Sunday, January 31, 2010

Merger Analysis: Pepsi's Acquisition of its bottlers

We are going to analyze the antitrust situation brewing in PepsiCo’s (PEP) acquisition of its two bottlers, Pepsi Bottling Group (PBG) and PepsiAmericas (PAS). In merger arbitrage transactions, regulatory approvals are critical. For the Pepsi deal, the HSR notification is under scrutiny with the FTC (recall that the Hart Scott Rodino Act governs the US antitrust filing process). For a little background, PEP made an unsolicited cash & stock offer for both companies on April 20, 2009, with bids worth $29.50/share and $23.27/share for PBG and PAS, respectively. The offers are cross-conditional based on the successful completion of both transactions. At the time of the announcement, PEP said it saw no issues in obtaining regulatory approvals. The offers were rejected by PBG and PAS’ boards, as all initial unsolicited proposals are. The spreads were negative, indicating that a higher offer was expected, and on August 4, definitive agreements were reached. The new offers were a cash or stock election worth $36.50/share for PBG and $28.50/share for PAS.

The antitrust review of a deal is paramount in risk arbitrage. It plays an important role in the timing of deal close and the ultimate successful completion of a deal. Deals with the most attractive spreads are likely to have complex antitrust issues, therefore it is essential to get a handle on this facet of deal analysis.

The first step in analyzing antitrust issues is to check right away whether there are any horizontal overlaps between the two companies. Horizontal overlaps are of great importance as these are the most likely to be challenged by the Antitrust Division of the Department of Justice (DoJ) or the Federal Trade Commission (FTC), if the merger results in a Small but Significant and Non-Transitory Increase in Price (SSNIP). We will discuss the meaning of SSNIP later. In the PEP/PBG/PAS merger, we can right away conclude that the merging companies do not have any significant overlaps.

In fact, the merger is a vertical merger. This is very good news, as historically, US antitrust authorities have had a fairly hard time challenging vertical mergers in a court setting. This gives us sufficient comfort to say that there is a very low probability that the merger would be challenged (blocked) by the antitrust authorities.

The next logical step is to look at the expected timing of the antitrust approval. The first thing we want to check is when the merging parties expect to file under HSR. We can usually find information related to the filing date in the Merger Agreement. Usually the parties commit to file either with the DoJ or the FTC in a fixed time period (usually 10 to 15 business days). So we check the PBG and PAS Merger Agreements (click here for the PBG and here for the PAS Merger Agreement). We are not that lucky here though: Section 8.01 of the Merger Agreement states that the parties will file under HSR “as promptly as practicable.” To remain on the conservative side we would pencil in one month for filing (early September 2009).

Next, we seek to estimate the length of the antitrust review period (here, we will not discuss the deals’ required European Union filings). We know that the initial waiting period under HSR is 30 calendar days for mergers. However, if there are substantial competition concerns the DoJ or the FTC could further extend the review period. This could substantially postpone the closing of the merger. In a Second Request, the parties would have to substantially comply with the DoJ’s or the FTC;s request for further information, for which there is no time limit. Once the parties have substantially complied, another 30 calendar day review period will start.

Does it follow from the fact that the PEP/PBG/PAS merger lacks any horizontal issues that the merger will result a quick antitrust resolution? No. There are two things to consider here. First, the FTC’s or DoJ’s track record in a given industry. Second, how complex the transaction is.

Complexity of the transaction is important because the FTC and the DoJ have scarce resources to look at a particular merger. Don’t forget that there are lots of mergers ongoing at the same time, and as a result, the DoJ and the FTC have to allocate resources (time and staff) efficiently. The antitrust authority has 30 days to decide whether a given merger deserves an in-depth investigation. What can be done in 30 days? Not much; the antitrust authority requests data on the companies’ products, the companies’ financial reports, name of the customers, suppliers and market share data. In the event of some overlaps or potential competition concerns, the antitrust authorities will contact major customers and suppliers, and if these do not complain, will allow the merger to proceed after the expiration of the 30 day HSR waiting period.

In the PEP/PBG/PAS merger, we are skeptical that the antitrust authorities will reach a quick resolutions on the deal. Why? The FTC has a track record of looking at bottling integrations very carefully. The FTC published an interesting booklet focusing on antitrust issues related to the US carbonated soft drink industry in November 1999 (prepared by staff members of the Bureau of Economics of the FTC). The FTC report analyzed bottlers in the U.S. carbonated soft drink industry and the effect of consolidation on carbonated soft drinks. Although the FTC’s study concluded that vertical issues were not of serious concern, we should conclude that the FTC will likely be concerned about the PEP/PBG/PAS merger. In this specific case, our best guess is that the FTC will be concerned because both PBG and PAS distribute products of PEP’s competitors (such as Dr Pepper). The FTC has historically been concerned that, as a result of consolidation, third parties’ products may be excluded, resulting in a price increase for consumers. Considering this, we pencil in a longer review period for the deal.

After a September 11th HSR filing, PEP announced on October 9th that it had withdrawn its HSR report forms from the FTC, and that it intends to re-file. A withdrawal of an HSR form can have various effects on a spread. If clearance is expected, then a withdrawal is negative, since it shows that there are still concerns to address. If a lengthy review is anticipated, then a withdrawal is largely a non-issue. It is positive is when the companies re-file the form, because it shows that they are confident that the material presented will be sufficient to gain clearance. When the form is re-filed, the clock is restarted, giving the FTC an additional 30 days to review the transactions. The withdrawal and re-filing process is done to prevent a formal extended review or Second Request (we will review Second Requests in more detail in a later post). On November 10, PEP announced that it once again withdrew its HSR forms. As of today, PEP has still not re-filed its application with the FTC. In PEP’s case, the market clearly expected a lengthy review and as a result the spread did not move too much.

On January 11, 2010, PEP disclosed that that it believes it can complete the deals by the end of the first quarter of 2010 and do so without a remedy that would constitute a material adverse effect.

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Monday, January 18, 2010

Merger Arbitrage Example #1

For our first merger arbitrage example, we look at BRK's acquition of BNI. Berkshire Hathaway Inc (BRK/A) announced on November 3, 2009 a definitive agreement to acquire the 77.4% of Burlington Northern Santa Fe Corp (BNI) not already owned by BRK for $100/share in cash and stock. The deal price represented a 32% premium to BNI’s November 2nd closing price. The expected closing of the merger is in the first quarter of 2010. We will analyze various aspects of this transaction, including the offer structure, valuation, and the regulatory process.

The Burlington deal certainly answered the questions of what Berkshire Chairman and CEO, Warren Buffett, plans to do with the company’s $23.8 billion cash balance (as of September 30, 2009). The $44 billion transaction value makes BNI Buffett’s largest acquisition. It also provided a glimpse of how Buffett is seeing things, as he is an investor who is widely followed, and indeed, worthy of respect and emulation. Buffett called this deal “an all-in wager on the economic future of the United States”. Moreover, the merger, which Buffett deemed “a huge bet…on the railroad industry” caused Burlington peers Union Pacific Corp (UNP), CSX Corp (CSX), and Norfolk Southern Corp (NSC) to gain an average of 6.8% on November 3rd.

Let’s assume that it is November 2nd and we get into the office hearing the merger announcement. What is the first thing we do? First, we have to spend time to dissect the merger announcement. Risk arb is about being meticulous, or as Schoenberg, the composer, once said “the only way that does not lead to Rome is the middle way.”

The first read of the announcement reveals that we will have to deal with prorationing and a collar structure (we will deal with them in-depth in a later post). The agreement provides that each BNI share will elect either $100/share in cash or a variable amount of Berkshire Class A or Class B common stock, subject to proration if the elections do not equal 60% cash and 40% stock. Proration is required because investors generally prefer cash, and this limits the amount of cash that Berkshire has to pay out. The stock element is accompanied by a collar, whereby the price of Berkshire stock determines the number of shares payable to Burlington stockholders. There are different types of collars but for this transaction, the value of each Berkshire share received is fixed at $100 if the price of BRK/A at closing is between $80,000 and $125,000/share (BRK/A was $98,750/share at announcement). The ratio will be fixed at 0.001253489 shares of BRK/A per BNI share for values below the collar range, and 0.000802233 shares of BRK/A per BNI share for values above the collar range. While the majority of the shares issued will be Class A, for the holders of smaller amounts of BNI who elect the stock payout, Class B shares will be needed. To facilitate this, Berkshire’s board approved a 50-for-1 split for its Class B stock. This split is subject to shareholder approval (we already know that the stockholder vote will take place on January 20th).

So once we know the transaction structure, we can take a closer look at the risks related to the transaction. From the date of announcement our brain focuses on one single question: what could derail the deal from closing? We have to look for every single risk element, even if some of them may seem irrelevant now. Never forget that something irrelevant now could become decisive at a later stage (especially if the deal takes several months to close).

The first step will be valuation. The Burlington deal was announced pre-open, so we need to have an idea of where the price will open. If the deal undervalues the target, the stock price could trade above the deal price (there could be counter bidders, or stockholder opposition to the deal). If the deal overvalues the target, then the bidders’ stockholders could oppose the deal, or the spread could simply be too tight to enter. For the Burlington deal, $100/share values BNI at about 8.4x consensus 2010 EBITDA. This multiple is above the average 6.9x where the aforementioned comps (UNP, CSX, and NSC) are trading. Another metric to consider is the multiple at which previous deals in the space were reached, and in this case, the prior Railroad deals analyzed were done at an average of 10.0x (not an alarmingly large discrepancy considering current market conditions). Additionally, the 32% premium to the November 2nd close for BNI’s share price is in-line with the premiums for previous Railroad deals. In short, the valuation is fair, and BNI should not trade through (with a negative spread), nor should it have an inordinately large spread. The transaction requires approval from two-thirds of BNI’s shareholders (other than the share held by Berkshire). So given our valuation analysis, we conclude that the stockholder vote is unlikely to be an issue (who would vote against Buffett?).

The second step in risk localization is regulatory approvals. A merger typically has to be approved by regulatory authorities. The most obvious regulatory authority is US antitrust (Federal Trade Commission and Antitrust Division of the Department of Justice). The Hart Scott Rodino Act is very important, and deals often trade based on the perception of how well/poorly the HSR review is going (we will look at them in more detail in a later posting). Having read the announcement, we know that the transaction requires antitrust clearance under HSR, and approval by the Federal Communications Commission (FCC). This deal poses little antirust risk, since BRK is not a prominent railroad operator. No wonder that BRK received HSR clearance quickly, on December 4th. The FCC is usually an important regulatory authority for telecom-related deals, however, we assign a low probability to FCC related issues here, given that the only reason the deal requires FCC approval is that trains use radios to communicate with the communications center. The deal has since received FCC approval. So, provided the low antitrust risk, we determine that the estimated first quarter closing is manageable.

Our analysis for the merger announcement day is more or less complete. We have done the job that was necessary to decide whether we want to enter the trade. The Burlington – Berkshire deal is a fairly safe transaction for merger arbitrageurs. The buyer is legitimate, the strategic rationale makes sense, there is no regulatory concern, and financing is not an issue. The market opens and although the spread is tight, we like the deal. In the meantime we wait for the next step in our risk localization process: the publication of the Merger Agreement. The current spread is 0.9%, which represents a 7.6% annualized return, assuming an early March deal closing. Now, 7.6% a year is hardly the most attractive opportunity for capital allocation, but due to its safety, it is position in many arbitrage portfolios (and let’s not forget about the current low interest rate environment). We will some cover higher risk, higher return situations in the future.

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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.

Email

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