Safeway merger arb: get the Casa Ley CVR on the cheap

Albertsons acquisition of Safeway is a done deal after receiving clearance from the FTC today and the company expects that the merger will be completed within the next five business days. When a deal is this close to being completed the spread between the share price and the offer price is usually non-existent, but Safeway’s case isn’t that straightforward since shareholders will receive two contingent value rights (CVRs). The merger consideration will consist of:

  • $32.50/share cash consideration for the merger
  • $2.38/share consideration for the sale of Safeway’s PDC subsidiary
  • $0.07/share CVR related to this sale consisting of money in escrow
  • An unknown amount for Safeway’s 49% stake in Casa Ley since it hasn’t been sold yet

The biggest unknown factor is the CVR for Casa Ley, a Mexico-based food and general merchandise retailer. Safeway estimated that the value of PDC and Casa Ley would be between $3.45/share and $3.85/share. If we subtract the $2.45 that was received for PDC it means their interest in Casa Ley should be worth something between $1.00 and $1.40/share.

Safeway merger presentation on CVRs

With Safeway currently trading at $35.15 we can buy the two CVR’s for just $0.27. I think the $0.07/share payment for the PDC CVR has a relative low risk, so we would effectively be buying their Casa Ley stake for just $0.20/share. That sounds like a pretty sweet deal to me!

The timing of the Casa Ley payment is uncertain. The deadline in the CVR is set at three years after the close of the merger and if it isn’t (fully) sold by then CVR holders will receive fair market value (see page 154 in the merger agreement for more details). Both CVRs are non-transferable so if the sale of the Casa Ley stake takes a lot of time you will have zero liquidity for years (the $0.07/share for the PDC CVR is payable within a year though). This could exactly be why the market is offering the current deal.

I don’t think that owning assets with a limited liquidity is a problem, since owning stocks should be done with a long-term time horizon anyway. And if the market is willing to pay a significant risk premium for owning illiquid assets I’m happy to pocket it. It could of course also be the case that I’m simply missing another risk that the market isn’t…


Long Safeway

21 thoughts on “Safeway merger arb: get the Casa Ley CVR on the cheap

    1. Alpha Vulture Post author

      Yes, that’s also what I figured out. Think it makes sense since what can someone deliver who is short a call? The CVRs don’t trade and have an unknown value. You can buy cheap puts to reduce margin requirements if you have an account with portfolio margin though (this is what I have done).

        1. Alpha Vulture Post author

          I bought the September puts, but everything that has more than a couple of weeks till expiry should be good I think. But if the price is the same the longer term option is of course a little bit more attractive.

  1. K2

    Just trying to value Casa Ley stake.

    SWY had equity in earnings of unconsolidated affiliate of $13.5mm for the LTM period. I calculate that using $17.6, $17.5, and $13.0 million in 2013, 2012, and 2011, respectively; $10.1 and $14.2 million for the 36 weeks ended 9/6/14 and 9/7/13, respectively.

    There has been approx 10-15% currency devaluation from the LTM period during which SWY would have translated the MXN earnings in USD. Let’s use 15% for conservatism.

    That makes LTM equity from earnings in unconsolidated affiliate of $11.5 million.

    Kroger trades @ 20x earnings. Using 10, 15, and 20x (I would assume a significant discount as the 5th largest Mexican chain vs one of the largest US chains).

    Applying 10, 15, and 20x to $11.5, I get implied value to the 49% stake in Casa Ley of $115, $173, and $230mm.

    With ~231mm SWY shares outstanding, I get an implied value of 50c, 75c and $1.00/share, respectively.

    If I assume your 20c cost assumption, you still are looking at significant upside, but not as attractive than at first glance.

    Let me know what you think of that analysis.

    1. Alpha Vulture Post author

      You could be right, but though to value a business if you only have earnings. Based on TTM earnings $1/shave might be too optimistic but based on 2013 earnings it seems reasonable. The book value of the investment in Casa Ley is US$206 million so something around, or perhaps a bit lower than, $1/share might be reasonable. When you buy it at $0.20/share I think it’s probably going to work out fine 🙂

  2. DavidR

    Just wondering about capital allocation to such an investment which is so short term… If I am correct you are calculating roughly an overall profit of $.80 for an investment of $35.15. However, the amount of time is extremely low between when you invest your $35.15 and when you get it back, less the $.20 you pay for what you believe is worth $1+.
    And if something weird happens, the world blows up or whatever, there may be a bit of risk… 2-3% profit for investing in something for basically a week which has probably 99% chance of working out. Is that about right?
    I like the idea of buying the puts as it reduces risk, but how to get them executed at a reasonable price and which maturity do you go for? Bid/ask spreads are somewhat wide for these things…
    The overall idea is very interesting. Perhaps most interesting is how you allocate your portfolio and how you try to manage the risk of something like this.

    1. Alpha Vulture Post author

      You can buy the options pretty cheap, ask is $0.05 for various options with a $34 strike (since the deal will close very soon it doesn’t matter a whole lot which option you buy). You are probably still overpaying at that level given the low risk involved, but it allows you to minimize your margin requirements.

      I think the way to play this idea is just to allocate some excess cash to it that isn’t earning anything and accept that you won’t make a whole lot of money since it ties up a lot of capital (for a brief period). The other alternative is making it a bigger position, but hedge it with puts so you can create more exposure to the CVRs.

      1. DavidR

        I saw those 34 strikes at $.05 and I grabbed a few before they were all gone. I am thinking of adding a bit more to this position which will end up being unhedged unless I move to the 33 strikes…I have to think about if it is worthwhile to bother hedging at that point.

        My allocation will likely be about 5% of my portfolio in the end I think which is fine.
        However, given the risk/reward of this trade, especially if the put options are available at reasonable prices, I thought that perhaps you were allocating a much larger portfolio percentage into this trade. With puts at a 34 strike for $.05 and the price at $35.20 ish you would end up paying $.30 for what we think is worth about $1. A blowup results in losses of $1 or so and a win with a gain of $.70. Given the odds of winning being so overwhelming one could make an argument that you really want to load up on something like this unless the $1 estimate could be way off.

        1. Alpha Vulture Post author

          I did in fact allocate more than 5% to this trade: it’s a big position for me and that’s why I have hedged it with puts. Actual value at risk is pretty limited though.

          1. DavidR

            On thinking about it some more I have now allocated roughly 10% to this trade. As long as I have some puts to protect me on the downside even though the initial investment amount seems very large of course you are right that the real value at risk is quite small.
            If we consider that in a losing scenario we lose $1 vs. a gain, if we win, of $0.50, but with 70% likelihood has Kelly telling me to bet 70% of my portfolio. 10% may be far too low…

          2. Alpha Vulture Post author

            I think you have to be very careful with using the Kelly criterion since that is for sequential uncorrelated bets while a portfolio is a set of parallel and correlated bets, and it also doesn’t account for the uncertainty and possible variance in your estimates.

          3. DavidR

            I agree with you about being careful about using Kelly in the portfolio. Many think of using Kelly/2 to take your points into account. For me, it simply made me consider increasing the portfolio allocation to 15% from 10%.

            If you really want to get into the weeds, you could try something like this:

            The bottom line is that the Kelly criterion simply tells you if you have what is a really great bet or not. Then use common sense to determine how much to allocate. This bet, if the risk is hedged out, is almost certain to win and any losses, if they occur, are not too bad. So the Kelly result matches what one would expect.

  3. pietje

    Slightly optimistic because you should discount the $1 win by a few years. But yeah, still looks like a good deal. I also bought ~20% extra $34 puts just in case something goes horribly wrong. Worst case the deal falls through and the stock trades at $34, I lose 3% on my long position but can probably sell the at-the-money puts for a small profit.

    That’s why I tried buying long-dated puts but after buying a few contracts the offer went up on all of them. Feb 13 still available though.

    1. Alpha Vulture Post author

      Yes, you could do an IRR calc to figure out what the return is when taking the timing of the payments into account. Luckily for us that’s exactly what you can find in the spreadsheet linked in the comment below 😀

  4. rowerburn

    Interesting write-up!

    A couple of quick notes, mainly from the merger proxy:
    1) As part of merger negotiation process, SWY Management valued the CVRs at $3.56-3.96 and $3.56-3.87 as of 02/06/14 and 02/15/14, respectively [Definitive Proxy, pages 63-66]
    2) On 03/5/14, another bidder, “Company A,” valued the CVRs at $3.95 [Definitive Proxy, page 68]
    3) As part of the Greenhill fairness opinion, the CVRs were valued between $2.56 and $3.64 [Definitive Proxy, page 96]
    4) Goldman’s fairness opinion did not specifically analyze the CVRs and instead relied on SWY Management’s representation that the CVR Payment amount will not be less than $3.44 [Definitive Proxy, page E-1-4]
    5) As part of the sales process in Dec13-Jan14 , CEO Edwards met with other owners of Casa Ley [Mr. Juan Manuel Ley Lopez?] to inquire about their interest in acquiring the 49% stake held by $SWY, but the other owners did not express any interest in acquiring the stake at that time [Definitive Proxy, page 60]
    6) Chairman/CEO and family owner of Casa Ley, Mr. Juan Manuel Ley Lopez [his father was a chinese immigrant that opened the first store in 1954], seems to be kind of a big deal in Mexico as he previously has served as a BoD member of Banamex and Telmex

    For reference, below is a dropbox link to my detailed Casa Levy valuation and arb calcs:

    Assuming a full three years to Casa Ley CVR monetization, I am coming out with annualized IRRs of 28.7% and 36.8% at $0.75/CVR and $1.00/CVR, respectively, utilizing the closing price today of $35.14/share. At least $0.75/CVR in eventual CVR monetization seems possible as represents less than 15x LTM earnings and a ~17% discount to book value as of 3q14. Any further comments/suggestions/questions are appreciated.

    1. Alpha Vulture Post author

      Thanks for your comment and sharing your spreadsheet! Not sure where I got the $3.45/share and $3.85/share range from for the CVRs, but that’s also an estimate from management that was mentioned in a SEC filing. But whatever the final outcome, I think everything is pointing towards a favorable deal at the current price for SWY :).

  5. Joel Wittenberg

    Has any information been released since the merger in January 2015 with respect to the likely timing of the payouts for each of the CVRs?

    1. Alpha Vulture Post author

      No new information as far as I know. Think we just have to wait till the expiry date of the CVRs. Unlikely that the Casa Ley stake will be sold IMHO.


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