Description

This is a merger arb opportunity.

On Sept 23, 2021, Otis Worldwide Corporation (“Otis”) announced a cash tender offer at €7 per share for the remaining 49.99% it does not already own in Zardoya Otis, S.A. (“Zardoya”), an elevator business in Spain, Portugal and Morocco.

The transaction is euro-denominated debt financed and expected to close Q2 2022.

The offer price will be reduced by the gross dividend received each quarter.

According to the Otis CEO: “​​delisting the Company will simplify Otis’ corporate structure, provide for more streamlined management of the business, and generate operational efficiencies for both businesses.”

The combination would probably eliminate royalties of 3% of sales that Zardoya has contractually paid to Otis.  Therefore Zardoya’s earnings would increase by about 9% or €15 million from historically reported.  

The prospectus has not yet been published, and is expected in just under one month’s time.

Valuation

€7 per share values Zarodoya at 18.0x P/FCF after royalty elimination, earned during the 12 months ending May-21 while the Spanish economy was brutally depressed by COVID-19.  This is not a rich price for a high quality business with scarcity value.   Its undisturbed public valuation has frequently been higher during the past 34 years for which we know it to have been consistently profitable.  The company runs a net cash position.

Background

Zardoya is a significant, publicly traded, non-controlling interest for Otis, and the proposed takeover represents one of the few ways in which Otis can reinvest profits within their existing global business.  After the 2020 Otis spin-off from United Technologies, Otis management are appropriately incentivized and focused on value creation.  As Otis stock has appreciated post-spin, funding US buybacks by repatriating European profits makes less sense than using these to repay Euro-denominated debt, incurred to buy Zardoya stock trading near long term lows.

The founder Zardoya’s family retains an 11.4% shareholding (Euro-Syns, S.A.) and one board seat.  They have not accepted the current offer and can block a squeeze-out.   

Financing

Otis has obtained fully committed bridge financing from Morgan Stanley and expects to replace the bridge facility with permanent debt financing.  Cost of debt should be slightly above ½% per year.  

Asymmetric opportunity

Expected value: €7.62 per share or 8.4% by guided deal close, 11.4% annualized.  The real attraction here is that the downside is very small in my opinion.  Most any surprise would be positive.  

Risks: Deal is unlikely to break and is a low risk business even if it does

Compared to most risk arbs, this has a low probability of breaking: due to the existing 50% Otis control, no competitive reviews are required; nor any foreign direct investment authorization; no Otis conditions to the offer.

In the unlikely event of a break, this is an unlevered, good business that has endured the pandemic test without missing a beat.  The stock was trading higher than the current offer pre-pandemic, so it is conceivable that any price decline would be short lived. 

Base case

The absence of an alternative bidder is Otis’ biggest advantage.  Spanish squeeze-outs require 90% acceptance, which the Zardoya family could block.  But 75% acceptance permits a de-listing if certain valuation criteria are met.  If the independent committee recommends the current valuation, and if merger arbs do not find this sufficiently interesting, the deal would go through as stands.  Therefore this seems the most likely scenario.  In which case you lose very small: just transaction costs and cost of capital.

Incentives for a price bump

Otis “...(e)xpects up to mid-single digit percentage accretion to adjusted run-rate EPS” if the tender completes. That 5% of Otis’ $36b mkt cap represents $1.8 bn of potential value creation from the tender, compared to a $1.9bn transaction value, suggesting Otis management could conceivably almost double the offer price and still create value for Otis shareholders and themselves.

Only two members of the Zardoya Board are independent.  For many years Otis has not only had representation on the Zardoya Board but also promoted Zardoya directors to senior executive Otis roles, partly reflecting the respect with which the Zardoya operation is held within the Otis group.  For example, current Zardoya Chairman, Bernardo Calleja Fernandez also serves as Otis President of Europe, Middle East and Africa; he was previously Zardoya CEO; and was preceded as Zardoya CEO by a future Otis CEO.  Managing such conflicts of interest during a takeover, and ensuring all negotiations are conducted within the regulations, are two obvious constraints for the bid strategy.

The strategy of announcing a bid without either the Zardoya Board’s recommendation or the Zardoya family’s agreement might seem odd given all the long standing relationships.  But it is perhaps the cleanest.  Negotiation discussions with Euro Syns, the fellow board member and potential deal blocker, can now be started after the initial lowball offer, satisfying regulatory constraints.  And the independent committee - fellow Board members to the conflicted directors - can be perceived to fulfill their duties by negotiating a materially higher price.  

Merger-arb / activism

Several typical tactics could be employed, resulting in the deal completing to Otis’ satisfaction, but at a considerably higher price than the current offer.

Otis has made its first approach for Zardoya since the original 1972 merger with then Schneider Otis.   Having waited almost 50 years to take out minorities I suspect that Otis now just wants to get this deal done.

Reference Materials

https://www.sec.gov/Archives/edgar/data/0001781335/000114036121032145/ny20000774x1_ex10-3.htm

https://www.cnmv.es/portal/verDoc.axd?t=%7b0eba7ec2-1df8-444f-b5fc-be85402f9d30%7d

Catalyst

Merger arb arrivals (any new buyer above 1% has to file).