Giant Industries: A Risk Arbitrage situation

As previously stated by the blog’s philosophy statement, Purecapitalism will try to seek out good value investment strategies. One of these strategies is based on the concept of risk arbitrage other known as merger arbitrage. This opportunity is created by many different factors such as: time value of money, risk that the deal falls through, the underlying change in the value of the stock market, or regulatory restrictions. It first is imperative to examine the process of a merger. The first step is the agreement in principal and then the definitive agreement. After the definitive agreement, the firms file a SC 14D1 agreement and files according to the Hart-Scott-Rodino act. Then the firms wait for the shareholder vote and the HSR approval. Examining this current deal, Western Refining (WNR) agreed to buy Giant Industries (GI) for $83 per share. Then bad luck struck the early arbitrageurs; Giant Industries had not one, but two fires at their refineries. This obviously reduced the value of the sale and on November 13, the two firms agreed to a new selling price of $77 per share. The prices of GI on the previous closing date, November 10, was $80.95 and closed on November 13, at $76.25, a loss of 5.8%. A merger arbitrageur is trying to make small amount of money on many transactions, so this one day could set them back for the whole year. This caused most of the original arbitrageurs to sell and take their losses. Fast forward to today, GI is trading at $75.22 and the shareholder meeting is convening on February 27 to approve the merger. WNR is still going ahead of the deal, and has announced how it is going to retire GI’s debt. So the deal is still on and is supported by both boards. The next step is to value the situation and deal. There are three main elements to a risk arbitrage situation. First, is to look at the annualized expected return, risk, and the probability. Below are the calculations for expected return, using three different closing dates. First is using Friday March 2, the closing date. Second is using a 15 days after, and lastly using 30 days after that. Most probable will be the March 2 date since the shareholder meeting is on February 27, which should approve the merger and the deal should close shortly after. The rest are less likely but regulatory hang-ups could happen and could delay the close for a short period of time. I calculated the return on these three methods and also if 50% leverage was involved. Here are the results:

The next step is to determine your risk, which includes your up-side price and down-side price. For the upside we will use the deal price of $77 per share. For the downside we will use the pre-announcement price range of around $68 per share. One also has to account for the fires and also that is trading at around 11X next years earnings so that the downside is limited. I will give the probability that the deal goes through at 70% and the stock falling to $68 at 30%. Here is the output for this calculation. I based the annualization on 55 days in this example.

If you make the annualization to the first and second scenarios then the risk adjusted return goes to 77.37% and 30.9% respectively. This is the type of situation I like to invest in. The risk adjusted return is great compared to the downside risk. It seems the early arbitrageurs have been burned so that this provides an excellent chance for special situation investors to make an outsized risk adjusted return. The deal is all cash deal also so keep that in mind for taxable accounts. As always this is merely a single person’s written opinion, not a suggestion or advice to buy or sell any securities. Please do your own research. I will be waiting for others input and questions.