Bracell: a pretty juicy merger arb play

I don’t often pursue merger arbitrage (the practice of buying stocks with announced takeovers pending, and/or shorting the shares of the acquiror, hoping to capture the spread to the deal price if/when the deal closes). I am not an expert in the space, and oftentimes the returns don’t justify (to me) the real risk that deals can fall through. But every now and then there is an exceptional case, and Bracell (1768.HK) looks like one such opportunity.

Bracell is an interesting small-cap stock. While listed in HK, the company has most all its production facilities and assets in Brazil; even more interestingly, it is majority owned (85%) by an Indonesian tycoon, Sukanto Tanoto – who also controls one of Bracell’s key customers (this is not normally a good thing, but bear with me).

Bracell manufactures dissolving wood pulp (DWP), a naturally occurring fiber used in a variety of applications. The higher grades (“specialty grade pulp”) are used for cigarette filters, eyeglass frames, pharmaceutical tablets, cords in tires, and the like. The lower grades (“rayon grade pulp” or “commodity viscose”) are a feedstock for the textile industry. As you can imagine, specialty grade commands a higher price and margin, while the commodity grade is of lower value, more competitive, and possesses much lower margins.

Both commodity and specialty pulp markets are quite competitive – there are at least five or six large-ish players globally – but Bracell possesses two key structural advantages. Firstly it is fully integrated, owning all its own forestry assets (trees are the key raw material input as you might expect) – this is necessarily an advantage when it comes to input costs. Secondly, these forests are entirely located in Brazil – a double advantage both because of the recent weakness of the local currency (BRL) versus most all export markets for DWP, and also because of the nature of the trees grown there. South American eucalyptus trees grow to maturity in ~8yrs, versus the 30yrs for North American hardwood used by a number of Bracell’s competitors, meaning Bracell has a long-term cost advantage as the effective yield of a eucalyptus plantation is so much better. Thirdly Bracell has an off-take agreement with an affiliate of its major shareholder, to sell as much commodity product as it needs to to maintain full utilization of its facilities (at the moment ~25-30% of its tonnage goes towards specialty, the balance towards commodity grades). This provides a further layer of operational security in times of low utilization.

It should be no surprise then that Bracell is effectively the low-cost competitor in the space, and can profitably produce specialty grades of DWP at prices ~$200/t cheaper than its North American rivals (Rayonier, Tembec, etc). With specialty grade prices around $1200/t, this is a massive cost advantage.

This is all by way of background. The key takeaway is that within this market, Bracell possesses a number of quasi-structural advantages that look likely to persist in the medium term.

Recent events and the opportunistic bid for the company

This brings us to recent events. For much of the past year, Bracell stock drifted along unnoticed in the $0.9-1 range, despite solid operational results and high cash flows. In early June, however, the company announced 1H profit (to be fully reported in August) would post 100-150% higher year-over-year, a function of the lower BRL, price stabilization in specialty pulp, continued cost discipline and (in my view) further customer wins due to their cost advantage. The stock immediately took off, rallying from ~$1 to the $1.5-1.6 range – a level that still looked very cheap on fundamentals (as we shall discuss).

At this point the company announced that the majority shareholder had bid to acquire the remaining public float (just ~15% of the outstanding), sending the stock spiking to $2 as arbitrageurs piled in, before settling back to $1.6-1.65 once the offer price (just $1.78) became known. This is effectively a ‘take-under’, given where the stock was trading pre-price announcement.

So this is where we stand today (mid-July). The stock is currently at $1.62; there is a $1.78 bid on the table from the current 85% shareholder. The company has hired Morgan Stanley to evaluate the offer, and according to HK Takeover rules, there is a requirement for 75% of MINORITY shareholders to approve the bid, and ALSO for <10% of shareholders to veto the deal outright. While not insurmountable, these are reasonable protections for minority shareholders, in my view.

It is worth considering now how cheap this $1.78/share bid is. Last fiscal year (Dec’15), Bracell generated ~$172mm of FCF, which equates to ~39c per HK share – or a LTM FCF multiple of just 4.5x. You would be hard pressed to buy a dying, heavily levered business at <5x cash flow. Bracell is quite the opposite – it is the low-cost producer in a commoditizing industry, possesses very little leverage today (~0.8x EBITDA), and will be effectively net debt free by year end 2016. You could easily argue a 10x FCF multiple for this business is too cheap, even absent an acquisition premium.

Of course, we also know 2016 earnings numbers will be better than 2015 (due to the 1H profit guidance). In the below abbreviated CF statement, I assume a decent step-up in cash taxes, capex spend, AND no working capital benefit but still think Bracell will throw off at least another ~30c per share (or ~$133mm) in FCF:

bracell1

The majority owner is thus offering to pick up the remaining shares in what could become an industry leader at 5-6x FCF with no leverage…clearly very opportunistic, to say the least

Heads I win, tails…I win more?

This brings us to the source of the opportunity. As we sit today, I estimate the following three possible outcomes:

  • minority shareholders simply don’t care that they are being expropriated – they vote the deal through. As such you receive $1.78 for the $1.62 paid today, likely in <6 months (this is not a complex deal), thus ~22% annualized return or better. Not bad at all.
  • MS suggests the bid is too cheap, and, fearing losing the shareholder vote, the majority owner raises the bid. I estimate fair value much closer to $3 than $1.78 for this asset, but even a nominal bump in deal price would lead to significant returns. For example, 7x FCF would equate to ~5.5x EBITDA, which looks cheap versus comparables but is not as egregious as the current price. That alone would increase gross returns (vs $1.62 current) to 35.8%, and, if the deal closes in <9months (again, very conservative, it should be faster than this), to 48% annualized returns. Again – not too shabby.
  • MS suggests the bid is wayyyy too cheap, and the majority shareholder drops the bid. While this seems a fairly bad outcome, I really don’t think the stock has that far to fall. Recall this business is already trading at 4.2x LTM FCF and ~5.5x current year FCF, with no net debt from end-2016. It also pays a ~2.5% dividend which will surely be raised if the takeover doesn’t go through, AND it was trading in the $1.5-1.6 range BEFORE the takeover bid was announced. Finally, since the majority owner owns 85% of the issue, there simply isn’t much stock for arbs to dump if the deal breaks (frankly I think most of them bailed once the deal price was announced). Adding it all up, I don’t think the stock price falls that much if the deal breaks (5% or so?) and if it did I would buy more.

We must also consider the motives of the major shareholder. As of today, the entire market cap is $715mm (USD), and the EV is ~$850mm. At deal price, the implied EV is $923mm (looking at LTM numbers), or $785mm looking out to year 2016 end (due to the FCF generation). Of this EV the major shareholder already has $668mm invested (his 85% stake at $1.78) thus leaving only ~$118mm of ‘value’ being paid out to minorities. Increasing his bid by say 25% thus only amounts to an incremental ~$30mm being paid out, or just ~3.8% of EV at current deal price and <5% of the value of his stake at deal price. This does not seem like a large incremental amount to pay to achieve closure for this valuable asset, in my view.

Really the main limiting factor here is liquidity (the stock trades ~$200-300k USD per day, or less), and then timing (it is as yet unclear when the vote will be, though I anticipate it will be ❤ months). However for smaller funds/private investors, the risk/reward looks compelling.

Disclosure: long 1768.HK

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24 thoughts on “Bracell: a pretty juicy merger arb play

  1. hsa July 13, 2016 / 3:40 am

    Enjoy it

    Like

  2. Duff, Richard July 13, 2016 / 4:01 am

    I always enjoy it when these hit the email.

    Sent from my iPad

    Like

  3. Thomas Bachrach (@PFHCapital) July 14, 2016 / 12:23 pm

    Very persuasive idea. Think this one works out well and I agree if the deal breaks, it may be an interesting opportunity to double down on. Thanks Jeremy.

    Like

  4. cc1691 July 15, 2016 / 2:09 am

    Do you know when the vote is?

    Like

    • puppyeh July 15, 2016 / 2:15 am

      Not sure it has been set yet but it should be relatively soon. Co will announce 1H in mid-Aug, and MS should issue some opinion on the fairness of the bid. I would suggest a vote by September sometime, thought this is purely an estimate.

      Liked by 1 person

      • cc1691 July 30, 2016 / 2:02 am

        What I don’t understand about this proposal is why the bidding party waited until after the profit warning announcement to make the offer. Wouldn’t it have made more sense for them to make the offer a month or two before the announcement to minimize consideration? Given that they are insiders, they would have had knowledge of the company’s improved performance even prior to the announcement.

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  5. puppyeh August 2, 2016 / 3:37 am

    Well, clearly if they bid before the profit announcement it would have seemed even more blatantly opportunistic. additionally, by waiting until after the positive profit alert, they can claim they are bidding at a substantial premium to the average 30/60/120 day price (a typical move in acquisitions), even though the premium to the post-profit alert price is basically minimal…so really waiting helped thme here.

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  6. Thomas Bachrach August 4, 2016 / 2:07 pm

    Looks like the controlling shareholder bumped the offer from 1.78 to 2.28 (28% increase). Well down, Jeremy (thus far at least, knocking on wood).

    Price is 2.10 as I look, leaving a nice 8.5% spread on a stock that still looks reasonably inexpensive (though it now has further to fall on a deal break). You think this deal gets accepted? Curious regarding your latest thoughts?

    Like

    • puppyeh August 5, 2016 / 4:57 am

      thanks Thomas. I still think the spread is too wide and I actually added to my position. The acquirer has clearly demonstrated they want to clean up the remaining shareholders and raised their initial bid 28% before the 1H results even came out. At ~6x EBITDA and 7-8x FCF, the bid has simply gone from ‘insanely cheap’ to still ‘very cheap’.

      I think it highly unlikely the deal breaks, at this point, and there is still a decent chance (25-30%?) that the bid gets raised again once MS comes out with a fairness opinion on the new price. Either way I still think the price is pretty attractive.

      Like

  7. ss August 4, 2016 / 9:57 pm

    Congrats!

    Like

  8. Ambiter August 8, 2016 / 2:03 am

    The company hired MS, whereas the independent committee hired Rothschild. If there’s a difference of opinion between the two, which one do you think takes precedence? Also, given that this is the 85% shareholder buying out the 15% minority shareholder, would the concept of a minor discount come into play and offset any/all acquisition premiums?

    Like

    • puppyeh August 8, 2016 / 12:33 pm

      not sure i follow your second question. the minority shareholders need to give 75% approval to any deal accding to HK takeover law.

      the MS/Rothschild difference is probably not meaningful either

      Like

      • w51w52 August 8, 2016 / 3:21 pm

        Hi, sorry my question wasn’t clear. In the scenario where a third party wants to buy Barcell, there would be a control/acquisition premium paid, that we all get. However, in this situation, it is the majority shareholder buying out the minority shareholder, and a third party would never buy out just the stakes of the minority shareholders. As such, there may be a minority discount (not minor discount, typo for me, my bad) as opposed to a control premium. So, the question is, MS/Rotschild will come up with an estimated fair value for Barcell, but would they apply a minority discount (say, I don’t know, 15%) to reflect the nature of the transaction?

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      • puppyeh August 9, 2016 / 5:07 am

        i see what you are saying, though in my experience these independent valuations generally just value the co in line with comps without considering minority/majority ownership or control premiums, and then say if they think its fair or not. clearly this can and will generate a large variation in fair value but 1.78 was massively cheap on any metric, while 2.28 is still at the low end of most all reasonable metrics but may be technically defensible from a comp perspective. i still think the bid will be raised a bit but even if its not the return is still attractive from here

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  9. w51w52 August 8, 2016 / 2:06 am

    The Company hired MS, whereas the Independent Committee hired Rothschild. If there’s a difference of opinion, which side do you think carries more weight? Also, given that this is 85% majority squeezing out the 15% minority, would the concept of a minority discount trump any/all acquisition premiums here?

    Like

  10. cc1691 August 22, 2016 / 10:47 am

    ‘Further to the Price Increase Announcement, the Offeror advised the Bracell Board on 19 August 2016 that the Offeror does not intend to increase the Revised Cancellation Consideration and the RSU Offer Price and does not reserve its right to do so. Accordingly, the cash consideration for every Scheme Share cancelled under the Revised Proposal will remain at HK$2.28 and the ‘see-through’ price payable in cash by the Offeror to the RSU Holders under the Revised RSU Offer will remain at $2.28 for each RSU.

    Shareholders and potential investors of Bracell should be aware that, following the making of this statement, the Offeror will not be allowed to increase the Revised Cancellation Consideration and the RSU Offer Price save in wholly exceptional circumstances in accordance with Rule 18.3 of the Takeovers Code.’

    Does your thesis remain the same even after this statement was released by Bracell today?

    Like

    • puppyeh August 31, 2016 / 3:24 pm

      sorry i was traveling. clearly it makes further upside quite unlikely, I think 2.28 is still too cheap but given the bankers suggest it is ‘reasonable’ minority shareholders probably just take it and walk away. not the best outcome but still not too bad at all if you got in at 1.6…

      Like

  11. Thomas Bachrach August 31, 2016 / 11:47 am

    I closed my position today. My understanding is the prospect of a deal bump is gone. Using 2.17 current price, 2.28 upside, 1.50 downside… market pricing probability of deal going through at 86%.

    Ultimately, I’m not a huge merger arb guy + I can count the number of things I am 86% sure of on one hand.

    Jeremy, thanks again for the great recommendation. Very handsome profit on this one! I owe you a drink or ten.

    Like

    • puppyeh August 31, 2016 / 3:23 pm

      glad this worked out for you Tom. I concur the deal is likely to close and there isn’t much upside left. But I think downside is much smaller than 1.5, I think it would retrace only to 1.75 or so (given the acquirer could come back in again 6mos later), so I still think the implied spread here is too high.

      While unfortunately another higher bid didn’t follow, given the independent bankers suggest 2.28 is ‘fair and reasonable’, I do think this gets over the line so annualized return for the amount of risk here should still look good.

      Liked by 1 person

      • Wei Wang September 9, 2016 / 4:19 am

        When do you think this thing closes?

        Like

      • puppyeh September 14, 2016 / 11:51 am

        Assuming it gets voted through on Sep30 (still not a done deal), this should close by end Oct/early Nov. Risk reward on the spread still pretty attractive in my book.

        Like

    • puppyeh October 25, 2016 / 5:41 am

      Talk to your broker – Interactive Brokers, my broker, says they will handle it all for me so no worries if its a physical check

      Like

  12. sd October 23, 2016 / 5:27 am

    “Payment…will be despatched by ordinary post at the risk of the recipients to their registered addresses shown in the register of members of the Company.”

    A check for a significant amount floating around in the ordinary post system at the risk of recipient? Doesn’t inspire much confidence. Guess registered post must be too experience for a billion dollar company.

    Like

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