Sunday, November 15, 2009

Gwalior Chemicals – Shareholders Gain, Arbitrageur lose


I’ve had a small break from the blog due to work pressure. Along the way a lot of water has flown under the bridge both on the Gwalior Chemicals front and a lot of other special situations opportunities have come on my radar.
The board of Gwalior Chemicals made the following announcement after the board meeting
In the first phase the Company proposes to buy back maximum of 40,50,000 shares at Rs. 120 per share through a tender offer route in this financial year. The aggregate amount Rs. 48.60 crores is the maximum permissible buy-back in this financial year ended March 31, 2010 as per Section 77A of the Companies Act 1956.
The market of course didn’t like it and the stock promptly went down to Rs 90 and has been hovering around there.
Lets examine what it the management is trying to achieve I spoke to the company secretary and asked him on the thought process. According to him the company intends to deploy Rs 100 crores as stated in the original press release to buyback shares in 2 phases
1) Phase 1 - This is the announcement that we read above.
2) Phase 2 - Will be done in the next financial year and I would assume somewhere around the Sept – Nov 10 kind of time frame.
So this brings out the logical chain of questions some of which I have received as comments
1) Why the share buyback in 2 phases?
This is because under Section 77 A of the Companies act a company can in a financial year buyback only 25% of the paid up capita+ free reserves of the company. This acts as a upper limit to the amount that can be deployed towards the buyback process hence a 2 stage buyback.
2) Why no dividend?
The management’s view is that share buyback is value accretive to the shareholders of the company and is clearly more tax friendly to the long term shareholders of the company. Factoring in either indexation or without it long term capital gains is lower than the dividend distribution tax that the company would have been borne out of the amount. I cant argue against it.
3) Will the promoters participate in the buyback?
The promoters will be participating in the buyback. The promoters would have to participate in the buyback bcos under the SEBI Takeover code, they cant increase their stake beyond 5% in a given year. Any increase beyond that will force them to make a open offer.
4) What will be the acceptance ratio?
The acceptance ratio is about 1/6th of the shares tendered as the buyback is of 40 lac shares on a equity base of 2.4 crores shares. Assuming about 10% brain dead shareholders who don’t tender we can at best assume a acceptance ratio of 1/5th or 20% of the shares tendered. This is presuming that the promoters will tender in full. The promoters could tender partially and use this as a route to increase their stake by 5% which will further improve acceptance ratio.
I have just worked out a sheet below listing down how the event can play out and the associated returns. I have assigned multiple scenarios giving different haircut to the terminal value that market will assign to the stock based on holding company discount. There is however a potential upside as according to the company secretary the company is looking at potential acquisitions. This will reduce the terminal value discount if the market factors it as a operating company.


So am I happy or unhappy?
I think the arbitrageur has lost in this transaction at the expense of the long term shareholder. I cant fault the management for its actions though I might lose money in the interim.

So what should I be doing?
I entered the transaction wearing a special situation arbitrageur hat and today have the option to wear the long term shareholder hat. I have always been advised by my fellow special situation arbitrageurs with whom I compare notes to never change my hats.

If u entered with a spl sit hat and that went wrong then exit the trade and not to change boats in mid seas. I think I will go with that though somewhere still not convinced that the trade has really gone wrong.

17 comments:

Anonymous said...

Hey man..
good morning..just a special situation idea for u, if u hvnt already seen it!
BSE code 700132

there r, of cors, some risks here, but at a price, it is a sitter..
am sure u will easily analyse the rest :-)
cheers
Neeraj

Ninad Kunder said...

Hi Neeraj

Will check on it.

Can you send me the original issue doc if u have it handy on you to ninadinvest@gmail.com

Cheers

Ninad Kunder

Mayank said...

Hi Ninad,

Looks like the 2nde round buy back price you seem to have assumed is 150, and not 120 as mentioned in your excel.

Also i believe the sudden drop to 90 was unwarranted and going forward there is high chances of the scipt maintaining around 90 levels even after the buyback, hence +16% returns looks most reasonable to me.

Cheers,
Mayank

Anonymous said...

Hi Ninad..
Have mailed u the doc..
cheers
Neeraj

Rajiv said...

Any clear idea on what management intends to do with the residual cash?

Ninad Kunder said...

Hi Mayank

I dont know how u have arrived at the 150 number. I have factored in 25*120 = Rs 3000

Correct me if I m wrong here.

Cheers

Ninad

Ninad Kunder said...

Hi Neeraj

I have sent you a response with my comments on the opportunity.

Cheers

Ninad

Ninad Kunder said...

Hi Rajiv

I spoke to the CS on this and he told me that they are looking at few potential acquistion targets.

This would be good provided they dont overpay for the acquisitions. The market will then tend to remove the holding company discount and value it like a operating company.

Cheers

Ninad

Mayank said...

Hi Ninad,

Assuming 120 as the 2nd buy back price - since you have already tendered your 20% shares in the 1st stage, your holding is now only 80 shares, hence 25% of 80will be 20. so 20*120=2400 should be the return in row 11, and correspondingly the terminal value will increase accordingy as number of share pending will be 60 instead of 55.

Also i understand that since the total share capital of the firm is going to remain the same even after the buyback, hence the next buyback price if its greater than 120 would mean less number of shares getting bought back reducing the acceptance ratio. Hence the buyback price for 2nd stage is to a large extent immaterial.
Kinldy correct if i am wrong.

Cheers,
Mayank

Ninad Kunder said...

Hi Mayank

You are right on the error pointed on the excel sheet. It should be 20 shares in the second offer and number of shares pending will be 60. I will rework the excel sheet and post that.

The buyback price in the second stage becomes material because it alters the NAV post the buyback and hence the terminal value based on the haircut that the market will give.

A higher offer price would be better as it will lead to higher money in hand. I have taken 120 as a conservative estimate.

Cheers

Ninad

Ankur Jain said...

Ninad,

Why do you think the offer price in the second buyback is going to be 120 ? That is the best possible outcome.

A probability of lower offer price should be factored in after considering a lower probability of the second offer.

I think it will largely depend on the market conditions and promoters' intentions whenever they decide to do a second buy-back .

Random said...

Ninad,

I have the same question as Ankur

Putting too much faith in what Management is saying can be harmful

As far as I know a Buyback AND a special dividend were on the way earlier

Human Behavior is pretty circumstantial and that will be the case here, forecasting management intentions at this point in time is tough

How are you arriving at two things?
a) That a second Open Offer will come? Has it been Announced?
b) How are you arriving at a Offer price now? Has it been Announced?

What inferences have you drawn from public information etc to be thinking on these lines

What can go wrong here? Let your imagination run wild, I can think of plenty of things :)

Random

Random said...

And who told you this - The promoters would have to participate in the buyback bcos under the SEBI Takeover code, they cant increase their stake beyond 5% in a given year. Any increase beyond that will force them to make a open offer.

Heehee, there have been many instances in the past when companies have been allowed to do this by SEBI

The Promoters have to go to SEBI to get this exemption

Ask the secy if what he means to say that nowhere in the past has Promoter Shareholding gone up by more than 5% in a single year through a buyback

Think about it, the management is also taking money home :), I mean who would not

Now the intention is not to poke too many holes, just to put the point across that your line of thinking requires too many assumptions and not enough margin of safety

Feel free to point out mistakes

Random

Ninad Kunder said...

Hi Ankur

The NAV post the first open offer would move up higher by about Rs 5. I have kept the same open offer price without factoring in NAV increase.

You are right that there is a probability of the open offer price moving up of down based on the market conditions. A lower second offer price will be detrimental to the arbitrageur but obviously better off for the long term shareholder.

There is a probability that the second offer might not take place if the management decided to deploy capital in other avenues. The upside on that is that the holding company discount will diminish provided the management makes sensible asset allocations.

Cheers

Ninad

Ninad Kunder said...

Hi Random

If you look at all their formal announcments they have stated that this is phase 1 of the buyback program. The CS has also explicitly stated that a buyback is lined up for next year. They could change that but as of now that is the official line.

The second open offer price is a guestimate based on NAV and other variables. I have answered in my response to Ankur's query on that.

You are right that in the 55-75% shareholding band for the promotors they can increase beyond 5% by taking a SEBI exemption. The process typically takes 3-4 months to get that exemption and as it is a exemption it is not necessarily a sure go ahead. You are right the management is taking money home like any other shareholder and I dont blame them.

Please feel free to poke holes bcos the objective of this blog and the effort that I m putting in writing it is to have ppl who could poke holes in assumptions enabling a learning process.

Cheers

Ninad

Random said...

You are pretty wise for your age :)

Random

PS - It is very difficult to think straight in a situation like Gwalior where management can cause a drop in Intrinsic Value of the business with their actions yet you manage to say something on the lines of - "if the management decided to deploy capital in other avenues"

Even through I am not convinced with your analysis, I would easily grant you the "Wise" part :)

Ninad Kunder said...

Hi Random

Well you dont know what my age is and i hope there was no pun intended on the "wise" part :-).

I am not recommending to buy or be invested in the stock thru my analysis. I am just doing a scenario analysis factoring in assumptions some of which could turn wrong. It is obviously dynamic but based on the data available this is how we can build a payoff matrix right now.

Cheers

Ninad