A Fat Pitch Arbitrage?

A version of this article originally appeared on May 5, 2009 in Opportunistic Investor. Subsequently, the Opportunistic Investor acted on the article's idea, buying FMCN at $7.53 and SINA September $27.50-strike puts at $3.70 each. You can access our Web site at mgi.morningstar.com

True arbitrage opportunities that an individual investor can act on profitably are fairly rare. Usually, the spread is too narrow, there's too much risk, or there is not enough liquidity. But recently, we may have found a good example.

While both companies involved are Chinese, they are incorporated in the Caymans and have American Depository Shares (ADSs) that trade on the NASDAQ, which are liquid. The potential investment is a merger arbitrage that involves  Focus Media  and  Sina .

The Players
Focus Media is a big Chinese advertising company. Most of its business involves setting up LCD screens, posters, billboards, or other displayed media in public places, such as elevators, supermarkets, and so on. It rents out space and time on these screens to companies looking to advertise. It also sells advertising slots in movie theaters (such as pre-movie advertisements), and has an Internet advertising business, where it essentially buys advertising space from Web sites and markets them to companies looking to run ad campaigns. Focus Media is the company being acquired, so we'll spend more attention on it for this article.

Sina can best be described as an "Internet media conglomerate" in the same vein as  Yahoo . Through its Internet portal (think yahoo.com), the company offers everything from search, to games, to mobile phone services, to online shopping.

The Deal
This is an unusual deal, but fairly simple to understand. Focus Media is selling most of its businesses to Sina in return for 47 million Sina shares. However, the Focus Media will remain publicly traded, albeit much smaller and much less profitable than before. Namely, Focus Media will divest its entire "out-of-home advertising" network, comprising LCD screens, posters, digital poster frames, LED screens, and so on. It will retain its theater and Internet advertising businesses. The 47 million Sina shares should be distributed to Focus Media shareholders after the deal closes--currently slated for the end of the second quarter. The deal has been approved by both boards of directors and is not subject to an approval via shareholder vote.

Focus Media has 129 million shares outstanding. So, each Focus Media share equals about 0.36 shares of Sina common stock. Here is where the math gets interesting. Focus Media is currently trading for about $6.80, whereas Sina is trading for about $29 (0.36 * $29 = $10.44). So the Sina shares are worth 50% more than what Focus Media is trading for! But wait, there's more. As of year-end 2008, Focus Media has $423 million of cash. Of that amount, $280 million will go to Sina post-deal, leaving the firm with about $142 million, or about $1.10 per share. This figure may change slightly, depending on working capital adjustments and 2009 cash flows.

But don't forget that Focus Media will have an operating business as well. Admittedly, this business is tough to value presently and its future prospects aren't jaw-dropping. Nevertheless, we think it's safe to say that it's worth more than zero. We provisionally estimate that Focus Media's cash and its remaining business are worth about $2 combined.

The math looks even more compelling in this light. When paying out $6.80 per share for a share of Focus Media, you theoretically receive $10.44 in Sina stock, plus $1 in cash and the remaining operating business. The Sina exposure is hedgeable through either a short sale or a put option. Best of all, the deal is slated to close in only a few months, potentially producing an annualized return of well over 100% if everything goes according to plan.

The Risks
As we said before, arbitrage opportunities like this are rare. And when something looks too good to be true, it usually is. So, what's the catch here?

Strangely, after several days of looking, we've found no major impediments to the deal. That doesn't mean we'll stop looking, but things are looking good so far. However, we want to point out two potential wrinkles:

• Sina, while fending off a hostile takeover attempt a few years ago, adopted a poison pill provision. Basically, if any entity acquires more than 10% of Sina's shares, the board can elect to trigger this provision, resulting in substantial dilution to the potential hostile bidder. This may be in play today. An entity known as Fosun (a big Chinese conglomerate) has acquired a very large number of Focus Media shares. If the deal happens as planned, Fosun will own a bit more than 10% of Sina, allowing Sina's board to trigger the poison pill if they want.
  
  If the poison pill is invoked, Fosun would be severely hurt, but this doesn't directly affect other minority shareholders. However, will Fosun's interest torpedo the deal? It doesn't seem likely. First, Sina has already approved the deal. Second, the deal looks very accretive to Sina, given Focus Media's valuation multiples and cash flows. So far, based on recent conference calls, we don't seem many signs of concern on this point.
  
  Another consideration is whether Sina can use Fosun's actions to invoke a material change clause in their deal contract and walk away. This is a much harder question to answer, because we don't know how Sina perceives Fosun's interest. Focus Media's management thinks Fosun is simply a financial investor looking to make a profit. But perhaps Sina sees something more sinister. However, Fosun's stake has been public knowledge for months now, and Sina hasn't done anything in response. And as we said before, Focus Media looks to be a very accretive deal for Sina, and we're sure they want to avoid scuttling it if they possibly can. Nevertheless, there is an element of deal risk. But so far it doesn't seem to justify the massive spread available today.
   
  
• There may be some out-of-left-field tax consequence for U.S. ADS shareholders. Focus Media, being incorporated in the Caymans and operating in China, has an unusual organizational structure--probably the weirdest we've ever seen. The company does not directly own some of its Chinese operating subsidiaries. This is designed to satisfy Chinese laws that restrict "foreign" investments in the advertising industry. Instead, the company has a series of tight contractual relationships that allows it to control the subsidiaries and to allow profits to pass to the holding company via dividends.
  
  Furthermore, Sina is issuing a very large number of shares. Focus Media shareholders will control 45% Sina when the deal is done. We don't know all the intricacies (which may involve Chinese tax law, U.S. tax law, and the exact legal nature of the transaction) at play here, and we are working with incomplete information. A question was asked of Focus Media's management on the last conference call, and they replied that their tax team is still working on it. We are trying to chase down some leads, but so far we've obtained no concrete results.
  
  This all sounds very alarming, but it seems manageable given the spread today. After all, what does the tax rate have to be to make a nearly 100% spread unprofitable?
  
  These are the two main issues we've found, and they both seem to be containable today. But given that we are somewhat in terra incognita, that doesn't mean that there isn't some other hidden issue out there. For example, the deal's closing is subject to regulatory hurdles like an antitrust review. We don't expect there to be issues, but Chinese regulators can be fickle. We are talking to a lot of people and chasing down as many resources as we can to figure out what it is, but so far, we've found nothing more significant.

What if the Deal Breaks?
Given that there are risks, and we are working with incomplete information, it pays to ask, "What happens if the deal breaks down?" We don't want to be caught holding the bag on a terrible company by itself. The good news is that Focus Media does not seem expensive today. It's not a terribly good company, but it has a huge cash position, very strong cash-generating abilities, and small capital reinvestment needs.

Focus Media is worth about $900 million in the market today, over $400 million of which is net cash. In 2007, the company generated about $108 million of free cash flows. We don't know the exact 2008 number, because the 20-F hasn't been filed yet, but we estimate that 2008 free cash flows were close to $150 million, based on the company's latest financial disclosures. No matter what the exact number is, paying $500 million for these cash flows seems attractive.

That said, 2009 won't be a good year for Focus Media. Advertising is a very cyclical business, and the Chinese economy is slowing. Advertising rates are falling, and utilization rates for screen usage may fall as well. Given the operating leverage of Focus Media's business, this won't be good for profits. But keep in mind that the company has ample cash, and capital expenditures will fall by two thirds. We are fairly confident that it will survive the slump in fine shape.

A bigger concern is Focus Media's management. Traditionally, Focus Media has been an acquisitive company--producing exponential growth for the last five years. But management has shown more talent closing deals than in running the acquired businesses. Last quarter, the company dramatically restructured its business, including shutting down a recently acquired division, and took goodwill write-offs totaling over $800 million. Thankfully, most acquisitions were done with stock at prices many multiples of where it is trading for today, so ironically, on a net basis, acquisitions may actually be accretive for new investors.

How to Structure the Transaction
The simplest way to structure the transaction is to buy FMCN stock, and short SINA, on a ratio of 0.36 shares of SINA per share of FMCN. However, this method entails two risks. One, Sina shares are being increasingly shorted. Currently, about 15% of its float is sold short. If short interest increases dramatically in the next few months (for example, as more traders jump on this bandwagon), an investor might face a short squeeze, widening arbitrage spreads, and his/her shorts might be called away. Second, if the deal falls apart, one would not want to be straight up short Sina shares.

Another option is to buy an at-the-money, or near-the-money, SINA put. This is a much more expensive option, but given the size of the arbitrage spread, the deal is still solidly profitable. The key risk here is time horizon. If the deal drags on, the put may expire, thereby forcing an investor to extend, costing more money and lowering returns. However, this is the less risky option. The size of the put is another interesting question. The simplest way is to buy one $27.50 or $30 strike put contract per 278 FMCN shares held. However, more-sophisticated investors may want to match their SINA deltas with their FMCN exposure. We wouldn't recommend this option for novice investors.

The Opportunistic Investor cannot short. So if we were to do this trade, it would have to be through a put or without any hedges. We do think Focus Media is relatively cheap, so the risk of holding it outright is much lessened. But, if the deal falls apart, we'd probably be inclined to sell our shares instead of waiting for the shares themselves to rebound. That said, if we were making this trade personally, we'd lean toward the second option. Our key consideration is that we are lacking information, and the second option has a much smaller possibility of "blowing up" in our faces. There seems to be plenty of money to be made here, and we'd gladly give up a little of it for safety.

Disclosure: Co-editor Michael Tian owns shares of FMCN and Sina puts.

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