Description

Announced merger arbitrage deals are not usually very popular on VIC, but in the current merger arbitrage environment, announced deal spreads are at the widest levels I’ve seen in over 15 years.  The cause is, naturally, the dislocation in the financial markets and fears banks may not provide financing they’ve committed to provide in deals that contain a cash element in the consideration.  This dislocation has provided some outstanding opportunities for investors with dry powder who are comfortable investing in merger arbitrage strategies.

 

Of all the cash deals in the merger arb universe, one deal stands out as particularly attractive.  This is the tendered shares of the German auto parts company Continental AG, which are due to receive €75 per share cash when the deal is completed in December.  The tendered line for the 2^nd tender expiration trades in Germany under the ticker symbol COND GR on Bloomberg.  There is also a less liquid tendered line (from the first tender expiration) that trades under the ticker symbol CONC GR that will also receive €75 per chare cash when the deal is completed.  The untendered shares, which will not receive any merger consideration and will not be merged or squeezed out, trade under the ticker symbol CON GR, and are a fair representation of the downside price of the tendered lines in the event the deal is not completed. 

 

In certain European countries (Germany, Switzerland), it is not uncommon for a “tendered line” to trade.  This is because the tender has to expire within a statutory timeframe which may not allow enough time for offer conditions to be fulfilled.  Since tendered shares cannot be withdrawn while the completion of the deal is pending (and the delay between deal expiration and completion can be one or two month, or more in some cases), trading of the tendered lines allows for a liquid market for folks who tendered to sell their tendered shares into the market. 

 

Normally tendered lines are not very liquid and trade close to the deal price.  In the case of Continental, the tendered lines trade 10% below the deal price due to concerns about whether or not the banks will actually fund the acquisition, and to a smaller extent, the receipt of antitrust clearance from the EC’s Competition Commission.  This antitrust clearance is the only remaining condition to be fulfilled.  The offer has no Material Adverse Change (MAC) condition.  I will address these two concerns below, but suffice to say that if the deal closes and payment is received in mid-December, as I expect, the tendered lines are trading with a gross spread of €7.35, or 10.9%, and an annualized rate of return of 72%.  Using the CON GR share price of €41.50 as the downside price, the risk per share is €26.15.  With upside of €7.35 per share, the risk/reward is 3.6 to 1.  This is a very low risk/reward by merger arb standards, and a 72% annualized return on a high quality strategic deal with fully committed financing, not financing condition and no Mac condition, with only EC competition clearance pending is a very high return.  I believe this is the single most attractive merger arb deal in Europe and probably in the U.S. as well.

 

Schaeffler’s offer period for the acquisition of Continental AG began on July 30^th and expired on August 27^th.  In line with German rules, a two week additional offering period expired on September 16^th.  The offer was initially unsolicited but on August 21^st, after increasing the offer price to €75 per share, Continental supported the offer and entered into an investor agreement with Schaeffler.  With shares of Conti Schaeffler owned outright at the time of tender expiration, plus the 82.41% tendered, Schaeffler ended up with control of 90.19% of Conti shares. 

 

Under the terms of the offer, Schaeffler agrees to limit its investment in CON GY to a minority stake of no more than 49.9%.  This will be accomplished with various banks holding the shares excess shares tendered above the 49.9% level.  If Schaeffler were to take control of more than 50% of Conti shares, it would trigger a refinancing of the debt issued to finance the Siemens VDO deal, which Schaeffler wanted to avoid.  Additionally, Schaeffler said it could accomplish what it wanted with a large minority stake in Conti.  The agreement Schaeffler has with the banks regarding how and when they can dispose of their Conti shares taken up to keep Schaeffler below 50% has not been disclosed though media reports say shares will be parked with a group of banks, with an agreement that are not allowed to sell at below €75 for four years without Schaeffler's consent.

 

The acquirer is Schaeffler Group, which is a private, German family controlled company with sales of €9 billion and 66,000 employees operating in 50 countries.  It is one of the largest privately owned industrial companies n Germany.  Schaeffler makes mechanical components for the automotive, industrial and aerospace markets.  Automotive accounts for 60% of Schaeffler’s sales.  Automotive brands include INA, LuK and FAG.  Automotive parts produced by Schaeffler’s subsidiaries are used in the entire drive train (engine, chassis, transmission and accessories) of passenger cars and commercial vehicles.  One of Schaeffler’s core components is bearings.

 

Continental operates in two divisions, automotive and rubber.  The automotive division makes electronic and hydraulic brake systems, telematics (which includes collision avoidance systems and wireless lifelines to emergency assistance after a crash occurs), powertrain/chassis systems, including electronic suspension systems, engine management systems, transmission controls and measurement systems, and electric drive (such as fan modules).  Continental purchased Siemens VDO Automotive in December 2007, which added actuators, power steering systems, sensors, cruise control, cockpit modules (instrument clusters), coolant pumps, fuel supply systems (fuel pumps, fuel level sensors, etc.).  The rubber division makes tires for cars, vans, trucks, motorcycles, bicycles, and industry.  The rubber division has a subsidiary called ContiTech that makes specialized rubber and plastic products for automotive, aerospace, mining, printing, and the textile industries.

 

ANTITRUST

In looking at the big picture, Schaeffler primarily makes mechanical components and Continental makes electronic components and tires.  Therefore the antitrust review at the EC should not present any problems.  Customers, including Porsche/VW have publicly welcomed the deal. 

 

Schaeffler has received antitrust approvals from the U.S. and Canada and provisional approval from Switzerland (formal Swiss approval will be coordinated to come at the same time as EC approval).  The EC competition clearance has not been received yet.  This is because the formal EC filing was just made this past Friday.  Why has it taken so long for Schaeffler to make the EC filing?  This is due to the fact that when Schaeffler first announced a bid for Continental in July, the offer was unsolicited.  After increasing the offer price from €70.12 to €75 per share on August 21^st, the deal became recommended by Continental’s board.

 

On August 22^nd, Schaeffler made an initial draft filing to the EC.  This filing had been prepared based on estimated Continental data in the filing because Schaeffler didn’t have access to Conti due diligence info prior to that point when the deal was unsolicited.  Based on the fact that an investor agreement between the companies was signed and the deal became friendly, the EC requested that the EC filing be revised and all information concerning CON GY “be based on current Continental AG figures instead of Schaeffler estimates.” Furthermore, the EU Commission asked Schaeffler to specify the worldwide potential relations between products in neighboring markets and corroborate this statement with financial figures. Since corresponding information is not centrally available at Continental AG, the compilation of such information is a time-consuming procedure,” Schaeffler said in a press release dated October 7^th.  In other words, in going from a hostile deal to a friendly deal, Schaeffler has to give actual data instead of estimated data in CON GY, and it takes time to collect this information.  This is Schaeffler’s explanation for such a long delay in the EC formal filing. 

 

I spoke to Continental the day after the Schaeffler October 7^th release came out and they confirmed that two weeks prior Schaeffler asked them for a bunch of specific information for the EC filing, and they didn’t have it handy so they had to go out to their units and gather it up.  The Continental lawyers put it all in a form that will be useful for the Schaeffler lawyers to submit with the EC application/filing and gave it to Schaeffler early last week.  This check was wholly consistent with what Schaeffler said in its October 7^th press release. 

 

On Friday, a spokesman for Schaeffler said the company would be submitting the final draft filing with the EC that day, though the actual filing confirmation does not yet show up on the EC’s website (it won’t show until it’s formally accepted).  The Schaeffler spokesman said Friday the company is in constant contact with the EC and expects approval within the normal 25 business day time frame.  This timing is consistent with phase 1 EC clearance. 

 

Considering the fact that overlaps appear minimal (i.e., mechanical components vs. electronic components), I do not expect the EC clearance to present any problems, and neither do the companies when one speaks to them.  Just to be conservative, I assume an extended phase 2, which will take 35 business days in total.  This gets to approximately sometime during the 2^nd week of December.  Add a week or so for settlement of tender offer consideration and mid-December is the pay date I assume. 

 

FINANCING

Schaeffler is a private company and therefore it does not publish its financial statements on its website or elsewhere (except for summary statements in the offer document).  I confirmed this with a Financial PR contact for Schaeffler.  The company does not even have a credit rating from any of the ratings agencies.  The debt financing for the deal is fully underwritten.  Any debt that cannot be syndicated by the underwriting consortium stays on the balance sheets of the underwriting banks.  There was a Reuters story last week that stated syndication was on hold due to market conditions, etc, but Schaeffler put out a statement clarifying that this had no bearing on the deal and it was essentially and issue for the banks, not the deal. 

 

The Financing section of the offer doc says:

 

Prior to publication of this Offer Document, the Bidder has taken the measures necessary to ensure that the financial resources required for it to fully perform the Offer will be available to it in good time.

 

On 12 July 2008, the Bidder entered into a syndicated loan agreement with Bayerische Hypo-und

Vereinsbank AG, Commerzbank Aktiengesellschaft, Dresdner Kleinwort, the Investment Banking Division of Dresdner Bank AG, Landesbank Baden-Württemberg (LBBW), UBS AG/London branch and The Royal Bank of Scotland plc as mandated lead arrangers, The Royal Bank of Scotland plc as agent and security agent and a syndicate of German and foreign banks as lenders (Loan Agreement). Under the Loan Agreement, the Bidder can draw on a loan in an amount exceeding the Total Transaction Amount for the purpose of meeting all of its payment obligations under or in relation to the Offer (Loan). Drawdowns under the Loan Agreement may made if the documentary conditions precedent specified in the Loan Agreement have been fulfilled, if there are no material grounds for termination and if material confirmations and representations are basically accurate. The Bidder has no reason to believe that these conditions will not be fulfilled.

 

The Bidder has thus taken the measures necessary to ensure that it will, on the relevant due date, have funds in the amount of the Total Transaction Amount.

 

As required under German law, an attestation of funding is provided in the offer doc:

 

The Royal Bank of Scotland plc with its registered office in Edinburgh, Frankfurt branch, which is an

investment service provider independent of the Bidder has, in the letter dated 29 July 2008, which is attached as Annex 3, confirmed in writing pursuant to Section 13 (1) sentence 2 WpÜG that the Bidder has taken the 88903-00003 FR:3684141.9 39 measures necessary to ensure that the funds required to fully perform the Offer will be available at the time at which the claim for the monetary consideration falls due.

 

The offer doc gives this consolidated pro-forma balance sheet for the deal (at the old €70.12 per share offer price):

			changes
			caused by
			acquisition	proforma
	INA-Holding		of shares	figures after
31Mar08	Schaeffler		(directly or	acquisition
In EUR thousand	KG	Continental	indirectly)	of shares
Assets
Fixed assets	3,672,537	17,599,600	4,785,262	26,057,399
Current assets	4,219,009	9,310,600		13,529,609
Prepaid expenses	80,998		205,972	286,970
Deferred taxes	178,018			178,018
Total assets	8,150,562	26,910,200	4,991,234	40,051,996
Equity and liabilities
Equity	4,401,015	6,912,300	-6,878,059	4,435,256
Provision	2,052,382	2,446,500	6,738	4,505,620
Liabilities	1,697,165	17,551,400	11,862,555	31,111,120
Total equity and liabilities	8,150,562	26,910,200	4,991,234	40,051,996

 

Debt is included in liabilities above.  At 30Jun08, COnti had total debt of €13.367bn and net debt of €12.186bn.  The €11.862bn in the “changes” column is debt incurred in acquiring the shares.  Schaeffler obviously has gross debt of no more than €1.697bn, but we don’t have any more detail, nor do we know how much cash they have.  Continental’s LTM EBITDA through 30Jun08 is €2.951bn for an EBITDA margin of 13.5%. (and net debt/EBITDA of 4.1x).  If Schaeffler has a similar margin, then Schaeffler would have 2007 EBITDA of €1.201bn, for combined EBITDA of €4.152bn.  Adding the acquisition debt (at €75 per share, plus €72mm in fees) of €12.672 to Conti’s net debt of €12.186bn and Schaeffler’s gross maximum debt of €1.697bn gives a total pro-forma debt of €26.555bn, for debt/EBITDA of 6.4x.  This is sounds very high and I believe the actual number is lower for the following reasons:

 

• Schaeffler won’t actually purchase all the shares tendered; the banks will take the shares above 49.9%. 
• Schaeffler most certainly has cash on the balance sheet, so its net debt number will be lower.
• Considering the state of the credit markets even just a few months ago, I do not believe banks would have lent to a 6.4x levered deal. 
• Schaeffler’s financial PR guy told me today that even though full financials for Schaeffler are not disclosed, the company has a reputation for being conservative and has been very successful in recent years against its competitors.   
• Schaeffler’s EBITDA margin is likely to be significantly higher than Continental’s as revealed by this summary of Q1 consolidating financials provided in the offer doc (see below).  From this we can see that Schaeffler’s EBIT margin is 11.6% compared to Continental’s 6.9%; therefore its EBITDA margin is likely to be significantly above Conti’s 13.5%:

income statement for the			changes	proforma
period 1Jan08 to 31Mar08	INA-Holding		caused by	figures after
	Schaeffler		acquisition	acquisition
in Eur thousand	KG	Continental	of shares	of shares
Revenue	2,330,640	6,639,400		8,970,040
Earnings before financial result	269,572	456,700		726,272
Financial result	-322	-206,800	-243,421	-450,543
Earnings before taxes	269,250	249,900	-243,421	275,729
Income tax expense	-72,607	-70,000	-6,738	-149,345
Net profit for the period	196,643	179,900	-250,159	126,384

 

Schaeffler has said a number of times over the past few weeks that it had fully committed financing for the deal, and has given no signal that there’s any issue with the bank’s ability or willingness to fund the deal.  The banks in the underwriting group are in better shape now than they were a few weeks ago now that European governments have shown a willingness to back the banks up.  RBS, for example, will get £20 billion of new equity from a new equity issuance backstopped by the UK Treasury, and will have (along with other UK banks) access to a special liquidity facility from the UK government.  I see no reason why the banks should not stand up for their obligation.  While it is not uncommon for banks in the US financing a deal to try to find an out, this is almost unprecedented in Europe.  I cannot think of a single case where this has ever occurred. 

 

In talking to Conti on the financing, they also said that according to the German takeover code a bidder has to prove to the BaFin that they can finance the deal, and the letter from RBS in Annexe 3 of the offer document does just that.   I also spoke to Schaeffler’s financial PR contact.  He said Schaeffler is working to get the EC approval.  They are committed to the deal.  It’s a family run business and they take a long term approach to the business (this is even specified in the offer document). 

 

Schaeffler buying tendered lines in the market in the past week

One of the most positive datapoints in getting comfort about this deal is the fact that since the market price of the tendered lines cracked with the sloppy market two weeks ago, Schaeffler has been buying the tender shares in the market, as summarized in this table:

 

Purchase Date	No. shs bought	avg price	hi price	% of shares	€ millions
09-Oct-08	671,069	59.1826	61.5	0.40%	39.7
10-Oct-08	1,559,906	61.3507	62.96	0.92%	95.7
14-Oct-08	834,000	63.096	64	0.49%	52.6
15-Oct-08	1,050,000	65.6238	65.65	0.62%	68.9
16-Oct-08	926,698	67.6107	67.9	0.55%	62.7
	5,041,673			2.98%	319.6

 

You wouldn’t expect Schaeffler to spend €319 million dollars buying tendered shares in the market if they didn’t intend to close the deal and believe they’d be able to close it.  The purchases of over 5 million shares at an average price of €63.39 will save Schaeffler over €58 million compared to the €75 per share they’d have paid by not buying the tendered lines and instead paying the offer consideration on these shares.

 

Conclusion

To me this is the most interesting arb trade around.  Plenty of deals have big spreads, but none has as good a spread with as attractive a risk/reward in a fully finance deal with no MAC and only an EC competition approval needed, which should not present any substantive competition issues, with the acquirer buying the tendered shares fairly aggressively.   This is a very strategic deal.  It will propel the combined company to the number one spot as the world's biggest automotive parts producer, ahead of Robert Bosch.  The acquiror is a large, private, family owned comapny that takes a very long-term view of business and will not be put off by recent market gyrations.

Catalyst

Satisfaction of final condition of tender offer in approximately mid December. 10.9% gross spread in ~55 days works out to 72% annualized rate of return with a 3.6:1 risk/reward in a very strategic deal that is fully financed and in which the acquiror is buying tendered shares of the target in the market. Should be minimal competition issue as overlaps are minor.