Description

O2 PLC – OOM LN on Bloomberg (Note all figures are in British sterling unless otherwise noted. GBP = pounds; p = pence) Price is quoted in pence, so 196p price is GBP 1.96.

While traditional merger arb trades are not usually very popular on VIC, There’s one out there that is clean, liquid, and offers a high annualized rate of return due to its size (and inability of arb money to close the gap because the deal is so big) for the kind of investor who can play a UK arb deal. Not since AT&T Wireless (AWE) have I seen such a large, liquid cash deal that has such an attractive rate of return – and O2 has none of the negative issues AWE had (deteriorating fundamentals and regulatory concerns).

I think that buying O2 at the current levels of 196p offers an excellent rate of return for the low level of risk involved. Telefonica has made a recommended offer of 200p per share, and although the deal is conditioned upon EC competition clearance, Telefonica currently has no wireless business in the three markets where OOM LN operates: the UK, Ireland and Germany. The EC’s phase 1 competition review expires December 19. Conversations with senior bankers involved in the deal shows very little concern about an antitrust issue. At 196p, the deal is trading with a gross spread of 2.04%. I believe holders who tender into the 2nd closing, which should expire on December 26, 2005, will get paid two weeks later, on January 9, 2006. The December 26 closing is key because EC competition clearance should be in hand by this date, paving the way for holders to tender with a reasonable expectation that the deal should go unconditional with the 2nd closing on December 26. The annualized rate of return to January 9, 2006 is 18.2%. Net of 7 basis point commission it is over 17.5% annualized. Of course it only makes sense to do this trade if an investor can make use of CFD or equity swaps to avoid the UK’s onerous 0.5% stamp duty. And it needs to be done through a prime broker who can/will tender on behalf of the investor. Any hedge fund that trades in the UK, Ireland or Australia is used to trading this way as a perfectly legal way to avoid stamp duty.

Timetable:
October 31, 2005 - The deal was announced on October 31, 2005 as an offer recommended by the board of directors of O2. At the time of the announcement there was rampant speculation that Deutsche Telekom, which had a few months earlier looked at acquiring O2 with KPN, would counter Telefonica’s offer. A few days later Deutsche Tel put such speculation to rest by declaring it had no intention of trying to top the Telefonica bid. KPN also ruled itself out. There has been mild speculation since that France Telecom might make a bid, but I strongly doubt anyone will attempt to top the Telefonica offer.

November 21, 2005 - Telefonica posted the offer document on November 21, 2004. This set the timeline for completion of the deal under UK Takeover Panel rules.

December 12, 2005 - The first closing, or the first date the offer can be declared unconditional, is 21 calendar days after posting, or December 12, 2005. This date is official. Since the EC phase 1 competition review is not likely to be completed by this date (since it’s scheduled to expire December 19), I expect this date will be extended by the customary 2 weeks to December 26.

The offer is conditioned upon the tender of at least 90% of share capital, but, as is customary in the UK, Telefonica reserves the right to waive this minimum down to 50.1%. Bidders frequently do waive the minimum down to 50.1% once regulatory approvals are in hand and the acceptance level has exceeded this level. This ensures no interloper can top the acquirer’s offer. Shareholders who didn’t tender get plenty of opportunity to tender once the offer goes unconditional, but they get paid later than those who tendered into the earlier offer, so there is incentive to tender early, as long as regulatory approvals are in hand.

December 26, 2005 - By the expected 2nd closing date of December 26, regulatory approval from the EC should have been obtained and I expect a majority of shareholders will tender, permitting Telefonica to declare the offer unconditional the next day, December 27.

January 9, 2006 – When an offer is declared wholly unconditional in the UK, settlement and distribution of merger consideration occurs 14 calendar days later, so this should be received 2 weeks after the second closing, or on January 9, 2006.

This puts the whole timeline from today to payment at 41 days. 4 pence upside / 196 pence stock price = 2.04% gross spread. 365 days / 41 days = 8.90. 8.9 x 2.04% gross spread = 18.2% annualized rate of return. Net of 7 basis point commissions, this works out to over 17.5% annualized.

Reason for the high rate of return:
First, two factors that should NOT be reasons for the high rate of return: Number one, financing on UK deals has to be committed and cannot be subject to the kind of escape hatch conditions that often exist on US deals. I cannot recall a case where a UK deal that was not conditioned on financing (as is the case here) was not completed because of financing problems. Number two, the UK Takeover Panel is extremely tough on buyers and rarely lets them wiggle out of a deal because of an alleged material adverse change (MAC). Two examples come to mind. Back in August of 2001, WPP bid for Tempus Group Plc. After the September 11 attacks, WPP tried to weasel out of the deal saying the attacks created a material adverse change in Tempus’s prospects. The Takeover Panel rejected WPP’s argument and WPP was forced to complete the deal on the original terms. And in August of 2005, the bidder for East Surrey Holdings PLC said it planned to withdraw its offer in light of a negative regulatory ruling from regulators in Northern Ireland. Again, the Takeover Panel said the developments were not of sufficient substance to permit the bidder to invoke conditions permitting it to terminate its offer. The deal was completed on the original terms in late October 2005. Telefonica is a good, experienced corporate acquirer and they haven’t reneged on any deal that I can recall. They walked away from the acquisition of Puerto Rico Telephone Co. when their bid was topped by GTE in 1998, but they haven’t busted any deals that I’m aware of.

In the case of O2, the rate of return seems excessively high. But I believe that there is a good reason to explain the relatively attractive spread/return.

Traditional long-only UK institutional fund managers rarely buy shares for a risk arbitrage rate of return and have not been buying O2 since the deal announcement. Most investors must also pay stamp duty of 0.5% which impacts substantially on the arbitrage return. Traditional long-only UK fund managers pay the stamp duty because they have a long-term perspective and want to be able to vote their shares (which owning through CFD or swap doesn’t guarantee). Hedge funds, on the other hand, have long been users of CFDs and swaps to play the merger arb game in the UK.

Hedge funds have been substantial buyers at around the 196p level. According to recent Rule 8.3 filings, Noonday Asset Management (Farallon) today reported control of 243 million shares (2.78%) through derivatives other than options (code for CFDs or equity swaps), Davidson Kempner have 90.6 million shares (1.03%), Deephaven have 90.6 million (1.03%), Och Ziff have 122.4 million (1.4%), and Citadel has 153.6 million (1.75%). Additionally, custodians (primer brokers) hold massive positions on behalf of hedge funds. UBS, for example, reports 552 million shares (6.3%).

Finally, Telefonica themselves have been taking advantage of the price discount and have purchased 120.3 million shares (1.37%) in the market since the offer was announced. And they do pay the stamp duty since the purchases are for cash rather than swap/CFD positions.

As with AWE in 2004, many funds have either reached their position limits for a single stock, or are waiting for a change of price/reduction in timescale, before buying more shares.

Risk/reward:
I’m using 150p as my busted deal price, which makes the risk/reward ratio 11:5 to 1. No worse than many other arbs deals and a lot better than most, especially with such a rewarding return. I think this busted deal price price is reasonable in light of where the stock came from and the decent 1st half results announced (November 14) since the deal was revealed. Sales were up 12% year over year, EBITDA was up 15%, and churn fell as the customer base increased 17% to 25.7 million. The average European cellular co. trades at 7.2x 2006E EBITDA and 14x 2006E EPS. Applying these two metrics to O2 gives prices of 182p and 124p, respectively, and averaging these two give a price of 153p. O2 came from 164.25 the day prior to the announcement of the Telefonica offer. There was some takeover speculation in the price however. Taking the average closing price over the three months prior to the deal’s announcement gives a price of 153p, so overall, I believe my 150p downside number is reasonable.

Financial Advisors:
Top notch advisors are involved, with O2 being advised by Merrill Lynch and JP Morgan Cazenove, and Telefonica advised by Goldman Sachs and Citigroup. According to the Financial Times (November 2), the GBP 17.7 billion deal will earn the investment banks about GBP 50 million purely in advisory fees. Additional fees will accrue to Citibank, Goldman and Royal Bank of Scotland for arranging the GBP 18.5 billion syndicated loan. So plenty of incentive for the bankers to see the deal gets done (and gets done as soon as possible).

Catalyst

The catalyst in an arb deal is pretty obvious, so no need to dwell here. While this type of trade may not be everyone’s cup of tea, it does allow the appropriate type of investor (fund comfortable with the UK event-driven and able to trade with swaps/CFDs) to deploy some capital which should earn 17.5% annualized before the use of leverage. Not a bad thing to own some of. Breathe a little O2 into your portfolio.