ALJ Regional Holdings merger/tender offer arbitrage

ALJ Regional Holdings (ALJJ) announced yesterday that the company has entered into a definitive merger agreement to sell their KES subsidary. After the merger is completed the company will basically be an empty shell with approximately $51 million in cash ($0.86/share) and large net operating losses. The company also announced that they will buy back more than 50% of the outstanding shares after the merger is completed at a price between $0.84 and $0.86 per share. For some background on the company I recommend checking out this post at OTC Adventures.

The company has 59,467,498 diluted shares outstanding as of yesterday, and Mr. Ravich, chairman of the board and owner of 13,142,221 shares (22.1%), has indicated that he will not tender his shares. This means that if everybody except Ravich tenders their shares you can sell 64.8% of your position to the company at $0.84/share. If you would buy $1000 worth of shares at $0.72 you would get back ~$750. What you keep are 490 shares with a $244 cost basis, or a 43% discount to the future net cash position of the company.

There are multiple ways to win here. I think it’s highly likely that not all shareholders will tender their shares. The current board, with Ravich as the leader, accomplished a lot the past years, and after the offer is completed the chairman will own almost 50% of the company. And while the tender offer is for roughly the cash value per share it ignores the valuable NOL assets. I imagine that there are investors who want to remain invested.

In a best case scenario the company will buy all or almost all your shares at $0.86/share and you make a quick 19%, but if the proration factor is for example not 64.8% but 85.7% you are already free rolling on your remaining position (assuming a $0.84/share price in this case).

A second way to win is if the discount to net cash value shrinks after the deal and tender offer are completed. If the discount for example would shrink from the current 43% to 20% it would mean that the share price post tender offer would only drop from the current $0.72/share to $0.70/share. Again using a hypothetical $1000 investment: you would own 1389 shares and sell 899 shares to the company at $0.84/share. The remaining 490 shares would be sold for $0.70/share for a total amount of ~$1100 or a 10% return.

The worst case scenario is obviously that the merger isn’t completed and the tender offer is cancelled. In general a very high percentage of definite merger agreements are successfully executed, and don’t think there are any special issues in this deal that makes this one above average risky. The acquirer has executed multiple successful deals in the past, and I don’t think there are potential regulatory or political issues with a small deal like this. A risk is financing since Optima has not yet closed the necessary arrangements, but with Jefferies as an advisor I would expect that they got this covered.

Conclusion

While it’s hard to know how this will exactly play out I think the odds are in my favor at the current prices. If the deal is completed successfully, and I think it will, the worst case scenario is that I bought a cash shell at a 43% discount to net cash value. I’m comfortable with that investment given the big discount and the fact that Mr. Ravich will be a major co-owner. And most likely I’ll effectively be buying less shares at an even higher discount if not all shareholders decide to tender.

Disclosure

Long ALJJ

More reading

Whopper had basically the same idea as me, and you can find his thought here.

6 thoughts on “ALJ Regional Holdings merger/tender offer arbitrage

  1. Keith Van Allen

    I don’t think you’re giving enough consideration to the deal falling through. ALJJ was a forty-cent stock for weeks before the deal was announced, plus operating results appears to have plateaued recently. If the deal falls through, the stock is going back to forty cents IMO and you’ll have a 45% paper loss–ouch! I agree that all indications are that the deal will complete, but that 45% downside needs to be given greater consideration vs the 12% arb upside…

    Reply
    1. Alpha Vulture Post author

      I’m fully aware that if the deal doesn’t go through the downside is large, that basically always the case in a merger arb. What matters is the combination of the probability of the deal failing and the downside. But if you google around a bit you’ll see that the probability of the average merger deal closing is quite high. That’s why the spread in a lot of merger deals is often minuscule, and note that a lot of research looks at the complete universe of merger deals, so also included are (relative) high risk deals with for example regulatory, political or fraud issues.

      I think the main reason the spread here is still quite high is that there isn’t a ‘clean’ way to play the merger arb. You don’t know how much shares you can sell back to the company, and you don’t know what the price of the cash shell is going to be post merger.

      Reply
      1. Eric Burnside

        Keith–
        After assigning a rather arbitrary 85 percent probability to merger approval and a 15 percent probability of merger termination (and thus a likely return to .40/share price for $ALJJ), I calculated an expected annualized return of 22 – 32 percent if the deal gets done in December. This calculation assumes a final tender offer price on the securities of $.84/share, and that all shares available for tender (exluding the chairman’s 13.1m shares) are submitted for tender.

        For those wishing an even greater margin of saftey than that presented could always adjust the probability of successful merger down and see how that impacts expected returns.

        Alpha Vulture–
        You note that after the tender is complete, $ALJJ will essentially be a cash box of $51mm with no debt, and valuable NOL assets. In regard to that $51mm figure, I came across an article that had a slightly different estimate for remaining cash (read here). The author figures the tender offer will raise approximately $112.5mm and that approximately $61.5mm will be used to pay off KES’ outstanding liabilities, preferred dividends due, and pay transaction costs related to the merger. The remaining balance of approximately $51mm will be used to repurchase shares through the tender offer. If that is correct, the remaining cash balance after the tender offer is complete would be something in the neighborhood of $25mm (assuming 30mm shares are repurchased at $.84/share). Of course the share count will be reduced by approximately half, so $ALJJ would still be considered a cash box with NOLs, but I wanted to point that out to get your thoughts.

        Thanks for the great write-up.

        Eric

        Reply
        1. Alpha Vulture Post author

          Eric,

          In my calculations I included the assumption that the company would buy back 30M shares for 0.84/share, resulting in 25.8M in cash post tender offer and 29.47M shares. This increases the amount of cash/share slightly from the estimated $0.86/share post merger to $0.876/share post tender offer. Difference isn’t really significant since the company is buying back it shares for almost exactly the per share cash value.

          Reply
  2. Keith Van Allen

    Eric,

    After reviewing today’s PR, what probability are you now assigning to the ALJJ deal completing?

    (DOW JONES) PRESS RELEASE: ALJ Regional Holdings and Optima Specialty Steel M
    ake Announcements

    – Optima is Continuing Financing Efforts

    – ALJ Special Stockholders Meeting Will Proceed as Scheduled on December
    21
    2012

    – ALJ Tender Offer Will Be Extended

    Reply
    1. Alpha Vulture Post author

      I’m not Eric, but think it’s obvious that the probability of the deal going through is now significantly lower that what I expected when I entered the position. We’ll have to see how this plays out.

      Reply

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