Events Trader #32: A very risky bet on a bankrupt US company

8th December 2009

• A very risky bet on a bankrupt US company
• And updates on ING and Cadbury's

Dear subscriber,

Welcome back. This week we'll be discussing some of our favourite stories, with updates on the Cadbury's deal, and the ING rights issue which is currently under way. We'll also be looking at a very high risk play on a distressed bond issued by a bankrupt US company.

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A correction on our BA / Iberia trade

But before that, I owe you an apology I need to issue a correction. Last week I received an e-mail from one of you, pointing out that the terms I highlighted in the BA / Iberia risk arbitrage play in issue 29 were slightly wrong.

Let me refresh your memory. For each Iberia (SM: IBLA) share you own, you'll receive 1.0205 shares in the new company (TopCo) that will be formed from the merger. This means that for every 1,000 BA (LSE: BAY) shares you go short (or for every £10 you spread bet on BA) you need only buy 980 Iberia shares and not 1,020 as I erroneously said. This correction also increases the overall profitability of the trade to around 11%.

My sincere apologies for this mistake. Iberia shares are now a little higher than when we tipped it, so I would suggest that if you've bought the extra shares, just sell them to reach the correct quantity (so if you have 1,020, sell 40), and you should be roughly flat on the deal.

The ING rights issue gets underway

The rights issue at Dutch financial conglomerate ING, which we highlighted in issue 26, is currently underway. The reason I picked up on it is simple: the company is splitting into its two main components the banking part, and the boring insurance bit. The big opportunity for us lies in the fact that once the process is over, the sum of the two parts should be worth more than the company as it stands now.

Last year the Dutch state invested €10bn in ING to prevent it from going under in the financial meltdown. The state also agreed to guarantee the large portfolio of Alt-A mortgage-backed securities it held in the US, and which were a big reason for the bank getting into trouble in the first place.

ING is now trying to raise €7.5bn. It will use the proceeds to repay €5bn worth of tier 1 securities issued by the company to the Dutch state last year as a part of the state bailout (plus an interest and repurchase premium of around €500m). The rest will be used to strengthen the core capital of the company. The tier 1 securities in question carry a high interest rate. So by swapping some of these for common capital, the result will be a rise in earnings per share for the common stock.

The terms of the right issue are as follows: each share receives one right. Seven rights plus €25.44 will convert into six new shares (each new share is priced at €4.24). The rights will trade until December 15th, so expect volatility during this period.

In the prospectus, the new shares are referred to as BDRs or Bearer Depository Receipts. This is because of the peculiar way in which ING is listed. The ING shares are actually shares in a trust that owns 99.9% of ING shares. Each share in the trust represents an economic interest in one ING share. You don't need to worry about this it's just a technicality.

I think the time to get in is if the shares fall to between €5.20 and €5.40 per share. Right now they are trading at around €5.90, so for the moment, we'll have to wait. However, the rights issue should provide us with enough volatility to give us a good entry point. Once the rights issue is complete, I would expect to see news flow regarding the possible spin-off of the company's insurance unit, which could reignite interest in the group.

Recommendation: Wait until shares fall below €5.40 then BUY.

The latest on Cadbury's

Cadbury's is taking over from National Express as our new "favourite company". The news this week was the start of the tender process for the Kraft bid, which will run until January 5th. So far no counterbid has emerged there's plenty of speculation but no real facts. As things stand, the original offer looks set to fail, as not enough shareholders will tender their shares. Kraft will also find it nigh-on impossible to come back with a higher bid.

So we're back in the same situation as we were three weeks ago, before the November 9th deadline expired. This time the new deadline is January 5th. And with Christmas fast approaching, the time for a counteroffer is getting more limited.

As you might have gathered, I'm doubtful that there will be a higher bid for Cadbury's, and I'm still convinced that the market is wrong in pricing the stock at anything like the current price of 785p. If you agree, then the way to make money is to re-open an option position, similar to what we did on November 4th.

This time you have to focus on the March 2010 put option. You have three choices:

Buy the 800p strike (in the money) for around 46.5p (in other words, you are buying the right to sell Cadbury's shares for 800p);

Buy the 760p strike for around 30.5p;

Buy the 720p strike for around 18.75p.

The best choice for you all depends on how willing you are to risk taking losses. The 800p option has the best risk / reward profile, but it's also the most expensive so if nothing happens you will lose the most money. The 720p gives you more leverage for the same amount of money, but you will need the stock to fall by 12% to make money.

To explain, a bit further if you wanted to invest £500 in this trade, you could get exposure to 1,075 shares or £8,440 with the 800p put. With the 720p put, your exposure will be 2,667 shares or £20,935.

Now there's no rush to get back into this position. The stock has been sitting around 780-800p for a while, and I doubt it'll move that much in the next couple of weeks. In fact, you could even let Christmas pass and see if Santa delivers a higher bid before taking out this position.

So again, let's wait and see on this one, and be prepared to act. The point is that if no bid materialises, you'll want to have a short position in the stock before the deadline passes. And in this case, you are better off using options rather than spread betting, for two reasons.

First, if Santa actually brings a higher bid, you could lose more money if you are short using spread betting rather than with options, where only your premium is at stake (imagine if a counterbid is made at 850p for example).

Second, because the options expire in March, the "Theta" is quite low, and if the stock fails to move you could easily sell back the options for a small loss. For those of you who are desperate to know, Theta' is the first derivative of the Black and Scholes pricing formula with respect to Time, or the sensitivity of the value of the options to time. In simpler terms, Theta measures how much value your option loses with the passage of time (the other Greek letters involved in options include Delta, Gamma, Rho, and my personal favourite Vega!).

As usual please remember to sit on the bid when trading options, as the spread between bid and offer can be quite wide. Also, do take another look at my previous note from November 4th (issue 27).

A high-risk play on Reader's Digest

And so to our final topic for this week. It involves a very high-risk distressed asset play on the Reader's Digest Association, a US publisher which filed for Chapter 11 bankruptcy protection back in August. The company is aiming to shed a large amount of debt which it took on a couple of years ago when it was the subject of a private equity deal lead by Ripplewood.

The debt was made up of a large tranche of senior bank loans, plus a $600m issue of subordinated notes yielding 9%, due for repayment in 2017 [ISIN US755267AF83]. The Chapter 11 filing was entered after the company agreed the terms of the restructuring with the lender's bank. Under this proposal the unsecured creditors holding the notes would have received nothing.

However, the bankruptcy judge appointed to supervise the bankruptcy proceeding Judge Robert Drain twice rejected the plan because the unsecured creditors were being treated unfairly. So the latest plan proposes a small payout to the holders of the unsecured defaulted notes. Specifically, holders of the notes will receive warrants for 6.5% of the company, with an exercise price set when the market cap of the group exceeds $1.8bn. The final hearing is set to take place on January 15th, and the company is expected to exit chapter 11 two or three weeks later.

The core business of the company is sound and in fact the titles published suffered a smaller fall in circulation then the average magazine. So the titles aren't doing badly - the company went under simply because it was loaded with too much debt.

Currently the notes are trading at around 1.5 cents to the dollar. At that level, I think you should buy some, as the recovery value is expected to be around 3 cents to the dollar. Once the plan is approved, you'll receive the warrants, which should be listed once the company starts trading again. If we're lucky, and the company's shares rise after readmission to the market, the value of the warrant could rise more than the value of the shares, further increasing the recovery value.

Obviously, this is a highly risky trade, and you should only invest money you're prepared to lose. You'll need a broker that deals in US markets, although if you have already bought the tier 1 bonds we recommended in past issues, you should probably be able to buy these from the same broker. There shouldn't be a problem buying defaulted bonds, as long as you're aware that this is the case.

Recommendation: BUY ISIN US755267AF83 at 1.5c.

If you have questions please feel free to e-mail me at 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.

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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