Christian Olsen’s Q1 2013 letter and March update has some interesting comments on merger arb play (see the 2013 letter here). Check out the full letter below.
I continued accumulating the ‘special situation’ investment
I discussed but didn’t name in last month’s update. This is D.E. Master Blenders 1753 BV, the Amsterdam-listed spin-off of Sara Lee’s coffee and tea businesses, which was acquired by an investor group for cash last fall
At this point, it looks like we will most likely earn almost 6% over our avg. holding period of about two months (approx. 40-65% annualized, depending on the timing of the final cash payout) on this very low-risk arbitrage.
After the investor group had acquired over 95% of the shares following the completion of the tender offer to shareholders last fall, the stock was delisted from Euronext Amsterdam and a squeeze-out procedure was initiated in the Dutch courts in order to force the remaining shareholders to sell their shares to the investor group at the buy-out price. A couple of months later, the stock started trading in the U.S. ‘grey market’ at a significant discount to the buy-out price (this was probably due to low liquidity and a lack of awareness about this trading opportunity among sophisticated arbitrageurs), while my research indicated it was highly unlikely that the court would not decide that the remaining holders would receive the same price as other shareholders. When I became aware of this arbitrage opportunity, I started accumulating the stock. As expected, on April 8 the court ruled that the remaining shareholders shall receive the buy-out price within the next few weeks. Please see the Q1 investor letter or the accompanying email for more details.
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Portfolio Updates
- Approx. 40-65% IRR on Arbitrage of Dutch Squeeze-Out
During the quarter, I invested in what I think was an excellent arbitrage opportunity. I bought shares in D.E. Master Blenders 1753 BV, the Amsterdam-listed spin-off of Sara Lee’s coffee and tea businesses, which was acquired by an investor group for cash last fall.
At this point, it looks like we will most likely earn almost 6% over our average holding period of about two months (approx. 40-65% annualized return, depending on the timing of the final cash payout) on this very low-risk arbitrage.
Stock Trades 10% Below Buy-Out Price in Obscure Over-the-Counter Market
Under Dutch law, depending on the legal structure of an acquisition, it may be necessary for the buyer to acquire at least 95% of the shares (generally via a tender offer to the shareholders) before it can force the remaining shareholders to sell their shares under a ‘squeeze-out’ procedure overseen by the courts. In October, shortly after the investor group obtained 95% of D.E. Master Blenders, the stock was delisted from Euronext Amsterdam and the squeeze-out procedure, which typically takes several months, was initiated in the Dutch courts. A couple of months later, the stock started trading in the so-called ‘grey market’ in the U.S., which is basically the least regulated tier of the pink sheets, at prices that initially were around 10% below the USD-equivalent of the EUR 12.50 buy-out price.
Very Low Risk Investment; Imbalance of Supply and Demand for the Stock
My research on the Dutch squeeze-out procedure generally as well as the particulars of this case indicated there was only a very low probability that the court’s decision would not result in the remaining shareholders eventually being bought out at EUR 12.50 per share, which I thought would probably occur around May of this year. Many of the shareholders who did not tender their shares (most likely due to inattention) probably also didn’t properly understand the terms of the buy-out and the squeeze-out procedure (and hence the value of their investment). Moreover, some of them were probably U.S.-based individual investors who owned this European-listed stock because the company was spun off from a U.S. company only 17 months before the delisting. Therefore, when the stock became tradable in the U.S. grey market, I think there was likely a meaningful number of natural sellers, but few arbitrageurs were buying because of low liquidity and lack of awareness (perhaps caused by the change in trading venue from Europe to the United States).
After I became aware of this opportunity, I accumulated as many shares as I could without pushing the price up significantly, and fully hedged the currency risk. As expected, on April 8 the court issued its decision that the remaining shareholders shall be mandatorily bought out at EUR 12.50 per share within the next few weeks, and the stock is now trading in line with the buy-out price.
- Sold Topps Tiles, Locking in 17.6% IRR
During January, I sold our remaining shares in Topps Tiles plc, as the price had performed exceptionally well in recent weeks and now reflected approximately fair value.
This £250 mil. market cap company is by far the UK’s largest specialty retailer of tiles and related products. This includes bathroom, kitchen, floor, wall and mosaic tiles, grout, adhesives, tools, and wood flooring. Based on the information I have, the company’s market share has increased every year since its IPO in 1997. Most customers are do-it-yourself consumers who are laying tile in a portion of their home as well as small, independent “jobbers” who perform small tile-laying jobs for others. The company does not sell wholesale to builders.
Superior Competitive Position, Superior Margins
Compared to the great majority of its many mom-and-pop competitors and the few smaller chains of tile specialists in the UK, I believe Topps offers at least comparable service (product knowledge of its sales associates), comparable variety, but better in-stock product availability (thanks to its size, own warehouse facilities, and bigger balance sheet which enables it to hold more inventory). The company’s substantially larger, national reach also gives it advertising and branding advantages. Even more importantly, it has a very big cost advantage because it has more buying power and is large enough to justify having its own warehouse and can therefore buy the majority of its inventory directly from manufacturers. This is the reason for its vastly superior gross margins, which are around 60%.
The ‘DIY sheds’ (equivalent to the large home improvement chains in the U.S.) also sell tile, but they usually focus on offering a narrower variety of products at lower prices. They also provide less service, as it is not practical or economical to staff the tile aisle (which probably accounts for less than 5% of revenues) with a tile specialist at all times. As far as I know, the DIY sheds’ share of the UK tile market has been roughly constant for many years.
So far, the Internet has had little impact on the retailing of tile. Via its web site, Topps sells a fairly small amount of tile, provides product information, and provides a ‘loan a tile’ service providing samples to customers by mail.
All in all, I think Topps Tiles has a superior, sustainable competitive position, which is the main reason for the superior margins and continual market share gains.
Overestimated Recovery Potential
Early in the economic recession, the company’s same-store sales dropped by approx. 20% and the operating margin fell from a little over 20% to around 10%. Contrary to my expectations, sales and margins have largely failed to rebound so far, although it looks like they will most likely show some improvement this year. However, relative to its competitors, it appears that the company is doing well, and it has apparently continued to grow its market share since the recession and remained solidly profitable and cash flow positive all along.
I think I may have underestimated how much UK tile consumption was inflated before the recession by the popularity of home improvement projects that were driven by homeowners’ exuberance about their dramatically rising home values, so I incorrectly assumed that most or all of Topps’ lost sales would come back soon after the recession was over.
Saved by Low Purchase Price, Realized 17.6% IRR
The fund’s average cost of Topps Tiles stock was only 4.5x the company’s pre-recession earnings per share. Our average sales price still only equaled 7.5x pre-recession earnings—however, I would no longer assume that the company will achieve this level of earnings simply as a result of a normalization of the market in which it operates (it will likely exceed these earnings eventually, but probably not for a long time). Depending on how much earnings improve this year, I estimate our selling price to be 16-19x FY
2014’s earnings. Given my skepticism that earnings will recover all of their lost ground, I think this is close to the fair value of the stock. The fund earned a 17.6% annualized IRR on this investment over its 3½-year avg. holding period compared to 9.6% for global equities and 10.0% for UK equities (incl. dividends) over the same time period.
- Accumulated Add’l Shares in Two Small European Companies
In January, I bought a few additional shares in the company I described in last quarter’s letter which had dropped approx. 20% in December following a mediocre earnings report. This company is fairly small, but reasonably diversified in terms of customers, types of services offered, reliance on key people, etc. The company is debt-free, operates in an attractive industry, and consistently generates lots of free cash flow. These additional shares were bought at prices corresponding to approx. 8.5x adjusted trailing earnings.
In addition, I continued to accumulate shares in the illiquid, profitable, asset-rich European company I described in more detail in the Q4 2013 investor letter, but unfortunately I have only been able to acquire a very small stake so far.
- Increased Stake in Two Stocks During Brief Emerging Markets Sell-Off
I also took the opportunity to increase our positions in two other companies in late January and early February when they temporarily became more deeply undervalued during the brief market sell-off that was caused by concerns about emerging markets (these are both very strong companies that are not highly exposed to emerging markets anyway).
