Events Trader #28: Let's close our Cadbury trade for now

There’s a lot of news to get through this week – the Schering-Plough / Merck merger has now closed, while new opportunities have come up amid various other deals done this week...

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10th November 2009

  • Let's close our Cadbury trade for now
  • How the latest news on banks affects our tier 1 securities

Dear subscriber,

Welcome back. There's a lot of news to get through this week the Schering-Plough / Merck merger has now closed, while new opportunities have come up amid various other deals done this week, including Warren Buffett's big railroad purchase, Burlington Northern. There's also some news from the British banking sector that affects our Tier 1 securities.

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But first, let's start with the Cadbury deal.

Kraft's offer disappoints but Cadbury defies gravity

Yesterday Kraft formalized its bid for Cadbury and went hostile. The offer was unchanged from what was previously announced, and Cadbury`s board duly rejected it. The offer now values Cadbury`s shares at around 717p. No white knight is in sight, and the offer looks like it may not even be raised, so the bid has a good chance of failing.

Yet against this backdrop, the share price did not budge and in fact closed at 761p, which frankly amazes me. I thought that the price would drop towards the 700p-710p level but I was wrong.

Anyway, let's close this trade and take what little money we did manage to make. You can either close your short position now at 760p (from a sell price of 773p), or sell the options - the prices are around 28p (bought at 24p) for the 760 December Put, or 18p (bought for 17p) for the 740 December Put. If you did play this story with the options, your gain will probably be offset by the commission.

I still feel this story was worth playing, but for now let's move on to the next trade, and we'll keep an eye out to see what happens next in this story.

Recommendation: Close Cadbury's short position

Bad news for some of our tier 1 securities

Several items of news came out last week, but the main news was buried in various prospectuses, and it's unfortunately negative. The European Commission will ask those banks which received state aid to stop paying dividends and coupons until 2012 on their tier one securities. This only affects HBOS, Lloyds and RBS.

This is not a default - it just means that you will not receive a coupon for the next two years. We have four such securities in our portfolio, but since you bought several of them at a steep discount to face value, I don't expect the prices in all cases to fall back to where we have bought them.

Recommendation: SELL the following four tier 1 securities

Anyway, it's probably wise to close our existing positions in RBS and Lloyds, while keeping the other names. These are:

Lloyds XS0107228024: bought for 46 on 19 May, now trading at 88 for a gain of more than 90% (including interest)

HBOS XS0353590366: bought for 52 on 18 August, now trading at 99 for a gain of around 90% (including interest)

RBS XS0193721544: bought for 65.4 on 18 August, now trading at 61 for a loss of around 6% (including interest)

RBS XS0102480869: bought for 70 on 8 September, not trading at 68 for a loss of around 3% (no interest payable)

Let's now keep an eye on what happens, and perhaps be ready to dip back in if prices fall again.

Lloyds' epic rights issue and RBS's results

The second piece of news came again from Lloyds (LSE: LLOY) which announced a plan to raise £21bn in one of the largest rights issues this country has ever seen, £13.5bn of which will come from issuing new equity. The new shares will be issued at around 10-20p (the price will be announced on 24th November). This issue is going to be highly dilutive, so if you have shares in the bank, it's probably wise to get out now ahead of the rights issue. Basically, Lloyds is doing all it can to stay out of state control and to resume normal operations.

Lloyds will also propose a swap of some of its hybrid securities (tier 1 and tier 2) for a new tier 2 bond that will automatically convert into equity if the core tier 1 capital of the bank falls below 5%. This is a "reverse convertible" and should pay quite a high rate of interest so far I have not seen the term of the swap but I am sure we'll return to this subject once we know all the details.

The other news came from RBS (LSE: RBS) which posted a quarterly loss of £1.8bn after writing down the value of its loan book by £3.3bn. This was nothing to cheer about, given that nearly all the other banks have started to make money again, but the shares rallied because it could have been even worse. And in all fairness, the management of the bank said that they do not expect to be profitable again until 2011.

All in all, the rights issue is good news as it reduces the chances of default. Remember that unless a bank is fully nationalized or goes bust, its tier 1 securities will still be worth something, and could eventually trade towards par. The tier 1 securities from Barclays, HSBC and the other banks are already starting to trade at more normal levels, and in some cases even above par.

The other news relating to the break up of these banks has only a minor impact on our positions, as the banks will have four years to implement the relevant disposals. So we have plenty of time to trade in and out.

Take advantage of this oil deal

On 2nd November, Dubai's state-owned oil company ENOC (Emirates National Oil Company), has launched a bid for the 48% of Dragon Oil (LSE: DGO) that it doesn't already own. ENOC is offering 455p in cash. The offer has been recommended by the board, and it's expected to complete by January or February 2010. The shares are trading at 447p at the moment or a 1.75% discount to the offer price, which means the annualized yield is 7% (before commission).

Although the yield is paltry, the reason I'm suggesting this trade is that Dragon Oil's assets are worth more than the bid price. The company owns two oil and gas fields in the Caspian Sea, off the coast of Turkmenistan, producing 25,000 barrels of oils per day. It also has some exploration licences in Yemen.

Some analysts reckon the company is worth between 600p and 800p, and that this offer undervalues it. As you probably know, Dubai is recovering from a big financial crisis that ended when its richer neighbour Abu Dhabi bailed it out. So it seems ENOC is trying to snap up the rest of the company on the cheap.

The fact that the board has recommended the offer puts a floor under the share price. What I'm now hoping is that a few institutional shareholders might kick up a fuss and push ENOC to sweeten the offer to placate their anger.

So the profile of this trade is simple. You buy the shares at 447p. If nothing happens, you take your 1.75% and walk away with 455p in three months' time. But if the deal is increased, you'll end up making quite a bit more. In this case, you have a "positive risk" that the offer will be sweetened. This is small, perhaps around 10% probability, but even if it isn't sweetened, you'll still end up making a small return.

There is a small risk that the deal will fail of course, but bear in mind that ENOC is the majority shareholder, and that the board has recommended the offer. On top of that, given that the company's assets are worth more than the bid, even if the bid fails, the share price is unlikely to fall much and may even rise above the bid price. Other risks which might impact on the share price, as you can imagine, are the oil price, which can plummet (or soar), and the stock market, which can more or less do the same.

Recommendation: BUY Dragon Oil (LSE: DGO)

How you can profit from Warren Buffett's latest deal

The second deal of interest to us this week involves a US railroad stock. I don't know about you, but there's something very evocative about railroad companies - they always make me think of the speculative bubble in railroads in the 1880s and 1890s, Westerns with John Wayne, and the beautiful old share certificates, with old locomotives printed on them.

Anyway, getting to the deal - Berkshire Hathaway (NYSE: BRK-A; BRK-B), the investment vehicle owned by billionaire Warren Buffet, has launched a bid for rail operator Burlington Northern Santa Fe (NYSE: BNI). Buffett calls it his big bet on the economic future of the US.

The terms of the deal are quite complex. For each BNI share you own you can choose:

A) to be paid $100 in cash or;

B) to receive $100 in Berkshire Hathaway stock (class A or B), provided Berkshire stock is trading at between $80,000 and $125,000. If Berkshire shares trade above $125,000 each, you'll receive 0.001253489 BRK-A, for each Burlington you own. If they trade below $80,000, you'll get 0.000802233 per Burlington share. In effect, this means that if Berkshire is trading above $125,000 you should go for the shares, otherwise you should go for the cash.

In each case you will receive one quarterly dividend of 40 cents. The deal is expected to close in the first quarter of 2010, and there should be no antitrust (competition) issues.

Our strategy here is to buy Burlington Shares (NYSE: BNI), which currently trade at $97.60, then hold them until the merger closes. The profit in this case would be $2.40 plus a 40 cents dividend payment, which comes to $2.80 per share. That makes the annualized yield around 8.4% (excluding commission). In this case you don't have to short anything, or hedge your bets, you just buy the stock and make a decision on which option to go for later on.

If Berkshire stock starts to trade above $125,000, you could then short it to lock in a profit (if the stock remains above $125,000, you'll be swapping your BNI shares for Berkshire stock, offsetting the losses on the short; if it falls below that level, you'll take the cash, and profit from the short). Another potential way to profit from this situation would be to sell call options against Berkshire (in other words, to bet on the price falling) to increase your profit. We'll discuss this in more detail in a future ET if Berkshire does tick above $125,000.

Again this strategy is similar to the previous one. You have a near-certain yield plus the possibility of making extra money (in financial terms this is described as a free call option).

Recommendation: BUY Burlington Northern Santa Fe (NYSE: BNI)

Don't buy into the DIY merger deal - yet

There was another merger story last week: Stanley Works (US: SWK) will merge with Black & Decker (US: BDK). It's an all-stock offer, with Black & Decker shareholders receiving 1.275 shares of Stanley Works for every share they own. The merger is expected to complete by the first half of 2010, but once you take into account the dividends paid by the two companies the premium becomes only around 1%, so as it stands this deal is not worth our while playing. We might reconsider if the spread widens a bit more.

The Merck / Schering Plough deal is done let's take our profits

This merger closed on 3rd November so you can now close the trade. Cover your short in Merck, and sell the Schering-Plough shares that you have received in your brokerage account as part of the deal. As usual please try to do the transactions at the same time, so that you minimize the potential market loss. This trade closed far more quickly than we thought, and has yielded 6% in just over four months, which gives a respectable annualized return of 16%.

Recommendation: SELL Schering-Plough / CLOSE SHORT on Merck

That's all for this week, but remember you can contact me at my e-mail

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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. 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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