Special Situation: Indo-Rama Textiles

Note Prepared by Ankur Jain:

On Feb 17, 2006, Spentex Industries bought 14.99% stake @ Rs. 84.15/share from the promoters of the Indo Rama Textiles and went into a Share Purchase Agreement to buy another 49.03% of the stake held by the promoters in the company. The announcements pertaining to the purchases can be read from here and here.

This triggered the Take Over Code under SEBI Regulations and the acquiree company had to come out with a mandatory open offer to purchase minimum of 20% of the outstanding paid up equity capital from the minority shareholders. The shares left with the minority shareholders were 35.98% (100-14.99-49.03) out of which a minimum of 20% were to be accepted. Spentex came out with an open offer on Feb 23, 2006.

On March 1, 2006, the share of Indo Rama Textiles was trading at Rs. 72 which was at a discount of Rs. 12.15 or 14.43% from the offer price. Logical though, that the discount was because of the time value of money, the probability of the consummation of the deal, the credit risk on part of Spentex Industries to pay up for the shares tendered in the open offer and the risk undertaken for the sale of the shares not accepted in the open offer. The open offer was slated to close on May 06, 2006 and the consideration for the accepted shares/ returned shares was to be received by May 22’2006. That meant that the total time period for the deal was 82 days. w.e.f March 01, 2006.

Experience of other similar opportunities in the securities market show that the spread between the market price and offer price narrows as the date of closure of offer approaches. In that case, if one gets the expected return due to the narrowing of the spread, there is no need to tender the shares and hold them for a longer period and also take the uncertainty regarding the selling price of the returned shares.

Calculating the economics of the deal, thinking backwards. Taking the opportunity cost of capital @ 15% per annum (twice AAA bond yield),for 82 days, the absolute return should have been at least Rs. 2.40/share in order to justify the investment in this opportunity i.e. sales realisation should have been minimum Rs 74.40/ share.

The possible scenarios in this special situation were: (1) Buying Indo Rama Textiles shares @ Rs. 72 and selling at anyprice above Rs 74.40 in the open market without tendering the shares (2) Buying the shares of Indo Rama Textiles @ Rs.72 and going through the tender process.

In case the shares were to be tendered, we based our calculations assuming the percentage of “brain dead investors” to be 5% of the total outstanding shares. Brain dead investors are the investors who don’t participate in the corporate action due to a number of reasons primarily being death, stock market illiteracy, too-much-paperwork syndrome, postal (in) efficiencies, signature mis-match on the tender forms etc.

Assuming the brain dead investors to be 5%, the shares left for tendering would have been 35.98-5 = 30.98%, which gives an acceptance ratio of 0.64 (20/30.98). In effect, for every 100 shares tendered, 64 shares will be accepted and 36 will be returned back to the shareholders. Cash outflow for the 100 shares would have been Rs. 7200 (100*72). Cash inflow for the shares accepted would have been Rs. 5385.60 (84.15*64). Thus the cost of the returned shares would effectively have been reduced to (7200- 5385.60)/ 36 = Rs. 50.40/share.

A big assumption is the price at which the share would settle post the open offer which would be the realized price for the returned shares.

At the cost of Rs. 50.40, the P/E of the company would be 7.25 X whereas pre-open offer, the company is selling at 11.5 x.

Why would the multiple contract? Operationally, there will been no change in the economics of the business due to the open offer; there will be no dilution of equity. Only thing that will happen was that the equity will changed hands. The risks that were inherent were the market risk and the risk of the new management running the company. Thus, the chances of P/E multiple contracting were low. Also, expected dividend payout of the company would act as a floor price for the stock. (Last year, it paid out 23% dividend, Face value Rs.10)

In his 1998 Letter to the Shareholders, Mr. Buffett wrote:

To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

We asked ourselves the same questions and the answers were:

1. Spentex Industries has a history of doing successful acquisitions of CLC Global Limited and Amit Spinning. Thus, the chances of the promised take over and open offer were very high.
2. The money will be tied up for a maximum of 82 days. This period can reduce considerably if the spread between price and offer narrows and we decide to sell in the open market.
3. We didn’t have an answer to that question. But if some better offer comes, what do we have to loose?
4. If the proposed open offer doesn’t go through, we will be left holding shares of a company which is not grossly over-valued and moreover, the stock price is protected by the dividend yield. The shares will have to be sold in the open market. But chances of that happening are minimal.

Based on the above calculations, shares in this company were acquired at Rs. 72 around March 1, 2006 and were sold at Rs. 76.50 around April 20, 2006. The operation produced a flat, pre-tax return of 4.77% (after considering trading costs) over a holding period of 50 days, which translates into an annualized return of about 35% p.a.

The returns might look miniscule in comparison to the market boom during the same period. However, given the current level of the market and our resultant aversion to market risk, we thought it to be an excellent opportunity which offered satisfactory returns with very little risk of permanent loss of capital. And that’s what investing is all about…

Ankur Jain, May 03, 2006.

Special Situation: BOC India

On March 14, 2006, Sanjay wrote a note on the BOC India special situation. A copy of the note is given below.

At this point, neither Tactica nor any of its clients have a position in this special situation. Long position in the stock was recently liquidated with pre-tax returns of 23.2% over a holding period of about 30 days.

Note on BOC India Opportunity

By Sanjay Bakshi

14 March 2006

On March 6, 2006, Linde AG of Germany announced its intention to acquire control over BOC Group Plc – a British company which is a leader in the industrial gases business. The combined company will be the world’s largest industrial business.

Linde is offering 1,600 pence per every share of BOC Group Plc, a 39% premium over the target’s pre-announcement stock price. The deal, which is a friendly one, is expected to close by September 2006. Details of the announcement can be viewed from here.

The announcement of this global acquisition has triggered the Indian Takeover Code in respect of the Indian subsidiary of BOC Group Plc. At present BOC Group Plc owns a 54.8% stake in this profitable subsidiary (BOC India).

According to the Indian Takeover Code, the acquirer (Linde) is supposed to make a tender offer to the minority shareholders of BOC India. The minimum tender offer size is 20% of all outstanding shares. However, we believe that there is an even chance for the acquirer to make a tender offer for all the shares held by the minority investors of BOC India. We give reasons for this belief later in this document.

Indian regulations require that Linde must make a tender offer to the minority shareholders of BOC India within three months of closing of its acquisition of BOC Group Plc. Assuming the global acquisition closes in September, as is expected by Linde, the earliest time by when the tender offer to Indian shareholders will be made is October 2006.

The price at which the tender offer must be made cannot be less than the maximum of four prices. Two of these prices are already known because they pertain to the past. The remaining two pertain to the future. Specifically, the minimum tender offer price has to be more than the maximum of: (1) the average stock price during 26 weeks before the announcement of the global acquisition; (2) the average stock price during 2 weeks before the announcement of the global acquisition; (3) the average stock price during 26 weeks before the announcement of the tender offer to the minority shareholders of BOC India; and (4) the average stock price during 2 weeks before the announcement of the tender offer to the minority shareholders of BOC India.

According to our workings, the offer price cannot be less than Rs 160 per share. We have bought a few shares at Rs 169. At that acquisition price, our downside risk is low.

BOC India has 49 mil shares outstanding currently quoting at Rs 173. The current market cap of this debt-free company is $192 mil. After acquiring control over BOC Group Plc, the market value of shares not controlled by Linde in BOC India comes to only $87 mil. In contrast to this, Linde’s cost of acquiring control over BOC Group Plc is $18 billion. So, the current market value of minority operations in India is only 0.48% of the size of the global deal. On the other hand, all the growth is in Asia.

Linde is paying 11 times EBITDA for BOC Group plc, a company with an expected top line and EBITDA growth rate of less than 7% p.a. In contrast, the Indian subsidiary’s revenues and profits are expected to grow much more rapidly driven by the steel capacity coming up. However, even if we apply the same EBITDA multiple of 11 times to the Indian subsidiary, the expected tender offer price comes to about Rs 200 per share.

Because of much higher levels of growth and profitability in India, and also because of the relatively insignificant value of the Indian subsidiary, we think there is an even chance for Linde to offer to buy all of the minority shareholders at an attractive price which could be in the region of Rs 250 per share. We believe that given current fundamentals of the Indian subsidiary, it’s not going to be difficult to justify a tender offer price of Rs 250 per share.

At this point, we would assign a probability of 50% for a full tender offer at Rs 250 or thereabouts.

Should Linde decide to make a full tender offer, the probability of getting an exit price of Rs 250 per share becomes very high. That’s because the acquirer will have to go through a reverse book building process to determine the tender offer price and that will shift the bargaining power in the hands of large institutional block holders who would now be in a position to extract a far more attractive price. There are precedents (e.g. the acquisition of Digital Equipment by Compaq/HP) in this area in which we have experience. We are relying on these precedents in arriving at this judgment.

However, whether or not Linde will make a full tender offer shall be known only at the after the public announcement of the offer, by which time it may no longer be profitable to buy the stock. Keeping this in mind, we are keen to accumulate stock in this company at near Rs 169 per share levels because of the favorable reward/risk equation.

If Linde decides to make a partial offer (only 20% of the total outstanding shares), which, we believe is a possibility, then we’d have to look at this investment operation as one in which we acquire an equity stake in the company at a price which is significantly lower than the prevailing market price, and also low in relation to the underlying value of the stock. This would happen because the profit on the shares accepted in the tender can be correctly treated as a reduction in the cost of the shares which are returned.

Our estimate is that out of every 100 shares bought and tendered, at least 57 shares will be accepted. Assuming a conservative offer price of Rs 200 per share, this would mean that we will end up with 43 shares having an effective cost of Rs 130, a price, which is very attractive, given the fundamentals of the business.

We expect the stock price of this company to start appreciating progressively as various milestones relating to the global acquisitions are crossed. This is rational because as each cause of uncertainty is removed, the spread between value and price narrows.

We would, of course, be monitoring these milestones. The first few milestones will be connected with the approval of the global transaction by various governments and anti-trust authorities. The last milestone is likely to be the announcement of the tender offer to the minority shareholders of the Indian subsidiary. Since uncertainties will be minimal at that point of time, our preference is to preserve optionality by deferring the decision of tendering vs. selling in the market till the last possible moment.

What can go wrong? In our view, a couple of things can go wrong. One is the collapse of the deal due to objections raised by governments and/or anti-trust authorities. We believe this to be a very unlikely scenario. Our view is also supported by the UK stock market, where the stock price of BOC Group Plc quotes at a very small discount to the offer price of 1,600 pence per share (reflecting a high degree of probability of the deal going through), as can be seen from the following graph:

However, even if the deal collapses and no tender offer is made, the outcome for us is not going to be terrible because all that would happen is that we would end up owning an equity stake in a profitable, rapidly growing company at a price, which is not excessive.

The second thing which can go wrong in this deal is unexpected delays. If the global acquisition takes time in closing, the tender offer for the shares of the Indian subsidiary will also get delayed. We plan to deal with this risk by buying slowly instead of aggressively and taking advantage of lower price levels should they occur in response to any delays.

The chief reason for our liking this opportunity is that it offers a combination of: (1) a low chance of permanent capital loss; (2) a high chance of a good profit; and (3) low market risk.

Free Warrants in JSW Steel: A Special Situation

Recently, Tactica initiated an investment operation in JSW Steel with the intention of creating free warrants in the company. The operation is now substantially completed with success.

The investment operation commenced on January 20, 2006. On that date, the stock price of JSW Steel closed at Rs 203. Yesterday, the stock closed at 367. The appreciation of more than 80% in three months has virtually guaranteed the success of this operation.

Tactica's CEO, Sanjay Bakshi, wrote a note on this subject on April 2, 2006. This note can be read from here.

Reflections on Indian Stock Market Levels Revisited

Further to his blog entry of July 31, 2005 on Indian stock market levels, Tactica's CEO, Sanjay Bakshi, recently updated his views on April 2, 2006. These can be seen from here.

Indian Finance Minister Agrees With Tactica's View

On July 29, 2005, both Sensex and Nifty hit their then all-time-high levels. Sensex closed at 7635.42 and Nifty closed at 2312.30.

Amidst concerns that market levels were dangerously high, the next day, Tactica's CEO, Sanjay Bakshi posted an article on his blog titled "Reflections on Indian Stock Market Levels". In the article, in which he used various historical charts depicting both absolute and relative price levels, Sanjay concluded:

Given recent performance of the corporate sector, and given the sustainability of this performance, the current level of interest rates, the Indian stock market is not expensive.

In other words, "Stocks are high, they look high, but they're not as high as they look."

The Indian Finance Minister has expressed agreement with Tactica's view. On September 8, when Sensex crossed the 8000 level mark and closed at 8052.56 and Nifty closed at 2454.45, the FM was interviewed by the media. Hindu Business Line had this to report:

ASSERTING that the Government and the capital market regulator were keeping a close watch on the domestic bourses, the Finance Minister, Mr P. Chidambaram, today said that the Sensex crossing the 8,000 points level was not a cause for "worry or concern." He, however, advised investors in the stock markets to take informed decisions.

"Sensex rise is not a cause for worry or concern. Stock market movement is orderly," Mr Chidambaram told newspersons.

Stating that the second quarter results of business houses and banks are expected to be as good as the first quarter results, the Finance Minister said that the Sensex crossing the 8,000-mark also showed that business confidence was very high. "We are still in comfort zone," he said.

Noting that the price-earning ratios of both the Sensex and the Nifty were at present hovering between 14.5 per cent and 15.5 per cent, Mr Chidambaram said "at this level, they look comfortable."

Saroni Ray

1st post

This blog is under development. During the next few weeks, material about Tactica's various activities shall be posted.

In the meantime, you can visit the blog of Mr. Sanjay Bakshi who is the CEO of Tactica and also his website.