Merger Arbitrage- PLUS Expressway Berhad

One of the things I seek to accomplish during 2011 is to involve more on the special situations space- mostly dealing with spin-offs in US or Europe. However, within our doorstep in Malaysia, we have a very compelling special situations going on with the takeover of PLUS Expressway Berhad. This takeover involve another (usually more risky) branch of special situations investing- merger arbitrage. For those who are unfamiliar with the term, merger arbitrage, it is defined by investopedia as:

A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. A merger arbitrageur looks at the risk that the merger deal will not close on time, or at all. Because of this slight uncertainty, the target company's stock will typically sell at a discount to the price that the combined company will have when the merger is closed. This discrepancy is the arbitrageur's profit.

The investopedia definition involve an acquisition or merger paid by company stock, in PLUS case, it is an all cash deal, hence, it is much simpler. Whereas a stock deal involve shorting one company stock and long the stock of another, an all cash deal simply involve buying the stock of the target firm and hoping that the deal will go through. However, I do feel that the term "arbitrage" in merger arbitrage is misleading, as my definition of arbitrage is a risk-free way of making money without using any money. A merger arbitrage is certainly not risk free and it does involve some initial capital before the deal is consummated.

Before I proceed on to talk about the deal proper, I need to bring up the definition of value investing to let readers who are unfamiliar with the special situations space on why this is a value investing opportunity. Value investing, based on what I understand from Graham and Dodd, is basically a process of buying any asset classes below its intrinsic value at a huge margin of safety. Graham and Dodd nets-nets criteria basically tell us to buy a huge basket of nets-nets stock and on average, these basket of nets-nets stock will perform well although some of it may go to zero. So, if we define value investing as a probabilistic game, it is basically an investment with asymmetric payoff, a low downside if we lose money and a high upside if we make money. In Mohnish Pabrai speak, "Heads I win big, tails I don't lose much". To put it in statistical term, it simply means that we are buying assets that has a high positive expected value. Nassim Taleb talks about betting on long tail event with positive expected value, although he did not mention that it is value investing and he is not a fan of Buffett, the things he is doing is actually value investing. Value investing, to put it simple terms, is investing in asset classes that have a high positive expected value.

Why you should not trust me 100%?

As usual, a little warning on some reasons that you should not trust what I write 100% without doing your own research:

1. This is the first time I am doing any sort of merger arbitrage, so, my experience is extremely limited.
2. I have never held a stock that is subject to a takeover offer, so, my understanding on the matter is limited.
3. I have practically ZERO knowledge with regards to the corporate personalities in Malaysia. I feel that knowledge of corporate personalities is very important when it comes to a corporate exercise involving such an important national assets. My lack of knowledge will make my analysis extremely incomplete.
4. I am threading beyond my circle of competence when discussing about taxation and corporate finance matters in the analysis. So, what I wrote with regards to such matters may be 100% incorrect.
5. I have not followed PLUS that extensively. My knowledge of the company is very limited.

The Situation and Possible Scenarios

The reason that the PLUS takeover is a compelling opportunity is due to the market, I feel, is asking the wrong question. The market is asking the question of "whether Jelas Ulung (JU) deal will be accepted by the government?". The correct question to ask, IMHO, is "Whether EPF-Khazanah-UEM(EKU) will be forced to increase its bid to match JU?". Asking questions such a way will lead to a different analysis of the situation. As I defined earlier, value investing is an investment activity in which we invest in asset classes that yields a high positive expected value. To calculate expected value, we need to define the scenarios and its probabilities.

By asking the correct question, we have three scenarios.

1. JU turns out to be a distraction. It did not manage to post the RM50mil deposit and EKU proceed to takeover PLUS at RM4.60.
2. JU post RM50mil deposit. EKU raised offer to RM5.20.
3. Both EKU and JU walked away from bidding. PLUS shares plunge to RM3.50, a level not seen since 13th July 2010. The first official takeover offer is on 15th October 2010, the closing price on 12th October 2010, a day before the suspension of trading of PLUS shares is RM4.27(Source: Yahoo Finance). The lower price of RM3.50 is used to provide a better margin of safety as well as to take into account of unofficial rumors about an impending takeover that drives up the share price.

The Jelas Ulung Deal

A lot of articles and research reports have been questioning the viability of the JU deal. Some analysts as well as journalists alike questioned the viability of JU offers. The market is doubtful that JU offer is actually commercially viable as JU is not seeking any tax exemption, compensation from the government as well as extension of the concession period. All these doubts is reflected in the closing price of PLUS shares since the JU's offer is announced, which goes as low as RM4.50, lower than that of the EKU offer. The closing price for today(3/1/2010) is RM4.57, still lower than EKU's offer of RM4.60. All these prices reflected the market participants view that JU deal is not viable and will not go through. As a value investor, sometimes,you need to be a contrarian. You need to ask, what if the market got it wrong?

The most damaging report has to be that of UBS which rated the company a sell and said that the concession period need to be extended for another 20 years for the deal to be viable. UBS, being a foreign research house, may carry much more weight in the eyes of local investors as Malaysian tends to think anything foreign is usually better. But, sometimes, my experience tells me that the local research houses may produce better research than the foreign houses. I feel some foreign research report on local companies are being done in a sloppy and lazy manner. I have not look at the UBS report yet, thus, I do not know how they come up with the cash flow assumption [anyone who have the report, feel free to send me a copy :-)].

The good thing about PLUS is that, it is the first company financials that I have ever read that produce its cash flow statement using the direct method. This make it very easy for me to produce my own back of the envelope discounted cash flow valuation. The model done by UBS probably involve at least a hundred lines of variable. My back of the envelope calculation involve just 3 line, LOL. So, the one done by UBS should be more accurate if they fill up all those variable correctly, if not, it may be GIGO-Garbage In, Garbage Out. Here's my numbers: In FY 2009, PLUS churn out roughly RM2 billion of operating cash flow(OCF). Within these RM2 billion, it includes RM225mil in routine maintenance, probably for expenses such as fixing toilets in R&R, planting trees but do not include expenses such as re-turfing the expressway which is done every 7-8 years. The OCF only partially includes compensation from government. Last year, the government are supposed to pay PLUS north of RM 800 mil in compensation, but, my estimate shows that the government probably pay just RM200mil while owing PLUS another RM600mil. The government has been delaying payment to PLUS, the current amount owed by the government to PLUS is around RM 2.3 bil, almost 75% of PLUS annual toll collection. That's the reason why I think JU is not seeking any government compensation, I suspect they are doing their computation based on similar OCF figure and finds that government compensation is not required to make the deal feasible.

Apart from the OCF, since we are doing a firm valuation, financing cash flow is not important. As for investing cash flow, there are a lot of items in the cash flow statement, but, the only item that is important is an item known as "concessions assets". These is a required capital expenditure which probably includes expenses to re-turfing the expressway. The past few years, these item range from around RM300-500mil, but, these numbers includes the expenditure for the 3rd lane of some popular stretches of PLUS. These construction activities had been completed in 2009. So, going forward, I think this CAPEX item can be reduced to RM250mil. I have read some research done by opposition members especially Lim Kit Siang that said an expressway in Malaysia cost 2-3x as much on per-km basis compare to other developing countries. I am not sure about the validity of these statements, but, if it has 10% truth in it, RM250mil is very achievable if the maintenance contract is awarded to the most efficient contractor.

So, with these, we are seeing around RM 1.55bil for FY2010 [2000-200(government compensation)-250(CAPEX for Consession Assets)] of Free Cash Flow to firm that can be used to pay back debt, service interest payments and pay dividends. The current run rate of FY2010 should exceed this figure but I will be more conservative and use this figure instead. I use a 28-year free cash flow to firm discount model, which is the time frame for the remaining concession period (source: PLUS companies announcement). Assuming a 3% annual growth rate for the 28-year period (note: EBITDA has been growing at 8% CAGR for past 5 years) and using the 6% WACC given by UBS, I manage to get a value of about RM30.2bil. By adding the cash on PLUS balance sheet, we have an enterprise value of around RM33.2 bil. JU offer price values the enterprise value at around RM36bil [26b(equities)+13b(liabilities)-3b(cash)]. So, RM36b may seem to be a bit of a stretch. But, if we look carefully at its liabilities, RM900mil is actually deferred tax liabilities. These liabilities can be ignored completely, the reason will be explained later on. So, now we have a deal price of around RM35.1bil. If we look at its asset base, around RM340mil consist of foreign assets such as expressway concession in India and Indonesia. I suspect all these asset actually do not contribute much, if any, to its cash flow. So, if JU dispose these non-core asset at 1.5x EV, it will get another RM500mil, lowering the EV of the deal to around RM34.6 bil. The assets in India and Indonesia should attract some interest as Indonesia has a much lower paved-road-km/1000 people ratio compared to Malaysia. If we used paved expressway KM/1000 people ratio, the numbers is even worst [2.221KM(Msia) vs. 1.519KM(India) vs. 0.779KM(Indonesia) as at 1999. Source: Nationmaster ]. So, there is some potential demand for the Indonesian assets and it should fetch a good price.However, even with the disposal,it is still RM1.4bil short of my intrinsic enterprise value. But, please take note that my valuation is done without considering any efficiency gains. If they manage to find around RM100mil of savings every year, they would be able to get an extra RM2bil in present value terms for the duration of its operations. RM100mil of RM2b in OCF is just around 5% efficiency gains, so, it is quite feasible. In addition, my model assume a conservative 3% annual growth from now on whereas EBITDA has been growing at a rate of 8% in the past 5 years. If JU use a 2-stage model, it can easily find a billion or two.

So, based on my back of the envelope computation, I think the deal is actually quite feasible.

Another thing to note is that, some members of the media as well as some members of parliament has been fooled by the no tax concession demand by JU. They question how on earth JU could make the deal possible if they are not asking for any tax concession. Actually, the highly leverage nature of the deal means that JU probably do not need to pay any tax to the government for the majority of the concession period. JU deal promises interest coverage ratio to maintain above 2x. If EBITDA is used to calculate the ratio instead of EBIT(1-Tax Rate), which is more conservative and a better reflection of cash flow, we get a cost of debt of around 4.4%, which is still a bit low. So, if I mark it up to 6.5%, the current average cost of debt for PLUS, JU will have an interest expense of RM1.75bil (6.5%*RM27b). The AR2009 profit before tax is around RM1.6b, so, JU will probably continue to rake up all these after tax losses for quite a number of years, meaning, JU do not need to pay any tax at all, hence, tax concession is rather not meaningful. PLUS had a tax bill of RM400mil+, by raking up all these operating losses, JU can save RM400mil+. All these operating losses will also add up and serve as a tax credit to offset against the deferred tax liabilities. After a few years, these deferred tax liabilities will be gone and JU will have a healthy deferred tax assets in the future.

The key for JU to make the deal feasible is actually to find efficiencies gain. PLUS made around RM55mil in cash flow on ancillary income compared to a toll collection of around RM 2.5bil on FY2009. So,JU can probably seek some extra income from these areas.Some analysts and journalists said that the efficiency gains will come from putting more advertisement. However, I am not that positive on this front. The 2009 advertisement expenditure for Malaysia is around RM6.6bil, with outdoor advertising commanding a 2% market share or roughly RM132mil. Assuming the market share doubled to 4% (which is highly unlikely as I see little catalyst plus other advertising platform such as online advertising is much more effective) and PLUS manage to get 30% market share, the contribution is just RM79.2 mil. Can PLUS obtain 30% market share? Highly unlikely as the market definition involve things like advertising on shopping complexes, LRT lines, monorail beam and etc. So, the efficiency gains will probably come from cost cutting as well as leveraging on their R&R facilities to turn in more income. The vacant land R&R perhaps can be turn into some retail centre for some areas as there are relatively little retail facilities for certain towns that the R&R is situated. It may serve to attract population within 20-km radius as well as visitors. Budget hotel can also be set up for long distance travelers.

The detailed explanation of the JU deal is actually to show that the offer of RM5.20 is commercially viable. This is not to say that government will accept JU deal as national assets should not end up in private hands. However, the explanation is to show that EKU is capable of coming up with similar offer especially when they have the ability to command an even lower funding cost.

Scenarios, Payoff and Probabilities

By clarifying the doubts on the viability of the JU deal, we can proceed on to discuss each scenarios in detail as well as calculating its payoff and attaching a conservative probability. All the discussion will be using the old board lot definition, that is 1000shares. In addition, brokerage charges is based on charges by HLeBroking, one of the cheapest options available for retail investors. The charges are 0.55% for purchase transaction, as well as a RM10 fixed rate for CDS transfer fee after the takeover deal is consummated. As there are fixed charges involved, the payoff will be higher if more shares are purchased.

Base Case: JU is a distraction. EKU takeover at RM4.60/share (Probability : 60%)

Based on today closing price of RM4.57, the payoff would be -RM5.13 [(RM4.6-RM4.57*1.0055)*1000-RM10].

The discussion on this scenario centers around whether JU is really a distraction and they do not have any money to financed the deal. The problem with such an argument is that, Bank of China has come up to support the deal. So far, there are no denial on BOC part, meaning JU should have the loan funding. As for the equity funding, we still do not know whether JU has RM5 bil. However, BOC probably would not agree on the funding if it had not look at the people providing the equity. So, we can think that BOC has done its due diligence and satisfied with the equity partners- meaning RM5 bil should be there. Plus, BOC probably would not risk its reputation by dealing with shoddy partners.

A potential conspiracy theory I could think of is that, Malaysian government may lobby to the Chinese government to instruct BOC to cut off the funding. Since all Chinese banks are controlled by Chinese government in one way or another, this scenario is plausible. The key to this would be how much clout Malaysia has on China. Is Malaysia dispensable? Probably. It is worth to owe the Chinese government a favor just to save RM3bil that is not even government's money? I don't know. In addition, I think JU would have signed some agreement with BOC which involve some compensation if BOC pull out, so, the compensation may complicate matters. However, conspiracy theorist can again argued that Malaysia can pay for the compensation.

With the discussion above, I will stay conservative and attach a 60% probability on this case even though I feel that the probability can be lower. All answers would be known a week from now when JU tabled its deposit, signalling its intent.

Bull Case: EKU upped its offers to RM5.20. (Probability: 30%)

The payoff for this case would be, RM594 [(RM5.20-RM4.57*1.0055)*1000-RM10]. This is the upside that this merger arbitrage seek to capture. The deal provide a net returns of 12.9%. If the deal is consummated within 4 months, we have an annualized return of 38.7%, if it took half a year its annualized returns is 25.8%, a decent return by most standards.

As I have shown that JU offer can be considered commercially viable, the key now would be to see whether EKU will match JU offer. I don't think JU will get PLUS due to the fact that it need approval from the government as well as EKU probably would vote down any JU offers. To get PLUS, if JU offer is deemed proper, EKU needs to match its offer.

Some may asked, why can't EKU reject JU offer in the vote approving JU deal and uses other government-related entity such as Kumpulan Wang Persaraan, PNB to force the minority shareholder to accept the deal in the vote approving EKU deal? Based on Thomson Reuters database (there may be error in the database as the data is computed based on different fillings date), EKU owns about 67.48% of the company, so, those that are involve in approving the deal amounts to the remaining 32.52%. By adding together the shareholding of Kumpulan Wang Persaraan, PNB, Lembaga Tabung Haji, Valuecap and Pertubuhan Keselamatan Sosial, the total shareholding of these government-related voting parties is around 15.74% or 48.4% of the shareholders eligible to vote. It is less than 50%, but, assuming some retail investor do not submit their votes, it is very possible that this deal could be voted through. But, it is possible that this scenario happened? I think it is unlikely. Firstly, other minorities investors would probably bring the case to court and void the vote. Government entities such as PNB may also faced legal lawsuits from its investor for not acting on their interest but rather, acting on government interest. Secondly, it will tarnish Malaysia's reputation. There are around 15.74% foreign shareholding (source:Thomson Reuters) in PLUS, which is a significant numbers. If the government entities really band up and rigged this vote, the foreign investors will sue and more importantly, they will never invest in a GLC again as this event increases the expropriation risk. It waste all the effort done by Najib in the past few years to encourage foreign portfolio investments in Malaysia. It is worth to tarnish our reputation just to save RM3bil of funds that is not even government's money? Probably not.

So, if EKU really want to take over PLUS, assuming JU offer is valid, it has to match JU's offer. Now, we need to know how desperate EKU want the offer? Commercially, they actually can just walk away from the deal. But, politically, EKU has to takeover PLUS. One of the key points in the Pakatan Rakyat 100-day reforms is to abolish toll payment. As much as we like to think that Malaysians are a smart bunch of people, we are actually not.Most Malaysians, including the current batch of universities students, actually care more about subsidies than the independence of our judiciary. One of the slogan that enable Pakatan Rakyat to make so much inroads towards BN territories in the previous 2008 General Election is Anwar's promise to reduce fuel prices. This time, Pakatan do not explicitly promise to reduce fuel prices in their 100-day reform agenda but rather, to abolish toll (for those who are interested about Pakatan reform plan but would not like to read the crap written by the MSM, the Pakatan reform plan can be found here). So, it may rank high on BN's to-do list to actually take over PLUS. When PLUS is taken over, one of Pakatan key reform agenda will lose its attractiveness and BN spin master can convince the rakyats that it is ok to pay toll as the rakyats is basically paying back to EPF. (To prevent myself from being misunderstood on this issue, I prefer the toll paying model by BN rather than the no-toll model proposed by Pakatan. It is not perfect, but, it is a better model.)

So, commercially, EKU are not desperate to clinch the deal. But, politically, they may have to do it for the sake of BN. It is a good deal for BN as they are wasting an extra RM3bil using the rakyat money in EPF without putting any dent on the budget deficit. Good political move without much financial implications.I attach a 30% probability on this scenario to be conservative. The probability could be higher.

Bear Case: Both sides walk away. Shares drop to RM3.50 (Probability:10%)

The payoff for this case would be -RM1114.39 [(RM3.50*0.9945-RM4.57*1.0055)*1000, note: no CDS transfer fees is charged as there are no takeover.].

The payoff for this case is ugly. However,it is hard to actually see that both sides walking away. It is possible that JU will walk away, but, the probability of EKU walking away is rather low. So, the 10% probability may be on the high side. One possible reason that both sides may walk away is that there may be a double dip recession within the period of the takeover, hence, making valuation unattractive.

The payoff may also be exaggerated. If you have anything less than RM100k worth of shares of PLUS, I think you can probably get out of it before it falls to RM3.50. In addition, the RM4.60 offer by EKU actually created an anchor to the share price as RM4.60 is made by a knowledgeable buyer. If I am not mistaken, UEM actually built and own PLUS before it is being spun off. In addition, EKU most probably has a few board members on PLUS board, hence, they understand the operating condition of the company very well . EKU feels that RM4.60 is a fair price to pay even after considering the probability of reducing toll rate. This will create a strong anchor to PLUS share price.

The Expected Value


Based on all these, the expected value of this investment is RM63.72 (-RM5.13*60%+RM594*30%-RM1114.39*10%). This denotes an expected yield of 1.4%. If deal is consummated within 4 months, the annualized expected yield is 4.2%, within 6 months, the yield would be 2.8%. If we take fixed deposit rate as 3%, it offers a rather good expected returns. Bear in mind that these expected yields is computed using very conservative assumption especially for the bear case scenario. To have a better view of the asymmetric payoff, this investment can be view as a choice between the base case and the bull case. If we look at it by limiting it to these two most probable cases, we are seeing a bet of losing RM5.13 if we lose and a win of RM594 if we win. The payoff is asymmetric. We may lose RM5.13 this time, but, as long as we consistently making these bets, provided that probability is almost the same, we will win something big eventually.

Disclosure: Long PLUS Expressways Berhad


P/S: It is highly possible that you can lose money on this investment, but, the risk-reward payoff is worth it. When you buy TOTO, you are betting that you will win RM2500 while risking only RM1. This deal is better than TOTO in the sense that the probability of winning RM2500 in TOTO is very low, but, in this case, the probability of getting RM594 is decent.A better way to play this is actually to use a warrant. The warrant expire around June. As I fear that there is a slight risk of legal complications that force the deal to consummate after a 6-month period, I decided to play safe and do not use any warrants.

Disclaimer: The company analysis above is not a buy or sell recommendation on the company mentioned. The author do not guarantee the accuracy of the facts being presented. Please consult your investment advisors before acting on any information provided by the analysis above. The author is not responsible for any profit or loss made by any action taken based on the company analysis above.