Does the 3Com / HP Merger Arbitrage Idea Make Sense?

Since I don’t see much appreciation in the market this year, now is a good time to look into merger arbitrage again. It’s been a while since the failure with DISK and now may be the time to get back on an easier horse to ride.

3Com (COMS) Corporation Merger Arbitrage Details

• Acquirer: HP (HPQ)
• Target: 3Com Corporation
• Announced date: Nov 11, 2009
• Closing date: April 30, 2010
• Closing value: $7.90
• Last price: $7.48 at time of writing
• Profit: 5.3% excluding fees

This merger is a cash deal so 3Com shareholders will receive $7.90 per share in cash if the merger is successful.

Cash deals are much easier to analyze and calculate whereas profits can fluctuate with stock mergers. It’s one less variable and the key point of merger arbitrage is to remove as many variables and risk as possible.

Recent Events

On Jan 26th, the shareholders approved the merger by 77% which clears most but not all the hurdles to finalize the deal. The Chinese Ministry of Commerce (“MOFCOM”) now has to formally ok the deal.

“Under the Anti-Monopoly Law of the People’s Republic of China, the parties are required to submit a filing to the Ministry of Commerce (“MOFCOM”). The parties made a joint filing on December 4, 2009. MOFCOM formally accepted the filing on December 28, 2009, commencing the 30-day Phase I review process. On January 25, 2010, MOFCOM notified the parties it would not complete its review by January 27, 2010, the end of the Phase I review period, and that a Phase II review would be initiated. The initial Phase II review period is up to 90 days and can be extended by MOFCOM by up to an additional 60 days.”

You can read all this from the latest SEC filing.

Merger Arbitrage Checklist

1. Due diligence by both parties

I immediately concluded that both have performed their due diligence. HP and 3Com want this merger badly. How do I know this?

“The Merger Agreement provides that, upon termination under specified circumstances, 3Com would be required to pay HP a termination fee of $99,000,000.”

At its current share price, 3Com is valued to be a $3 billion company. Before the deal, 3Com was around $2 billion so when they entered the agreement, HP wanted 3Com to pay half its market cap as a penalty to HP, and 3Com agreed. These two desperately want to get married.

2. Financing and regulator approval

Financing for HP isn’t going to be a problem. The tricky part is the regulator approvals. I’m not aware of how the MOFCOM acts and approves decisions when it comes to mergers, but it seems like the Chinese antitrust approval will be the final hurdle. Will have to wait for news on any European and US antitrust laws but looks good so far.

3. Get preliminary shareholder sentiment (or controlling shareholder approval)

Not required

4. Obtain regulator (SEC, FCC, any and all) approval

Same as (2) above.

5. Get final shareholder approval

Shareholders approved by 77%

3Com Valuation

With a merger, knowing the downside level is also just as important should something go wrong and you are left holding the company.

Quickly running through COMS on the stock valuation calculator, I see that the company’s fundamental history isn’t great. A few things I immediately see.

• The net income was inflated because the company didn’t have to pay much taxes from all the losses over the years.
• FCF has been negative for most part of the past 10 years.
• Management has done a terrible job of using its cash.

With the following valuation, I’ve kept it slightly optimistic.

DCF: $6.70

Graham’s Formula: $5.87

EPV: $4.94

Looks like COMS is a $5 company. No need to be exact, just take the average and COMS' valuation is $5.84 which is what it was trading at before the merger announcement.

Probability Calculation

• Potential Upside: About 5% (based on closing value of $7.90)
• Potential Downside: 26% (based on a stock valuation of $5.84)
• Time: 3 months but has to be completed within 1 year, i.e. Nov 11, 2010.
• Probability of success: 85%

I then plug the numbers in a Kelly formula calculator with the above stats and the result is a Kelly Percentage of 27%. Meaning, you can allocate up to 27% of your portfolio to this particular investment. I’m not 100% convinced with the Kelly formula but in this case, I would have to agree.
COMS Fundamental Stock Valuation Overview

Disclosure: No position at the time of writing. Need to free up some cash to make it worthwhile.