At the end of October Heartland Financial USA (NASDAQ:HTLF) announced that it would acquire Founders Bancorp (OTC:FBCP) in a $29.1 million transaction. No details are known yet about the deal since the press release doesn’t contain any, and the proxy statement isn’t yet available. This could very well be the reason why there is an opportunity, although the low liquidity of Founders Bancorp might be an even bigger reason. The stock trades on the pink sheets, and for some reason it is impossible to buy it using Interactive Brokers, TD Ameritrade or SogoTrade. In the end I managed to buy it using Binck, a small Dutch broker.
At first sight the deal doesn’t look super attractive. The press release mentions a $21.87/share consideration while the stock is now trading at $21.40: a spread of just 2.2%. What makes it interesting is that the deal is a 70% stock and 30% cash transaction. While the proxy statement for this deal hasn’t been released we can simply look at earlier deals that Heartland Financial has done to figure out what are likely the most important terms. In previous deals the amount of HTLF stock to be issued was based on the 20-day VWAP of the stock in the days preceding the close of the merger. So while HTLF is up 16% since the deal was announced this doesn’t increase the per share consideration.
What does offer an opportunity is that in previous deals there was a cap and floor on the VWAP price used by Heartland Financial to compute the number of shares that will be issued in the merger. For CIC Bancshares deal the cap was +15% and -15% compared to the price the day the deal was announced, and the Premier Valley Bank deal had the same cap and floor. With Heartland Financial up 16% since the Founders Bancorp deal was announced this cap has most likely been reached, and offers at this point an unique opportunity. When Heartland Financial drops from the current level we get more HTLF shares so the consideration remains effectively $21.87/share, while if HTLF goes up more we profit directly. In other words: we are getting a free call option on HTLF by purchasing FBCP.
We can make a rough approximation of the value of this option by throwing the following variables in a Black-Scholes option calculator:
- Spot price: 43.30
- Strike price: 43.01 ($37.40 price before merger announcement + 15%)
- Volatility: 30% (historical volatility for the past year is 30.5%)
- Interest rate: 0.50% (yield 3-month US government bond)
- Dividend yield: 0.92% (current yield HTLF)
- Expiry date: 2-28-2017 (merger is expected to close in Q1 2017)
If we feed this to the calculator it spits out an option value of $2.75. Since the merger is 70% stock the same percentage of the option value accrues to one Founders Bancorp share. So the value of the merger consideration is $21.87 + $2.75 * 0.70 = $23.81. This implies a spread of 11.2% which is quite juicy.
A final complexity is that the press release mentions that the payment per share is subject to certain adjustments, without mentioning what kind of adjustments these are. Based on previous deals this is probably an adjustment if tangible equity of Founders Bancorp suddenly drops below a certain level. I don’t think this is a big deal. If book value suddenly ends up a lot lower it means there are some hidden cockroaches in the bank, and if it wouldn’t result in a lower takeover price it would otherwise probably result in a failed deal. It’s the kind of tail risk that is almost always there in a merger arbitrage.
So I think that what we have here is simply a merger that is just being ignored by the market, not a merger that is exceptionally risky. Therefor I think the current spread is way too high, and Founders Bancorp is an attractive addition to my special situations portfolio.
Author is long Founders Bancorp
Interesting post, thanks. For other readers, on Schwab I put a small after hours gtc order in that doesn’t seem to be rejected like it is at IB/TDA… may confirm if it actually works next week.
Thanks for this. Couple of questions/clarifications. Assuming a purchase of 100 shs of FBCP at $21.70. With the 15% vwap Price cap hit, this would assume a stock component of roughly 35 shs of HTLF @ 43.01 (70% of $2170).
If the price of HTLF drops below the 15% cap, the conversion ratio would be adjusted to maintain the 70% of the equity component correct? So essentially no downside risk from a drop in FBCP Price..
So for the trade to make money at the FBCP buyout price, HTLF must remain above $43.01 correct?
I valued it using the same methodology as CIC Banchares transaction. (Warning: this is all under the assumption that they use the same structure as this transaction).
CIC Bank Transaction
HTLF was trading at 37.74/per share at the time of announcement of the CIC Bancshare acquisition on October 23, 2015. From public disclosure I found that the midpoint of the collar range was 35.47 – which is equal to a 93.9% of the trading day value of $37.74. The collar range (in public documents) was 30.49 – 41.25 and with a maximum and minimum conversion ratio between .36 to .27. So the range of values for the stock portion of the deal was $10.97 (minimum) to a maximum of $11.14.
Founders Bancorp Transaction
HTLF was trading at 37.45/per share at the time of announcement of the Founders Bancorp acquisition on October 31, 2016. I calculated the mid point of the collar range from the CIC Bancorp transaction 35.20 – which is equal to a 93.9% of the trading day value of $37.45. I inferred the collar range based on the same proportions in the CIC Bancorp transaction to calculate the range which was 30.32 – 41.03 and with a maximum and minimum conversion ratio between .50 to .37. So the range of values for the stock portion of this deal assuming a fixed cash value of 6.561 (30% of 21.87) gave me a stock valuation range of 15.28 – 15.51.
This essentially meant that at the very worst case scenario you would receive total value of 21.84 with a best case scenario of $22.06.
I want to be clear that I made the following assumptions that could greatly impact the valuation ranges:
1) I assumed the same collar range and mid point range proportional values would be used as the previous transaction – assess a probability to this
2) I assumed that cash was fixed at 6.56 per share (21.87*.30) – assess a probability to this
3) That minimum requirements regarding the lease book didn’t decrease over time. – assess a probability to this
Cash Value $6.56 $6.56 $6.56
Equity Range $15.28 $15.31 $15.51
Total Value $21.85 $21.87 $22.07
HTLF Share Price Implied $30.32 $35.20 $41.03
Share Price Today $21.70 $21.70 $21.70
Collared Return 0.67% 0.78% 1.70%
HTLF Share Price 12/2/2016 43.3
Equity Value $16.37
Cash Value $6.56
Total Value $22.93
Merger Arbitrage Return 5.66%
For every $1 above 41.03 you get an incremental .38 lift. If the HTLF shares go below $41.03 the collared return matrix isn’t as appealing.
You get a free option on the HTLF share price with incrementally better economics after $41.03 where the least you could earn on a downside barring any adjustments or changes in assumptions above of $21.85.
Please provide comments or suggestions of where my logic is flawed or inaccurate – as it would help me become a better investor.
Thanks for this site – great ideas and readable enough for me to take a deeper dive into the analysis.
I don’t really understand what your stock valuation range of 15.28 – 15.51 represents? The value is at minimum 70% * 21.78 while the maximum doesn’t have an upper bound since HTLF can (in theory) go up an infinite amount.
Take a look at TBNC. Another stealth payout case. It is likely that the equity of TBNC will increase by 1-2M$ by the merger close, which should translate to approximately $.25-.50 increase in payout sometime in Q1 2017.
Thanks for all your good work on this blog.
Thanks for the idea. I’m wondering if you have any idea what the impact of rising rates are on the book value of the bank?
On TBNC: I guess the most important thing is knowing how the bank will classify the special dividend. When it will be classified as Return of capital non-US holders will be better off than when it is classified as normal income, as taxes will decrease the payout substantially.
Hmm, I think trying to understand how book value behaves when rates change is also quite important since rates are up significantly in the US since the merger was announced. Since the bank presumably has mostly assets that are long-term in nature and liabilities that are short-term in nature (typical for a bank) book value might have gone done meaningfully the past months.
And we aren’t getting anything for the stuff that is propelling other bankshares higher: that less regulation in the future might mean higher earnings, or that higher rates add earnings power. So I’m not too confinced about TBNC since the adjustment can also work against us, and we can get less than $10.
Can you say anything about how sure you are as to whether the terms of the deal are the same as the previous deals? I guess the terms are already determined, but only not made public yet?
I think it’s highly likely, but of course I can’t be 100% sure. And yes, the terms are most definitely already determined.
Funny enough, 15 minutes after your comment the filing was there and showed the terms were indeed the same as previous deals. One thing I was thinking about though, isn’t it more correct to use a lower volatility rate in the calculation of the option value, since the spot price is determined on the 20-day VWAP of HTLF stock? The 20-day VWAP is much less volatile then the stock price itself.
Looked into purchasing FBCP on TDAmeritrade. A rejection message said the stock could not be purchased on TDA. Stock certificates were necessary to purchase. Someone’s sense of humor.
That’s what I wrote in my post, impossible to buy with TD Ameritrade (and a bunch of other brokers). Probably why there is an opportunity.
Any idea if Binck will let you make an election between cash / HTLF stock? I tried asking customer service, but the guy that answered didn’t even understand the question and started talking about it being a “stock dividend”.
This is how shares are treated if a shareholder does not make an election: “Shares of Founders common stock subject to no election will be treated as cash election shares or stock election shares so as to minimize the amount of any cash or stock proration.”
Let’s say that it is still work in progress… so far haven’t been able to make the election, but not the first time that the corporate actions desk at Binck needed a bit of help to get it right.
Ok, thanks. I’ve just followed up on this with them as well.
Good, a little bit more attention can’t hurt 🙂