Showing posts with label BNI. Show all posts
Showing posts with label BNI. Show all posts

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.


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.


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