Description
Disclaimer: Please do your own research. Do not rely on this research as it may have factual errors and relies heavily on judgment and subjectivity. Sometimes statements of opinion may not be caveated as such, leading to confusion. The only thing I am certain of is that many assumptions made in this write-up are likely flawed. I may (and likely will) buy or sell securities related to the companies mentioned in this write-up without any obligation of disclosure. To the extent I make disclosures about those actions, they may be temporary and are likely an incomplete picture of my actions.
Shaw Group (SHAW: $43.86) is the subject of a friendly takeover by CB&I (CBI) announced this past July. I believe shares in Shaw have a reasonable merger arb base-case return, low downside, and attractive takeover dynamics that could lead to an outsized return. The deal is trading wide, which is at odds with my perception of its low risk, near term shareholder vote (short timeline), and upside catalysts to a potential deal repricing. I believe arbs are scared by the large premium to the pre-deal trading price, which leaves many players scared that a broken deal has huge downside dynamics. I think that is a low enough probability to take comfort and participate. Further, the threshold for motivated shareholders to influence the deal price upward is quite manageable, creating a valuable potential option.
Shaw has four primary lines of business, generally related to serving the power generation industry (primarily fossil fuels and nuclear power): ranging from design, engineering, and construction (the Power segment) to plant maintenance and value-added support (Plant Services) to environmental consulting and post-disaster response and recovery (Environmental and Infrastructure) to fabrication and manufacturing of piping systems in the power and chemicals value chains (Fabrication and Maintenance).
On July 30, 2012, Shaw announced its intention to be acquired by CB&I Group (FKA Chicago Bridge & Iron, ticker: CBI). As structured, consideration for the deal will be $41 of cash and 0.12883 shares of CBI per share of SHAW. At CBI’s last close of $37.25, that consideration equates to $41 + $4.80 = $45.80. $46 is a 72% premium to Shaw’s pre deal price SHAW today trades for $43.86. This leaves a 4.5% deal spread for the next few months, which would make for a reasonable IRR but not something that is exactly mouth watering on an absolute basis. Perhaps a decent parking spot for the manager trying to avoid the perception of mailing it in to lock-in their incentive fees, but, in reality, wanting to mail it in and lock-in their incentive fees.
However, that is not the primary opportunity here. The opportunity is that this deal, while a large one day premium to the pre-deal share price, has reasonable odds of being repriced upward given the low threshold for shareholders to reject the deal. As structured, CBI seems to be stealing the company.
Shaw Group is poised to have a step function improvement in operating performance beginning in 2013 and accelerating into 2014 and 2015. Shaw and CBI each acknowledge this inflection in their filed merger documents and in prior public discussions. Based on its on internal expectations, both communicated over time in public and filed in the CBI merger documents from August, Shaw expects its EBITDA to increase 150% by 2016 over 2012 with large increases each year along the way. This is driven by top line growth and margin expansion, the beginnings of which can easily be seen in the recent FY 2012 release. Further, the company has a balance sheet with over $1.4 billion of net cash and growing. It has 67 million shares outstanding, so at $46/ share the company would have a $3.1B market cap and a $1.7B EV.
While the announced price may be almost 6x EV/2012 EBITDA, a few things are worth noting:
- Shaw was trading at <1.5x EV/2012 EBITDA pre-deal. From a broken deal standpoint, I believe it’s exceedingly unlikely the stock goes back to pre-deal levels.
- Given the ramp in EBITDA and free cash generation over time, excluding any benefit for likely synergies (which I believe merits a control premium), Shaw is being sold for <5x 2013E EBITDA and only 3x 2014E EBITDA (less than those at today’s discount to closing price).
All of that may very well be egregious or comforting or some other self indulgent descriptor, but the reality is the deal is what it is and it will take a huge voting block to get either appraisal rights or to obstruct the deal. Right? Wrong. In this case, deal approval requires a supermajority thumbs up of 75% of shareholders. Over 5% of shareholders are excluded from the calculation due to conflicts of interest. Given a likelihood that many owners probably won’t vote, it seems quite plausible that a mere 15-20% of shareholders could block the deal. I am tempted to write extensively about this subject, but the reality is one of Shaw’s shareholders - Denali Group - is actively working toward a more equitable compensation for Shaw shareholders. Denali has established a website that lays out its case through a series of letters, white papers, and presentations on the subject:http://www.shawfairvalue.comDenali provides a lucid case for why Shaw is worth 2x the current transaction price in a change of control. I recommend you read their work and assume as much in my write-up.I won’t punt entirely to Denali as I believe a few points warrant specific mention.The sale process was incredibly fast and lacking many of the characteristics of a healthy “best practice” sales process. The Shaw board (and management did not establish any auction dynamics, has not communicated with shareholders either verbally or via standard deal presentations, and did not form a special committee to pursue the transaction. Instead, the process looks rushed, opaque, and amateurish.One of the primary unanswered questions is why management would sell the company for such a low price in the first place. As a quick review of past conference call transcripts will show, in the months leading up to the sale, Shaw management repeatedly discussed their view that Shaw’s stock was ridiculously cheap, the Shaw story was about to be simplified, and how the business of Shaw was about to hit an inflection that would grow top line and expand margins. Given that backdrop, why would they choose to sell just as those improvements were beginning to wash up onto the beach? In my mind, this remains an unanswered question though as you’ll see, Denali postulates that the Chairman, James Bernhard, Jr., is preparing to run for either US Senate or Governor of Louisiana in the next two to three years and that the prep time for that means he must begin immediately. By selling, he crystallizes wealth and frees himself to move on successfully to his next endeavor.One point on this that Denali does not delve into extensively is that this sale triggers a meaningful Golden Parachute for Bernhard, Jr. of at least $42 million (that excludes the value of his stake that was already vested). $36 million will come from accelerated vesting. Bernhard will also be provided ten years of 150 hours per year of private airplane service upon his exit, paid for by CB&I. Finally, he will receive, if he chooses to resign within 90 days of the deal closing (which is a virtual lock given the deal structure) three times his existing base salary plus three times his highest bonus of the prior three fiscal years. It appears Bernhard currently makes a $2 million base. His FY 2012 final compensation and bonus have not yet been disclosed and it is unclear in the merger S-4 what comprises the “bonus” (whether it includes stock, option, and retirement compensation). If FY 2011 is an indicative year, the composition of this number adds up to somewhere between $0 and $5.5 million, before being tripled as a golden parachute. I suspect FY 2012 compensation exceeds anything from the prior two years given the substantially improved operating performance and the “successful” M&A events during the year. In any case, these two lump sum payments add anywhere from $6 to over $20 million of additional payments to Bernhard if he leaves Shaw/CB&I within 90 days of the transaction closing. Bernhard also owns another 2.4 million shares (between shares and options) that are worth close to $100 million. So, where are we?As with most merger/event situations, a probability matrix is my tool of choice. The shareholder vote is expected in about one month, and I thusly view most of the arb as in play by year-end. HSR has already passed, most of the important deal closing conditions have been met, and now the primary impediment to closing is a shareholder vote. Given the near term nature of the vote, I believe we will find out by December 31, 2012 whether or not the deal is going to close and at what price. After that, I assume the predominance of the deal risk arb will have played out, closing to 1.5% gap to expected value.(I’m using 1.5% based on an assumed final closing date of March 1, 2013, which leaves a reasonable deal IRR). My rough around-the-edges probabilities and outcomes are as follows:- 70%: $46 - Deal closes on original terms $32.20- 20%: $60 - Deal is repriced upward*: $12.00 Note:
- 05%: $46 - Deal is rejected for inadequate compensation and does not close: $2.30
- 05%: $35 - Deal fails to close for unforeseen reasons: $1.75
- $48.25 Probability weighted value at close.
- 1.5% discount at year end = $47.53
Conclusion:
Acknowledging this is all overly precise, this would indicate Shaw has an 8.4% expected return to year-end (only two months away, believe it or not), which equates to better than a 60% IRR. This comes with what I believe is a reasonably low downside case and an upside event situation that could flex the share price significantly higher in the near term. Further, a small change in the ownership composition toward a motivated, value-oriented shareholder base could push the repricing case odds significantly higher as only a small portion of shareholders could reject the deal and thus wield negotiating leverage.
In my opinion, this is a sound home for a decent return. It comes with attractive embedded option value and low downside, which I find to be a nice reprieve from the risk-fraught macro environment.
*$60 in the repricing case is itself a blended case of a spectrum of outcomes, as are other two non-base case scenarios.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
- shareholder vote in the next six weeks or so
- deal closing by end of Q1 2013 (and possibly sooner)
- deal spread continues to narrow