think this is unlikely but I can't rule it out.

This is why I would favour using options in this case. But if you decide to do so, please do use limit orders as the bid-ask spread is quite wide. You can use spread betting for the naked short strategy, but do be very aware that if the bid is formalized or raised, the share will trade towards the offer price before you are able to cover your position.

Just to remind you the terms of the Kraft bid are as follows: Kraft will bid 300p + 0.2589 Kraft Shares (US: KFT). Kraft closed yesterday at $27.54, so the bid is worth around 736-740p per Cadbury share.

I will be back next week with a new edition of Events Trader. If you want to contact me my e-mail is eventstrader@f-s-p.co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

One investment idea above is using options where any profit depends on the potential price decrease of an underlying security. The potential loss is predetermined and limited to the premium amount paid, and can be as much as 100% of the premium initially paid for the put. 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.

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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