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An investment idea that I haven't heard anywhere else yet...A new "Merger Security"

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June 19, 2011 – Comments (12) | RELATED TICKERS: ETE , SUG

Hi everyone.  I was dying to write about this strange special situation last week, but I had to wait two days to abide by TMF's trading guidelines.  I found a new "Merger Security" that is being issued by Energy Transfer Equity (ETE) to finance its recently announced purchase of Southern Union Company (SUG).  This one isn't going to turn into a ten-bagger like some of the awesome Rule Breaker selections, but it does look like an excellent low risk, solid return place to park one cash in today's low interest rate environment.  Here's my rough notes on the situation for anyone who's interested. 

"I just purchased a position in Southern Union Co.  (SUG).  As you may have heard, the company agreed to be bought out by ETE today.  So why purchase a stake in a company that's already up over 17% today you ask?  Well, I'll tell you (even if you didn't ask).  The unique structure of the buyout makes this an interesting investment.


When the deal closes, ETE will issue SUG shareholders $33 face value "B" shares.  These B shares will pay investors a minimum dividend payment of 8.25% over the next year.  At that point they can be traded in for either $33/share in cash or 0.77 shares of ETE.


One could look at this situation as the best available bond out there with a free upside call on ETE.  I have been looking at corporate bond interest rates fairly closely over the past several weeks and the very best thing that I have seen out there is some 20-year MeadWestvaco Corp. (MWV) paper that yields 6.9%.  This is a company with a crappy credit rating (not that that means anything, but still) and you have to lock your money up for two decades to get this rate.  By the time that twenty years passes interest rates will probably be double digits again ;).  At the current SUG share price of $33.25, we're looking at essentially a one year bond that pays 7.4% interest which may even be taxable at the dividend rate rather than as regular income.  If that's the case then this 7.4% is even more valuable.  Wait, there's more.  This 7.4% yield assumes that you are trading in the "B"shares for $33 in cash at the end of one year and losing a quarter per share.   If you end up taking the 0.77 ETE shares (which as if the current quote are trading at $45.62 for a conversion price of around $35.13) then the interest rate on the bond-like payment jumps to around 8.2% plus you get any of the free upside in ETE.  ETE's acquisition of SUG is supposed to be immediately accretive to ETE's earnings and I think that barring a change in tax laws (which I find unlikely) its stock should do fairly well over the next year.


So there you have it, the best bond-like return out there right now plus an absolutely free upside call on ETE.  The only danger that I see here is if the deal falls apart, which I suspect is unlikely.   Oh and of course, the closing of the deal could drag on delaying the start clock on the dividend payment and lowering its annualized yield." 

"OK, here's some additional information on SUG (in case you're still interested).  ETE is issuing a whopping $4.2 billion in "B" shares to finance the SUG acquisition.  Yes, technically it has the right to call the B shares at any point during the first year, but I highly doubt that it will have the money to do so.  In addition to the new B shares that it is issuing, it's assuming $3.7 billion in debt with this deal.  ETE's credit rating isn't the best, though one of the major credit rating agencies recently said that they viewed the SUG acquisition positively.  Earlier this year, ETE attempted to float a bond issue of a little over a billion dollars at 7% and the market basically rejected it and they had to pull it back.  I read that a smaller issuance at 7.75% might have worked.  That leads me to believe that if ETE wanted to call in all of the B shares immediately, which it would probably be in its best interest to do, it probably would not be able to.

In the event that the shares are not called, they will pay an 8.25% dividend quarterly for the first three years and then 8.25% or LIBOR + 750 basis points...whichever is higher after that.   Also, if the shares are not called at $33 during year one, the option to redeem them for 0.77 ETE shares and capture much of the upside in the stock kicks in. 

As I mentioned, the million dollar question here is whether ETE would be financially able to pay off all of the B shares during year one.  It looks to me as though it would be difficult for them to do so.  If they don't, then this is an amazing place to park one's cash.  The downside is less than 1% and the potential upside is a cumulative 8.25% dividend with a possible option to capture any gain in ETE's stock.

Here's a link to the presentation that describes this deal:

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NDEzODMzN3xDaGlsZElEPTQzMDY2OHxUeXBlPTI=&t=1

SUG's stock has rallied slightly to $33.56 since my purchase at around $33.21, so anyone who buys in now risks losing out on $0.56/share if the "B" shares are called immediately rather than the $0.21 that I am risking.  As I mentioned earlier though I personally believe that the risk of losing capital here is low.  It doesn't hurt to have some, low-risk trades like this in one's portfolio especially in an economy that seems to be foundering.  I am trying to be more positive nowadays so I am generally bullish on where the market and my stocks are headed, but I'm a sucker for high yield bonds and that's essentially what this trade works like so I'm in. 

Deej 

12 Comments – Post Your Own

#1) On June 19, 2011 at 10:26 PM, HarryCarysGhost (99.75) wrote:

What do you think the long-term price action of ETE will be?

and I was suprised by no mention of ETP.

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#2) On June 20, 2011 at 1:28 AM, XMFConnor (97.87) wrote:

Deej,

I like the idea. If you don't mind me asking, what are the places where you tend to find most of your special situation investments? (aka what is your general search strategy). 

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#3) On June 20, 2011 at 1:28 AM, XMFConnor (97.87) wrote:

Deej,

I like the idea. If you don't mind me asking, what are the places where you tend to find most of your special situation investments? (aka what is your general search strategy). 

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#4) On June 20, 2011 at 10:40 AM, TMFDeej (99.45) wrote:

Hey HarryCarysGhostI actually like ETP.  It's gotten knocked around a little bit lately, but that has resulted in an amazing yield of over 7%.  A long time ago I decided to make my EPD my play in the sector it has done very well and seems to be very well managed.  I'm not sure that I want too many MLPs in my portfolio.  I also have SEMG, which I expect will convert to an MLP, and UAN already.

I think that this is a solid acquisition for ETE.  I love the fact that it will supposedly be acretive to earnings immediately.  I suspect that the company's stock will do well.  If it does, and it doesn't elect to call the B shares, they have solid upside potential with very little downside risk ($33).

Deej

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#5) On June 20, 2011 at 10:42 AM, TMFDeej (99.45) wrote:

Thanks Connor.  This one I just sort of stumbled upon this one when reading about the ETE acquisition.  I think that the first mention I saw of the B shares was in Forbes.

Google works well when looking for ideas.  One can Google key phrases, such as spin-off, etc...  I also read a lot of excellent blogs that others run.

Deej

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#6) On June 21, 2011 at 4:47 PM, XMFConnor (97.87) wrote:

Deej,

With SUG's current price of $33.70, I ran the numbers myself...

It looks like the one-year bond yield, if converted back to $33/share, is now at 6%: (dividend payment of $2.72/B share - ($33.70-$33.00))/($33) = 6%

While most would agree that is an attractive bond yield in this environment, it looks like the most upside comes from the call option on ETE...

With a .77X exchange ratio, it seems as if the breakeven price of ETE common stock that would make this exchange worth exactly $33 is $42.85 (.77*42.85). 

This essentially provides a free call option on ETE with a strike price of $42.85. This is very valuable. For example, if ETE were to not move in price over the next year, at the current price of$46.08, you would make $2.48/ SUG B share. You can add this to the $2.72 of dividend payments for your total return. Note, you do not have to subtract the price appreciation from SUG either in this scenario.

This would yield a one-year return of ($2.48+$2.72)/($33.70) = 15.44%. 

Deej, is my math off here? It seems too easy..

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#7) On June 21, 2011 at 4:52 PM, TMFDeej (99.45) wrote:

More analysis: 

Time will tell what happens.  I was in on SUG at $33.21.  Assuming that the deal doesn't fall apart (which actually could theoretically could be a good thing if it leads to a higher bid), I'm entitled to $0.45 in SUG dividends plus 8.25% in dividends quarterly in 2011.  I suspect that ETE would wait until the last possible minute to recall the shares before the one year anniversary if they do call them.  If that happens, I'll collect $2.72 in dividends in 2012 plus the $0.45 from SUG in 2011 for a total of $3.17.  If one then subtracts the loss of $0.21 for the conversion at $33, this equates to a That's a 8.9% return in around a year and a half, or around 5.93% annualized.  That's a pretty darn good place to park one's cash in today's zero interest environment.

If ETE doesn't force a conversion during the first year, the potential returns rise from there.

Deej

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#8) On June 21, 2011 at 4:57 PM, XMFConnor (97.87) wrote:

http://www.marketwatch.com/story/the-briscoe-law-firm-announces-investigation-of-southern-union-company-2011-06-17?reflink=MW_news_stmp

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#9) On June 22, 2011 at 11:10 AM, TMFDeej (99.45) wrote:

Thanks for the link Connor.  Lawsuits like this seem to be very common when companies agree to be bought out.  I don't know how to weigh the probability of any successful litigation that would block the deal, but I suspect that it is low.

Theoretically, a lawsuit like this might even be a good thing if it forces ETE to up its bid or enables another company to swoop in with a higher offer.  I know that the current deal has a very low termination fee or whatever one wants to call it.

I think that your calculations are sound.  You're right, the big upside in this deal comes from the potential to convert the SUG shares to ETE shares at 0.77 per.  Keep in mind though that one cannot do this until one year after the close of the deal AND ETE has the right to call the shares for $33 in cash at any time during the first year.  One has to handicap the odds of them doing so.  I personally think that it would be difficult for them to come up with the money to call the shares during year one, but it is in ETE's best interest to do so.

Deej

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#10) On June 22, 2011 at 11:28 AM, XMFConnor (97.87) wrote:

Deej,

It is my understanding that the company can call back the shares and convert to $33 in cash at anytime correct? Isn't it a bit unusual that the "screw clause," being able to convert into shares, doesn't kick in until after a year?

If they really will not call them back immediately, it seems unusual that they would even leave open the option for them to screw over Series B holders immediately.

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#11) On June 22, 2011 at 2:48 PM, TMFDeej (99.45) wrote:

Hey Connor.  Your understanding that ETE can call the B shares at any time during the first year for $33 is indeed correct.  If you look at the investor presentation that I provided a link to above, ETE certainly seems to down play the issue and tries to make it look like the 8.5% yield and 0.77 conversion are an amazing deal for SUG shareholders.  They would have to be really scummy bastages to word it that way and then pull the rug out from everyone with an immediate $33 cash conversion. 

Having said that, I wouldn't put it past them.  The question remains whether they would be able to call in $4.2 billion in B shares.  After looking into this matter and thinking about it, I don't think that ETE will be able to earn enough cash between now and the end of 2012 nor will it be able to tap the bond market for enough money to pay off the B shares.  I just don't see where the money will come from, outside of issuing more A shares to retire the Bs...which wouldn't pay as large a dividend.

The bottom line is that the a forced conversion for $33 in cash is a very real possibility, but I am making an educated guess that it won't happen.  I'm not 100% certain that it won't, but the fact that I got in early paying only a twenty cent premium eliminates any possible loss of capital for me given SUG's $0.15 dividend per quarter until the conversion.  I'm only risking the time value of money, which isn't much in today's zero interest rate environment.

Interesting discussion.  Thanks for your interest.  It's making me think about this more.

Deej

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#12) On June 23, 2011 at 5:54 PM, XMFConnor (97.87) wrote:

Wow.. well this one worked out earlier than expected.. congrats on the higher bid

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