Monday, September 20, 2010

Merger Arbitrage: Opposition to the Cogent Inc (COGT) Takeover

In this post, we will look at a strategic deal that is facing shareholder opposition. On August 30, 3M Co (MMM) announced a definitive agreement to acquire Cogent Inc (COGT) for $10.50/share. The cash tender offer has an aggregate value of $943 million. MMM is a research and development firm whose core strength is in applying its more than 40 distinct technology platforms to a wide array of customer needs. COGT is a biometric identification solutions provider to governments, law enforcement agencies, and commercial enterprises. MMM was attracted to COGT because of its participation in the biometric market, which MMM projected to have an annual growth rate of 20%. Let's dig deeper into this merger arbitrage situation.

The deal price was 18% higher than COGT's August 27 close. All else equal, this is considered to be on the low side for a takeover. Especially with a strategic acquirer, who is expected to squeeze synergies out of a transaction (which should, in turn, translate into a higher offer price, thereby passing the added value to shareholders). The merger values COGT at about 12.5x consensus EBITDA, while the best peer is L-1 Identity Solutions Inc (ID), which trades at about 13.5x consensus EBITDA. Not only is ID's business similar to COGT's, but ID commenced a strategic review process in February, so the stock has takeover potential baked into the price. Another detail not in MMM's favor is that COGT was trading for over $11.25/share in January. Founder and CEO, Ming Hsieh, entered a voting agreement in favor of the merger with his 39% position in COGT, but noticeably absent are other shareholders, apart from this insider.

What these factors are telling us is that there's a good chance COGT was not adequately shopped. For, if it were, the competitive bidding process would have driven up the deal price to a higher valuation. We won't know about the deal background until the tender documents are released, but so far, investors are skeptical. COGT closed on August 30 at $11.09/share, for a spread of -5.3%. On September 1, Pointer Capital, Iridian Asset Management, and Corbyn Investment Management (who combined hold about 8% of COGT) came out against the merger, specifically its low valuation. Pointer Capital explained that the fundamental value of COGT exceeds $15/share.

MMM commenced the tender on September 10 (due to expire on October 7), and with that, we were provided the background section of the tender documents. Similar to how a child goes straight for the comics section of a weekend paper, an arbitrageur's first stop is the background section. COGT's was of particular interest, given the aforementioned reasons. The document explains that a third party gave a preliminary non-binding indication of interest of $11 to $12/share on August 18. MMM's initial offer (of $9.25 to $10.25/share) was made on May 24. Even if you are far along in the process with one party, the board has a fiduciary duty to exhaust discussions for a credible offer that is superior. Perhaps COGT did finalize negotiations with this bidder, but the topic was left dangling in the tender document. Either way, this is a mistake on COGT's part.

Pointer Capital again took offense to the newly-public information. In a thoughtful letter to the COGT board on September 14, the Atlanta-based investor noted:
The Company provided 3M with financial estimates through 2013. The most noteworthy item was the drastic cut in gross margins beginning in 2011. The Company projects 66 percent gross margins in 2010, in-line with management's historical projections of 60 to 65 percent. However, 2011 estimates show a reduction to 57 percent gross margins. During the second quarter earnings call, the Company continued to reiterate that 2011 looks promising and was excited about business prospects.

How does this compare to the fact that management is now projecting a 900 basis point decline in gross margins year over year? Should the gross margins remain at historical levels, we believe the Company would produce in excess of $60 million of EBITDA in 2011. Are these estimates that management provided to 3M too conservative or has there been a material adverse change to the outlook by Cogent's management?
In the announcing press release on August 30, the companies said that the expected close is in the fourth quarter. This is acceptable, especially since it is a tender offer (and antitrust approval was granted on September 10). However, Pointer Capital identifies a potential motivation for the timing of the transaction:
It appears to us that December 30, 2010 is an arbitrary date with one caveat: the proposed tax changes to long-term capital gains. At $10.50 per share, it is unlikely that many shareholders have long-term gains at this price so the proposed tax change may be a moot point. The only shareholder with a significant long-term capital gain to speak of is the Company’s CEO. While we understand his position, the lack of fiduciary responsibility to shareholders is very evident.
COGT has yet to respond to the shareholder opposition. With a Q2 cash balance of $3.0 billion, MMM can afford to increase the offer price. A higher offer is not out of the question, but we encourage investors to be mindful of chasing this too high. Sure, another 3PAR Inc (PAR) could happen, but that’s unlikely, and no one anticipated what happened there.

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About the Authors

Hunter is the founder of the Distressed Debt Investing Blog and the Distressed Debt Investors Club. He has worked on the buy side for the past 7 years in high yield and distressed debt investing.

Edward has been a professional investor for four years, focusing mainly on the event-driven space. His investment philosophy is value-based, and he spends the majority of his time identifying near-term catalyst based opportunities.

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hunter [at] distressed-debt-investing [dot] com