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.