Geoff Gannon April 26, 2006

Suggested Link: Value Discipline on Engelhard Recapitalization

Rick of Value Discipline just wrote a good post on the developing Engelhard recapitalization / BASF cash tender story. A review of Engelhard’s financials lead Rick to conclude that “the price being bid for EC appears quite fair, but certainly not generous”.

I agree with that conclusion. When I first looked at the original $37 offer, I thought it wouldn’t be particularly attractive as anything but an arbitrage commitment (in other words: if a deal couldn’t be worked out, there was no value in Engelhard).

Since then, the market price of Engelhard (EC) shares has not provided a good spread. In fact, if you look at a chart, you’ll see that the consensus has been that BASF (BF) was being a little cheap here. Shares of Engelhard have traded above the BASF offer, so there was zero opportunity for an arbitrage commitment based on public information (i.e., the announced BASF bid).

If you wanted to play the BASF offer, you had to engage in speculation. Only a higher bid would provide a profit if you were to buy shares at the market price.

Unfortunately, this is a contested takeover, not a bidding war. While buying above the announced tender offer is always a speculation, doing so when there isn’t another bidder is far riskier.

There’s the risk that the potential acquirer will walk away without a deal that would allow you to tender all of your shares. There’s also the risk that some adverse development will permit the acquirer to do a friendly deal below the expected offer. Finally, there’s the risk that a deal will be done along the lines of the already announced offer. If you were to buy shares in the market above the offer price, you would incur a small loss when the target’s board agreed to the previously proposed terms.

If no agreement was ever reached, you’d have two possible problems. The first is that you might not want to sell your shares when it became clear the potential acquirer was backing off, because there could be a lot of other sellers at that moment. Some owners of the target’s shares might be unwilling or unable to hold their shares for long after it was clear there wouldn’t be a deal, because they don’t want to be involved in a general investment. These investors only want to hold shares of a target or potential target; they don’t want to hold a stock that will rise and fall along with the general market.

The other possible problem with these contested situations is that the target’s board might do damage to the long-term health of the company. In this case, I’m not convinced the board is dead set against a deal. They may just be holding out for a bit more money.

Of course, Engelhard may still be wrong to engage in this recapitalization, because BASF won’t bite. However, I think the situation at Engelhard is a bit different from one where the board wants to block a deal at any cost. In those situations, the actions taken are rarely in the best interest of long-term shareholders. Here, I think the board may have the shareholders’ interest in mind. The board is playing hardball. That tactic may backfire; but, it does seem justified by the fact that BASF’s offer can’t be called overly generous.

While friendly deals can fall through, I still think they’re the only ones to play if you want to engage in arbitrage. Buying into hostile situations or buying on rumors that a company is being shopped around may work from time to time; but, that kind of operation is very different from looking to profit from the spread on an already announced friendly deal.

If you’re interested in special situations, you may want to read my recent post on the subject. My best advice is still to read You Can Be a Stock Market Genius by Joel Greenblatt and visit Fat Pitch Financials. The kind of deals George looks at are the ones I would suggest individual investors consider instead of a contested, higher-profile situation like this one.

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