Events Trader #36: Why Readers Digest is about to bounce back

19th January 2010

Why Readers Digest is about to bounce back

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Welcome back.

The big news this week is the revised deal struck between Kraft and Cadbury which pretty much means that our strategy has not worked out. Though this was a bet that was certainly worth taking.

On the upside, there was a very encouraging development for Readers Digest as Judge Robert Drain paved the way for the company to emerge from Chapter 11 protection by the end of January. And good news too for Ladbrokes with the company's shares rallying this week as under fire CEO Christopher Bell chose to resign suddenly.

Kraft clinches Cadbury

This morning Kraft announced the revised terms for the acquisition of UK confectionery maker Cadbury. Kraft will pay 500p in cash plus 0.1874 of its own shares, Cadbury shareholders will also be entitled to receive a 10p dividend.

The new offer values Cadbury at 850 pence or 15% more than the original price. Cadbury`s board has now agreed to the revised offer (after previously denouncing the offer as derisory) and now it looks set to be successfully completed.

This means that unfortunately our position has not worked out as planned and we stand to lose most of the option premium that we have paid. For this reason I recommend that we close our position in the option at 1.5p and move on.

The outcome was not what we expected but I still think the position was worth taking, here is why.

For a start we used options to play the potential downside of the trade, which meant that our losses were capped at the amount of the premium paid to buy the option. If we used a short position our losses would be around 60p a share - much greater than the 20p in our trade.

Secondly until the last moment there was a good chance that the takeover offer could fail and that no other bidder would enter the contest. In this type of scenario the downside would have been significant, and had the offer failed I am pretty sure that Cadbury shares would have fallen to below 650p. All this meant that for a 20p outlay we could have had a 100p payout, or 5 times the amount invested.

The risk reward ratio for the trade was 5:1 for an outcome that was more than 20% likely to occur and that is why it was worth taking a punt.

In theory we could now buy the shares and play a risk arbitrage strategy. But in this case I do not think it is worthwhile. With the bid set to close soon, the premium is very low. The hedging strategies required to carry out the trade also add a layer of complexity that is not worth for such a paltry return. Well we move onto the next trade.

Recommendation: Close out option at 1.5p

Readers Digest unloads its huge debt burden

There is good news however for our high-risk distressed asset play on the Reader's Digest Association. As you know, the US publisher filed for Chapter 11 bankruptcy protection back in August. And on Friday it caught a big break, as Judge Robert Drain approved the revised reorganization plan - allowing the company to emerge from Chapter 11 protection on the 31st of January.

The main effect of the process will be to lower the debt of the company from $2.2 billion to a more manageable $550 million. And that lifts a huge burden from the balance sheet. You'll remember that the company was the subject of a leveraged buyout in 2007 lead by Ripplewood Holdings Llc, which loaded the company up with a tonne of debt.

When the recession struck Readers Digest was left unable to service all the debt it had taken on using the earnings and decided to enter into a pre-packaged Chapter 11. It's called pre-packaged because the company and its main creditor agreed the terms of the deal before the company filed for bankruptcy.

There are three reasons why I was attracted to this idea. The company is fundamentally sound. First, their publications have held up quite well in recent years - having suffered a drop in circulation that was much less than the industry average. Secondly, the company should re-emerge as a viable healthy business once the Chapter 11 process is over. And finally, the unsecured notes we tipped were trading close to zero because the market was expecting a nil recovery value. This was treated as unfair by the presiding judge.

The Chapter 11 will allow the secured creditors to receive most of the new shares that the company will issue. They are expected to recover between 53 and 63% of their claim. This claim is based on the expected value that the market will place on the new shares once they restart trading.

Back in December in issue 32 we recommended purchasing the subordinated notes yielding 9% due for repayment in 2017 [ISIN US755267AF83] at 1.5 cents to the dollar. The holders of these notes (worth a total of $628 million) will now receive warrants that will entitle them to buy 6.5% of the new shares issued by the company. This payout should amount to a recovery ratio of 3%.

Details have been sketchy so far and I am waiting to see details of the main characteristics of these warrants - such as the numbers expiry and strike price. And once we have them we should have a better idea of the recovery value of the notes.

The next step now is the readmission to trading of the new shares, which is expected from the 1st of February. Hopefully we should also be provided with a new set of financial results for the company.

As usual I will keep you posted with any new information.

Ladbrokes rallies as chief executive resigns

Last Tuesday the CEO of Ladbrokes, Christopher Bell resigned unexpectedly. Bell apparently stepped down after major shareholders in the company expressed their anger at the way the company was managed. In particular they were pretty upset that after saying back in August that the company would be able to reduce the debt pile without the need to raise cash from shareholders, it went right ahead with a one for two rights issue last October (which we bought into).

The shareholders were also disappointed at the lack of direction and strategy for the company. Apparently a takeover bid for 888.com was shelved after the company became concerned about the possible legal exposure to the US market where online poker is banned.

The company has now instructed headhunters to look for a suitable replacement for the CEO. Hopefully a replacement will be found soon.

The shares reacted favourably and rallied to close at 150p, higher than our 140p entry point (they have been as low as 120p after the end of the right issue). And the market is now waiting for a new CEO to be appointed and for a new strategy to be announced.

These two factors should clearly be positive catalysts for the share prices and should generate some interest in the company. The Winter Olympics, a more favourable pattern of results from the premiership and especially the 2010 World Cup in South Africa should also help the company to recover from its 2008 blues. It looks like there are better times ahead of Ladbrokes.

So for these reasons, we are going to keep the position open.

As usual, you can e-mail me at eventstrader@f-s-p.co.uk. I will be delighted to reply.

This week, the Events Trader archive password is Rhyme.

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. The value of your investment can go down as well as up. Your profit depends on the potential price increase of the 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. 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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