Tag Archives: investing ideas

Is There A Merger Arbitrage Opportunity In Cleco?

Summary Cleco agreed to be acquired by a group of North American infrastructure investors led by Macquarie Infrastructure and Real Assets (MIRA). We believe the likelihood of the deal closing is high. The deal is expected to close in the first quarter of 2016. Shares look appealing with a weighted return profile of 22.87%. This article discusses the potential merger arbitrage opportunity in Cleco (NYSE: CNL ). On October 20, 2014, a group of North American infrastructure investors, led by Macquarie Infrastructure and Real Assets (MIRA) and British Columbia Investment Management Corporation (bcIMC) (Group), entered into a definitive agreement to acquire Cleco for $55.37 per share in cash. The deal is valued at $4.7 billion, which includes ~$1.3 billion of CNL’s debt. Cleco is a public utility company and owner of regulated electric utility Cleco Power LLC. It has served residents and businesses in Louisiana for almost 80 years. It owns 11 generating units with total capacity of 3,340 megawatts. This partnership will allow the company to operate as an independent and local business, which will help it stay focused on keeping its strong culture. Cleco is a well-run utility with a dearth of knowledge, experience, and expertise. It’s a very attractive infrastructure business, which just so happens to operate in a regulated, but stable industry. These attributes should help the company grow long term. Here’s what Bruce Williamson, Cleco’s chairman, president and CEO, had to day about the deal: “With this agreement, Cleco’s existing investors will receive an exceptional value for their shares to top off a superior total shareholder return of the past few years, and our customers and employees can expect us to retain our strong commitment to service and reliability. The board and management worked together in structuring this transaction to deliver a premium valuation to our public shareholders and ensure a continued local presence in the communities Cleco serves. This agreement is the right transaction for our shareholders, employees, retirees, and customers of all types. The new owners understand the value Cleco brings to the region and are committed to Cleco’s strategy as a safe, reliable electricity provider positioned to meet Louisiana’s long-term power needs.” So is there opportunity as a merger arbitrage candidate? Let’s dive in and find out. Despite the drop in commodity prices, this group led by Macquarie has very deep pockets. The new owners plan on refinancing Cleco’s debt at closing. The group of investors includes Macquarie, British Columbia Investment Management Corporation, and John Hancock Financial. We do not see a high probability of failure given the group’s strong capital position. The deal is said to close in Q1 of 2016 (three months); both sides appear to be excited about the deal and the synergies involved. Final stages of the state regulatory approval process have pushed the initial timeline back to Q1 2016. Initially, the deal was supposed to be finalized in Q4 2015, but utility deals always seem to take longer than expected. The Louisiana Public Service Commission (LPSC) stated that it was “recommending strong commitments” from the investor group. The investor group filed testimony with more than 70 commitments addressing concerns raised by the LPSC. The commitments appear to be more than adequate, and management expects the deal to go through in Q1 2016. Cleco is currently priced at ~14x FCF, which gives an implied yield of 7.26%. In addition, the company sports an EV/EBIT of 14.85. Although shares are not significantly undervalued at current levels, we would be surprised by a takeover either. However, the current commodity depression may hamper and potential bidders. There are many uncertainties around potential mergers, such as anti-trust approvals, multiple government reviews, changes in market conditions, shareholder approval, and due diligence. If the deal was not completed, we would expect prices to drop to the pre-deal price of $48.50, or a loss of $3.55. We give the deal a 95% chance of being complete based on the parties and terms of the buyout offer. If we look at the recent quote, the stock is trading at $52.05 per share, $3.32 below the announced cash offer of $55.37 per share by the investor Group. We calculate our expected return with the probability of a successful deal ($3.32 x .95 = $3.15). And we subtract that from our expected loss with the probability of that loss occurring (3.55 x .05 = $0.18). This is the expected weighted return, which gives us a potential return of 5.72%, or $2.98 per share. To calculate our annualized expected return, we divide that by the expected time of holding in years (three months = .25). This gives us an annualized expected return of 22.87%. Bottom Line The Cleco acquisition is an interesting deal. And we do not see a high probability of failure given the investor Group’s strong capital position. The regulatory interference concerns us some; however, it appears that the recent commitments from the investor Group may be more than adequate for a state regulatory approval. This appears to be an interesting opportunity at current levels with a potential 22.87% annualized return profile. The return appears to justify the risk in this case. Notable Shareholders: Abrams Capital Andromeda Capital Bryn Mawr Capital LMR Partners Adage Capital GAMCO Diamond Hill Capital Please share your thoughts in the comments section below, as I learn just as much from you as you do from me. It can be a time-consuming endeavor, but I answer all of your comments and questions myself. Your patience and understanding are greatly appreciated. Disclaimer: Merger-arb can be tempting for investors to use leverage to increase their annualized return on high probability events…Resist the urge! Many Wall Street firms conduct merger-arb as their main business and they will normally have 50 or more merger-arbitrage investments at any one time. They understand that if a couple of deals go bad, the winners will more than take care of the loses. Merger-arb can be a very crowded strategy at times. Similar to value investing, it can be cyclical and go in and out of favor over time. The key to merger-arb is to focus on the few deals that are highly probable (ideally ALL cash deals) with minimal regulatory hurdles and an acquirer with a great capital base. And if you’re new to merger-arb, watch a few deals play-out over various industries to get an understanding of the deals. If you do invest in merger-arb situations conduct proper due diligence and make sure to spread your risk appropriately. If you are so inclined to learn more about these types of special situation, I highly recommend Graham’s writing on arbitrage in his Security Analysis book.

AQR On Evaluating Defensive Long/Short Strategies

By DailyAlts Staff Heightened market volatility has many equity investors contemplating a move to defense. But in this environment, are defensive stocks too expensive to work? This is the question considered by AQR Principals Antii Ilmanen and Lars Nielsen and Vice President Swati Chandra in the November white paper Are Defensive Stocks Expensive? A Closer Look at Value Spreads . Value Spreads The paper’s authors begin by explaining the concept of value spreads: “Value” quantifies the “cheapness” of a long-only asset “relative to a fundamental anchor.” For a long/short style factor such as “defensive,” value spreads can be measured by comparing the value of the long portfolio (the most “defensive” stocks) to the value of the short portfolio (the least “defensive” stocks). When the style grows cheaper, the value spread “widens” – when the style becomes more expensive, the value spread “narrows.” Valuation and Strategies It only makes sense that a wide value spread is preferable to a narrow one, since a wide spread will (presumably) have the tendency to revert back to the mean, thereby “narrowing” and becoming more expensive (i.e., outperforming); while a historically narrow spread is more likely to “widen” and get “cheaper” (i.e., underperforming). AQR’s Cliff Asness and others have published research indicating that “over medium-term horizons, the future return on value-minus-growth stock selection strategies is higher when the value spread is wider than normal.” But Messrs, Ilmanen and Nielsen and Ms. Chandra argue that “valuations may have limited efficacy in predicting strategy returns” – strategy returns as opposed to asset returns. The authors highlight the “puzzling” case in which a defensive long/short strategy performed well during a recent two-year period when its value spread “normalized from abnormally rich levels.” They conclude that the relationship between valuation and performance – strong for most asset classes – is weaker for long/short factor portfolios. Wedging Mechanisms Buying a “rich” investment, seeing it cheapen, and yet still making money – how is this possible? Ilmanen et al. cite the following “wedge mechanisms” that allow the managers of long/short factor portfolios to loosen the “presumed strong link” between value spread changes and returns: Changing fundamentals Evolving positions Carry Beta mismatches Fundamentals May be Offsetting The efficacy of value spreads in predicting returns relies on the assumption that changes in valuations are primarily driven by prices, so that an asset or portfolio that becomes more expensive necessarily appreciates in price. This assumption, combined with the assumption that value spreads will always mean-revert, make the case that wide spreads are preferable to narrow ones. But valuation measures always compare price to a fundamental factor , and improving or deteriorating fundamentals – more than just price – can loosen the links between valuation and performance. Evolving Positions Portfolio returns are based on the price appreciation and “carry” of the portfolio’s holdings, as they evolve , but value spreads only consider the portfolio’s current holdings. Thus, the link between valuation and performance is therefore weakest for the most actively traded, fastest-evolving portfolios. Carry Returns Value spreads look entirely at prices, but portfolio returns are the sum of changes in price and portfolio income – i.e., dividends and interest. Portfolios that derive a greater-than-average percentage of their total returns from so-called “carry returns” will thus naturally have a weaker link between valuation and performance than portfolios that derive their returns more primarily through price changes alone. Misaligned Betas In AQR’s study, this final “wedge” had the most impact: Since the value spread will generally have a net non-zero beta, while a long/short portfolio may target beta-neutrality, the value spread could indicate cheapening or richening driven by its beta to the market, while a long/short portfolio designed for beta-neutrality won’t fluctuate with the market. Conclusion So are defensive stocks expensive right now? The authors give a concise answer to that question: “Yes, mildly, taking a 20-year perspective.” But as the “Tech Bubble” proved, mispricing can persist for a long time. The important thing, in the view of the paper’s authors, is for investors to be cognizant of the mechanics of value spreads and spread design choices.

Connecticut Water Service – A Stable Business With A Twist

Summary The company is primarily a water utility business. While the utility business is highly profitable, the return on equity is capped at around 10%. The Services and Rentals could generate significant value in the future. Connecticut Water Service (NASDAQ: CTWS ) is a utility company that focuses on water distribution. As a water utility company, the company does not have to worry about commodity fluctuations, unlike a natural gas utility company . Unfortunately, the company was not able to escape the pessimism in the market. Despite on the way to post another year of growth, the stock barely budged in 2015, fluctuating around $36. In the chart above, we can see that over the long-term, the stock tracks the company’s top-line growth. This makes a lot of sense because the company primarily runs a regulated business, so margins will be fairly consistent from year to year. More recently, the company seems to have benefited from economy of scale, as the operating margin climbed along with the growth in revenue. For any other company, this track record would suggest an extremely well-run business with the potential to generate a lot of profit. Unfortunately for investors (and fortunately for citizens), the utility business is regulated for this exact reason. The company’s two main water subsidiaries in Connecticut and Maine have a rate cap (return on equity) of 9.75% and 9.5%, respectively As you can see, ROE has fluctuated around the 10%, reflecting this cap. What this means is that the maximum growth equity investors can expect from the company’s regulated business over the long-run is around 10%. Because the company provides a critical service, I have no doubt that the company will achieve this rate of return over the long term. Of course, the company can try to apply for rate increases, but I wouldn’t count them since there is no way to know in advance whether they will be approved. While most of the revenue comes from the regulated water utility business (~90%), the company does have some non-regulated operations. On the non-regulated side, the main segment is Services and Rentals. The segment’s operation is quite diverse, ranging from typical repairs to providing emergency drinking water. While small, the company is highly profitable. Year to date, the segment’s net profit margin was 24%. This is pretty much on par with the margin of the water business (25%)! However, it would seem that the management has trouble growing it. Quarter on quarter, revenue only increased by 5%. That being said, the segment could generate significant value if the management figures out a way to scale it. While I am not seeing any promises right now, it nevertheless has good option value, after all, the segment’s services do go hand in hand with the water business. Conclusion If you are satisfied with the rate of return (~10%) over the long-term, then I think Connecticut Water Service represents a good opportunity. Due to the nature of water utility (a critical service), the company should be able to reach the rate cap over the long-run. While the non-regulated side of the business is still small, I believe that once the management finds a way to convince more water business customers to use the company’s maintenance services, there could be significant upside. Overall, I believe that the company will continue to deliver stable profits from its water business, and the non-regulated activities are an added bonus for investors.