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Value Stock-Picking, Week 3: How to Play the M&A Game

Stockpickr Staff

This assignment was written by Stockpickr member Ira Krakow.

Mergers and Acquisitions: One of the greatest feelings you can have as a value stock-picker is to wake up one morning, turn on CNBC or log on to TheStreet.com and discover that a stock that you bought has received an offer to be acquired or taken private . Why? Because immediately on the news, the stock usually rockets up.

The market, however, does not typically price a stock at the deal price. Why? There are risks involved between the time the offer is made and (if indeed it occurs) the time the deal closes.

The process of evaluating this risk and taking action on it is referred to as merger arbitrage. In Trade Like Warren Buffett, James Altucher identifies the merger risks that should be considered before making a sell or hold move. But before we get those risks and this week's assignment, let's look at a few current examples of companies "in M&A play."

BEA Systems: If you took Jim Cramer's advice and bought BEA Systems (BEAS Quote), on speculation of a takeover by Oracle (ORCL Quote), you would have experienced that "good news in the morning" feeling. In a Wall Street Confidential video on TheStreet.com TV, Cramer explained how he figured out that Oracle would bid for BEA Systems.

A quick recap: He looked at Carl Icahn's Stockpickr portfolio and noticed that Icahn had taken a 13.2% stake in BEA. Icahn is an activist investor who looks for value and who had been urging a buyout (or acquisition ) before the Oracle offer.

On the news of Oracle's offer, BEA rocketed from $13.82 to $18.22 -- a gain of over 30%, far higher than Oracle's $17 offer price. But BEA is looking for an even more lucrative deal. It looks like a bidding war is in the offing.

Sallie Mae: Should you sell on the deal news and pocket the immediate profit? Or, wait until the deal gets done and pocketing the full buyout price or perhaps even a bigger gain if a bidding war occurs? Just because a deal is announced at a certain buyout price, it's not a slam dunk that the deal will get done. Just ask the investors in student loan company Sallie Mae (SLM Quote), which was supposed to be bought out by the private-equity firm J. C. Flowers, Bank of America (BAC Quote), and JPMorgan Chase (JPM Quote), in April, at a price of $60 per share.

Sallie Mae currently trades at around $46 -- quite a discount. The reason: Flowers is trying to back out of the deal, and Sallie Mae is fighting to get a $900 million penalty from Flowers because the firm reneged on the deal. It looks like the lawyers will profit, though that may not be true for Sallie Mae shareholders .

TXU: What about the investors in TXU (TXU Quote), which was supposed to be bought out by private-equity firms Kohlberg Kravis Roberts and Texas Pacific Group in February for $69.25 per share? When the deal was announced on Feb. 27, TXU's stock price vaulted to $67.55, but it has traded around that level, as low as $63.01, until very recently. Now that the deal looks like it's getting done, TXU is trading at the buyout price. But as a shareholder, was it worth holding on to it and waiting over six months?

Business Objects: Another software company in play is Business Objects (BOBJ Quote), which received a $6.8 billion buyout offer from SAP. The deal is viewed as a strategic move for SAP to counteract Oracle, a company that has been aggressively moving into the enterprise software space.

SAP develops software to manage enterprise wide functions such as payroll and human resources, while Business Objects markets "business intelligence" software, which can make the SAP software smarter. Oracle recently acquired Hyperion, a competitor of Business Objects in the business intelligence space. The deal is not expected to close until early 2008. Should you sell Business Objects now (it's trading at around $59) or wait?

Clearly, the market does not typically price a stock at the deal price. A lot can happen between the time that a (potential) deal is announced and when (if at all) the deal closes. Merger arbitrage is the process of evaluating this risk and taking action on it. In Trade Like Warren Buffett, Altucher identifies the following types of risks inherent in merger arbitrage:

• Due diligence risk: The acquiring company can back out of the deal if, after doing the research, some negative information turns up. The type of negative information that can trigger the back-out is usually spelled out in the deal, but sometimes the waters can be muddy, as in the Sallie Mae deal.
• Regulatory risk: When an industry is heavily regulated, such as an electric utility or a media conglomerate, or if the merger might create an environment that triggers an antitrust situation, the government might step in and nix the deal. In the proposed Whole Foods (WFMI Quote) and Wild Oats deal, the Federal Trade Commission filed a lawsuit claiming that natural foods was its own market and that the merger would create a monopoly.

  The Federal Communications Commission made a similar argument against the merger of satellite radio providers XM (XMSR Quote) and Sirius (SIRI Quote), claiming that satellite radio was its own market.

• Other bidders might emerge: This is not really a risk, but more of a reward. See the Oracle-BEA deal.
• Interest rate risk. If a deal like SAP-Business Objects will take six months or more to close, why tie up your money in the stock when you can sell and reinvest, at the least, in a CD or money market fund , getting paid for waiting? Not getting paid for waiting is a definite risk.

Your Week 3 Assignment

Your third assignment in this program is to figure out whether to sell or hold the stocks of companies that may be bought out.

To help you get started, I put together a Stockpickr portfolio of merger arbitrage candidates for potential deals that have been announced but have not been completed. These include not only the potential deals discussed earlier, but others as well, such as the buyout of Tektronix (TEK Quote) by Danaher (DHR Quote). When news like this breaks, is it time to take profits, or to wait? This week, you will focus on just that question.

Step 1. On Stockpickr, create a portfolio called "M&A Analysis: [Your Stockpickr Username]." (To create a portfolio on Stockpickr, you'll need to first log in to the Stockpickr Web site. If you're currently not a Stockpickr member, you can register at www.stockpickr.com/register.)

Turn the "Portfolio Tracking" feature on, so you can monitor stock prices over time.

Step 2. Add the companies in the Merger Arbitrage Candidates portfolio. The portfolio includes both the acquiring companies and the companies to be acquired. Although usually the acquired company has the biggest increase in price, you might conclude that the deal is so good for the acquiring company that it's worth buying as well.

Step 3. Read the latest news about each company, by searching for articles and videos on TheStreet.com and via other sources. What are you looking for? The same kinds of risks Buffett looks for: due diligence risk (whether something happened that might nix the deal), regulatory risk (whether the government might step in) and interest rate risk (how long the deal will take to close). As you do this homework, enter your thoughts in the "Reason for picking" box. Why? You're building up evidence for either selling or holding.

Other Stockpickr portfolios that you can research include:

• Latest Activist Situations, which tracks SEC Form 13D filings, the "footprints" activist investors leave when they are building up their positions.
• Warren Buffett
• Carl Icahn
• George Soros
• T. Boone Pickens

Step 4. See whether any competitors might be in M&A play as a result of the deal. Sometimes these deals result in merger mania. You can find a company's competition on Yahoo! Finance. For example, to find Danaher's competitors, do the following:

1. On Yahoo! Finance, enter ticker symbol DHR and click the "Get Quotes" button.

2. On the left-hand side, click the "Competitors" link. According to Yahoo!, Danaher's direct competitors are Emerson Electric (EMR Quote), Johnson Controls (JCI Quote) and Rockwell Automation (ROK Quote).

You can then research the news on these companies as well, adding them to your Stockpickr M&A portfolio.

Step 5. For each stock in play, assume that you own it and note whether you want to sell or hold it. You may want to hold until a target price is reached, or you may want to set a stop limit order in case the deal sours. Note that as well.

Step 6. Follow these stocks for the next three weeks and rank them at the end of that time. Determine whether you should you have sold at the beginning of this three-week period or would it have been wise to wait.

Next: Value Stock-Picking, Week 4: How to Find the Next Big Value Play