Events Trader #35: A simple merger deal for us to profit from

12th January 2010

• A simple merger deal for us to profit from
• What to watch for with Cadbury's

Dear subscriber,

Welcome back. So far this year has been pretty quiet. I haven't seen any big stories that have got me excited. So as we've had a lot of news on Cadbury's recently, I thought it would be good to have a brief recap on that to kick off.

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After that, I'll also be outlining another risk arbitrage strategy. As you know, these trades provide a steady stream of predictable returns, and so can be useful when the market takes a breather.

What's going on at Cadbury's?

Here's a rundown of what's happening with Cadbury's, and what dates we need to be aware of.

January 19th: This is the last day in which Kraft can change its bid. The company is expected to finalise details of the current offer, which as you know, has been slightly amended to include a higher portion of cash.

February 2nd: This is now the final deadline for the takeover. Shareholders now have four more weeks to decide whether to tender their shares to the bid.

Rumours are still circulating about a possible joint bid from Ferrero and Hershey. The trouble is, Ferrero is struggling to raise the cash, while the Hershey board are split on the idea. Also, Hershey could have to change the dual company share structure which allow's The Hershey Trust to retain control of the company.

The other news was that Warren Buffet, who via Berkshire Hathaway is the largest shareholder in Kraft, has spoken against issuing a large number of Kraft shares to finance the takeover. In particular, he wasn't keen to issue 370m shares which trade at a lower p/e than the target company.

You can understand his feelings. If the takeover went ahead his stake would be diluted. But his comments need to be placed in context. By apparently speaking out against the takeover, he made Cadbury's share price fall. That makes it more likely that the share price will reach the offer price, which would increase the chances of a successful bid.

Hopefully after the 19th January, we'll have a clearer picture. All in all in my view is that this takeover has a high probability of failing, and that's why I think we should stay short of Cadbury's shares.

If you haven't already bought in, as I've said on several occasions, I believe the best way to play the trade is through options. If I had to choose just one option, I would buy the March 2010 Put option with a strike price of 760p.

As usual, do be aware that the spread on the options is very wide, so always use a limit order (around 22-23p) and never a market order.

Recommendation:

If you aren't in the trade already, BUY the Cadbury's March Put option, strike price 760p (Bid 20p / Ask 29p)

Let's stick with Dragon Oil for now

On December 11th, shareholders in Dragon Oil rejected the proposed takeover of the company by Dubai group ENOC. As a result the share price dropped to 370p. The price has now rebounded to 430p as the company's fundamentals are quite strong. The stock is now trading on 11.7 times earnings.

In all honesty, I was quite surprised by this. If ever there was a stock that should be trading at a premium to a takeover offer, it surely should have been Dragon Oil and not Cadbury. But the market is often irrational, and we can only go along with this.

But even although the offer has failed, the stock has pretty much recouped all the post-bid losses. Hopefully it could now climb above the previous offer price. Yesterday Merrill Lynch issued a research note on the stock with a buy' recommendation and a target price of 580p.

With the crude price hovering around $80 a barrel, this should be enough to push the stock back up through our original target of 450p. So let's wait a couple more weeks and see what happens.

Another risk arbitrage deal to profit from

Last week, I mentioned a merger story involving a stock called BJ Services (US: BJS). I've looked into it further, and I don't think there's enough profit left in it to make it worth our while for now. I'll keep it on my watchlist, and if anything happens, we can revisit it. But for now I won't trouble you with the details. However, there is another deal that's definitely worth trading.

Computer giant Hewlett Packard (US: HPQ) announced an all-cash deal to acquire networking equipment group 3com (Nasdaq: COMS) for $7.90 a share in November. The deal is expected to close by the end of the second quarter. Right now, 3com shares are trading for $7.64. That's a 3.3% discount. The strategy is simple just buy 3com shares and hold them until the deal completes.

The deal is similar to the Oracle-Sun Microsystems deal which we entered in the second half of last year. Like that deal, the main risk here is that competition issues could delay or block the acquisition. But in my view, the risk here is low. Why? Because this deal actually increases competition and so shouldn't worry the authorities.

How does this work? Well, back in the late 1990s, 3com was Cisco's main rival in the networking equipment sector (these companies supply internet routers and the like). But after the 2000 crash, 3com became just another fallen star like Nortel and Sun.

However, with this deal, Hewlett Packard gains a foothold in the networking equipment business. That means it can use the synergies from its computer and peripherals business to create a sizeable rival to Cisco.

So there should be no surprises here. And that's why I reckon it's worth buying 3com shares for a small but easy gain.

Recommendation:

BUY 3com (Nasdaq: COMS) at $7.64

As usual you can ask me anything by contacting me on my e-mail eventstrader@f-s-p.co.uk. I will be delighted to reply.

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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