The international role of the euro

A study called “The international role of the euro” published by the ECB just came out. The study showed that the currency preferences of the markets are quite stable and only in a limited way influenced by changes in overall financial activity, caused by the global crisis. This is in line with earlier conclusions that the international role of currencies tends to be relatively stable over time. It is however clear that the role of the euro is increasing. In markets that were tracked, like international debt markets, foreign exchange trading and global foreign exchange reserve holdings, the share of the euro increased from one to several percentage points.

Overall trading volume in the foreign exchange market declined quite significantly in 2008. Data from EBS showed that daily average trading volumes declined from USD 226 billion in the first three quarters to 179 billion in the last quarter, a drop of 21%. The report suggests that the drop may have been caused by the lack of trust among dealers in the interbank spot foreign exchange market. Additionally, market participants like hedge funds may have exited the market due to growing risk aversion and increasing costs.

There is also a special focus in the report on the currency choice in the issuance of foreign currency denominated bonds. The interesting conclusion there is that issuers prefer currencies with low nominal interest rates, while possible changes in foreign exchange rates do not have a significant influence on the currency choice.

There is a lot more information and data in the report, and I would suggest any interested readers to browse through it.

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Options as zero coupon bonds

The possibilities investors have with options are almost endless. Almost every view on the markets can be translated in an options strategy where call-options and put-options can be combined in various ways, and the options can be both purchased or sold. Many strategies have wonderful names like butterflies, condors, straddles and strangles, and are extensively described in books and articles. It is however less well known that options can be utilized as an instrument to generate income independently from any movement in underlying rates. The option transforms in a kind of interest instrument, where the investor can decide if he want to be on the paying or receiving end of the strategy. The strategy that I will describe here is essentially the equivalent of a zero coupon bond.

A zero coupon bond is a bond that does not make periodic interest payments, but only pays a certain amount of money, its face value, at a determined date in the future. One payment is followed by one redemption. The initial payment will obviously be lower than the face value and is determined by the required interest rate and the duration of the bond. By taking the actual value of a zero coupon bond, together with the remaining duration and face value, the effective yield to maturity of the bond can be calculated.

Options can also be used to create a cash flow pattern where initially a payment is made and a fixed amount of money is received at the expiration date of the options. This strategy can be set up with any underlying value and any expiration date, but my experience is that it is most efficient with index options on expiration dates with the highest trading volumes. Positions need to be taken with the highest and the lowest available strike prices. The advantage of index options is also that they are usually European style, which means that they cannot be exercised prior to the expiration date. With American style stock options there is always a risk that exercising the option may be efficient and therefore likely. This would obviously disrupt the strategy and influence the outcome.

As an example I use the AEX index options, expiring on December 12th 2012, which are listed on NYSE Euronext in Amsterdam. This exchange is very efficient for investors, with good liquidity and narrow spreads. Although in practice index options are always settled at the expiration date, I will assume in this example that the index is actually a deliverable underlying value. The result of this assumption is the same, but it makes it easier to describe the strategy.

By creating a combination of a purchased call-option and a sold put-option with the same strike price and the same expiration date, a position is created where with certainty the index will have to be purchased at the expiration date for the lowest available strike price, which in our example is 80. If the index is higher than 80 at the expiration date, the investor will exercise his right to buy the index at 80. If the index is below 80, the buyer of the put-option will sell for 80 to the investor. Because of the low strike price compared to the actual index value, the call-option will be very expensive, and will consist almost entirely of intrinsic value. The put option, which is far out-of-the-money will have a low value.
In a comparable way we can also create a position where with certainty the index will be sold at the expiration date of the options, by buying a put-option and selling a call-option, again with the same strike price, which in this case will be 640. When the index is below 640 on the expiration date, the investor will exercise his put-option right and sell the index for 640. If the index expires above 640, the investor will have to sell the index to the buyer of the call-option for 640. Either way, the index will be sold for 640. Because in this case the strike price of the put-option is well above the current index value, this option will have a high value, while now the call-option has a low value.

For this example I have taken the closing prices of Thursday June 25th, when the index closed at 254.12, and I have assumed that trading is possible at the mid prices between the bid and ask prices. The premiums are the following (all in Euro’s):

Buy call-option 80 -161.85
Sell put-option 80 +2.25
Sell call-option 640 +0.58
Buy put-option 640 -356.50

Net payable premium -515.52

On the expiration date at the end of December 2012, we will have a situation where with certainty the index will be purchased for 80 and sold for 640. This leaves a certain difference of 560.
Since we both know the initial cost of 515.52 and the final amount of 560, it can be determined what the effective return is on an annual basis. The implicit interest rate for the period of almost 3.5 years can be calculated to be 2.4% on an annual basis. An investor who believes that this is not an attractive return can decide to receive premium at the start of the strategy, which will give him an effective financing rate of 2.4%. However, this investor will need to have sufficient margin in his account and also needs to carefully consider how the received premiums are to be invested.

In Amsterdam, index options are listed until December 2013, which gives the possibility to calculate the strategy for 5 periods from 2009 to 2013. Through interpolation it is possible to determine a zero coupon yield curve for a 1-4 year period, which can be compared with the return on government bonds. The disadvantage of government bonds is that these normally can only be purchased, while the zero coupon curve of options can be both purchased and sold. The following graph shows how close both curves follow each other:



I find the zero coupon curve from options very useful, not just for trading purposes, but also as an information tool about the development of interest rates. Speculators with a certain view on the interest rate can also benefit from tracking the curve and trade accordingly. Investors who are interested in tracking these Euro interest rates, derived from options, can follow them through twitter, where I post actual calculated rates on a time schedule. The URL for these rates is http://twitter.com/eur_rates.

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Staples Launches Public Offer for Corporate Express

Update: Today Corporate Express announced the intention to enter into a merger with Lyreco. More updated comments can be found here.

Yesterday, Staples (SPLS) launched an offer for the acquisition of Corporate Express (CXP) for EUR 8.00 per ordinary share. Shareholders can submit their shares until June 27th. Staples also made an offer for Corporate Express’ preference shares and subordinated convertible bonds due 2010. The most important condition for making the offer unconditional is acceptance of at least 75% of ordinary shares.

This acquisition process is at a peculiar stage, with both parties not negotiating with each other and accusing the other party of unwillingness to do so. For shareholders this is a very unfortunate situation, with a real possibility of a failed offer, and therefore a missed opportunity to create significant shareholder value for shareholders of both companies. However, based on the current offer, we can try to evaluate the current situation from the perspective of both companies and their shareholders.

Corporate Express shareholders have a choice to accept the offer or to allow management to continue with the execution of the strategic plan 2008-2010. With the presentation of the results for the first quarter of 2008, we were given some insight in the ambitions that Corporate Express has set for itself.

For the full year 2008, Corporate Express gave guidance for revenue between EUR 5.7-5.8 billion and an EBITDA margin of 5.6%-6.0%. This means an EBITDA amount of between EUR 319-348 million. Depreciation and amortization are expected to be EUR 100 million, and interest expenses EUR 85 million. If we add fair value changes to this, net result before taxes would be around EUR 122-151 million. With a 20% tax rate, net result would be between EUR 98-121 million or EUR 0.54-0.66 per share. It also means that Corporate Express will have to earn an average net result of EUR 30 million per quarter for the remainder of the year. If we compare this with the net result of EUR 8.5 million for this quarter, this seems quite a task.

The strategic plan calls for a 6% average annual organic growth rate for the period 2008-2010 and an EBITDA margin of at least 7% by 2010. Based on the current progress and the stated ambitions, Corporate Express believes revenue of EUR 6.8 billion is achievable for 2011 with an EBITDA of EUR 475 million. With depreciation and amortization increasing in line with sales, and finance costs assumed to stay constant, this would imply a result before taxes of around EUR 275 million. With an effective tax rate of 25%, this should lead to a net result of EUR 206 million, or EUR 1.13 per share for the year 2011. If market conditions are favorable for stocks by the time such results are announced in 2012, this could well mean a value of around EUR 16.00 per share. Declining the offer and allowing the company to achieve its plans, would potentially create value twice the value of the offer of EUR 8.00 made by Staples, after a period of 4 years. This would imply an annualized return of almost 19%, which is by all means attractive.

Success of the strategy is however not at all guaranteed, and there is plenty of risk in the execution of the strategy. Ron Sargent, the CEO of Staples, makes the risk of failure of the strategy one of the key reasons why Corporate Express shareholders should accept his offer, when he states in the offer memorandum:

"I firmly believe that our offer of EUR 8.00 per share delivers superior value to Corporate Express shareholders, and does so without the risks found in Corporate Express’ long-term business plan. Rather than the uncertainty of potential value for your investment, our offer provides shareholders with the certainty of realizing immediate and premium value for your investment."

There are indeed risks that may prevent Corporate Express from reaching its targets. If the company only reaches 80% of its ambitions by 2011, which would still be a reasonable accomplishment, net income per share would be somewhere around EUR 0.90, and with a likely lower P/E ratio, the stock price could be around EUR 11.00. Compared to the offer of EUR 8.00, this would only give an annualized return of 8%, and makes the offer from Staples much more attractive.

It is possible that investors will perceive the risks associated with the stand alone strategy of Corporate Express quite high. This may cause the share price to drop significantly following a potential breakdown of the acquisition.

From the perspective of Staples the picture looks completely different. The company sees a target that can add significant value. Besides the strategic fit, they undoubtedly see potential for cost savings and further synergies. If the added value from the acquisition is estimated to be a modest EUR 100 million a year, and the estimated low end net result for Corporate Express in 2008 is EUR 122 million, Staples would add 222 million to its annual results. In US-dollars this is about $350 million. Since the purchase of Corporate Express ordinary shares would be financed with debt, there could be an additional interest cost of around $140 million, or around $100 million after tax. This would mean an additional net annual result from the acquisition of $250 million, which is almost 25% of Staples’ net result for 2007.

With a P/E ratio currently at 17, it is very likely the market has already priced some of the advantages of the acquisition into the share price. Because of the acquisition of Corporate Express, there will be a significant level of debt on the balance sheet of Staples, and this may also have some effect on the P/E ratio. However, one could argue that the post acquisition share price of Staples could be about $5.00 per share higher than the share price would be without the acquisition, based on reasonable and achievable synergy targets that do not seem to be too stretched.

At this moment we find ourselves in a situation where the companies do not engage in serious talks and the offer is considered hostile by Corporate Express. They state that the offer does not do justice to the real value of the company, and undoubtedly they believe a higher share of the synergy effects should be priced into the offer. Staples believes they are paying a considerable premium over the share price of Corporate Express prior to the date the offer was made, and they will surely feel it is them who are creating the synergy effects and should receive full value for them. A recurring net synergy effect of EUR 100 million could have a market value for Staples of up to EUR 1.5 billion, which would be around EUR 8.00 per Corporate Express share. Assuming this is a reasonable estimate, Staples is offering EUR 2.50 of this value to Corporate Express considering an offer of EUR 8.00 per share and a share price of EUR 5.50 before the offer was made.

Both companies are now in a situation where they need to make this offer succeed. For the management of Corporate Express, the pressure would be tremendous for the coming years to make good on the promises of the strategic plan, while Staples shareholders are already starting to anticipate the benefits of the acquisition. If the deal collapses, because Corporate Express shareholders refuse the current offer, both parties lose. It is also understandable that Staples does not want to change its course of action, without a willing negotiation partner. A negotiated and agreed final offer would probably identify many tangible synergy effects and would allow an integration plan to be implemented swiftly. I have no doubt that such a negotiated final offer could be higher than the current offer.

Unfortunately this requires two parties who are willing to engage. The signals we are getting from both parties are not encouraging, and put a lot more uncertainty on the final outcome of this acquisition attempt. In today’s earnings conference call, Ron Sargent expressed his frustration with the unwillingness of Corporate Express to negotiate and allow due diligence. He also stated that if Corporate Express shareholders reject the current offer, Staples would move on. I am willing to believe that this is almost true, since there is still the opportunity to raise the offer one more time with the extension of the acceptance period.

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Corporate Express Performance Q1-2008

This morning CE published the results for the first quarter of 2008, which can be found here on their website. At noon there was also a presentation of the results. The video, audio and presentation slides can be found here. I am disappointed with the net result of just €0.05 per share. I feel sorry for Mr. Ventress, who tried so hard in his presentation to show that his strategic plan is working and that results are forthcoming. In my opinion it was just not convincing enough, which makes an acquisition by Staples the more appealing choice.

But before I say more about that, let's have a look at the results. The most important part of the business is Office Products and we will take a look at Q1-2008, Q1-2007 and Q4-2008:



I understand that from an operational standpoint CE is not unhappy with the results for Office Products. There was organic growth in North America, and in Australia. Unfortunately the problem with these markets is that North America is confronted with a sharply declined exchange rate for the US-dollar, and Australia seems to operate in a deflationary environment. So a shareholder, calculating in Euro's, saw a decline in revenue both compared to Q1-2007 and Q4-2008. A shareholder would also notice a declining gross margin, which means that operating results in Euro's are down. CE makes a point of reporting operating results including and excluding special items. Since however special items seem to be recurring, although the subject item is always different, the existence of special items doesn't seem so special, and are part of normal operations. An operating result of 3.8% as a percentage of sales is lower than last year and only marginally higher than Q4-2008.



Sales for Printing Systems are down. CE is pleased with the performance, since the decline should be largely attributable to orders being postponed in anticipation of DRUPA, which is the largest printing equipment exhibition in the world, that is held once every four years, and will be held in Q2 this year. A shareholder unfortunately sees declining sales and a declining gross contribution margin.



Corporate costs are in line with guidance already given by CE. There was again a significant benefit from pension assets. Although this is part of operational results, and we have been given guidance by CE for this, I would not dare to discount an uncertain benefit such as this beyond this year.

Interest costs were substantially lower than Q1-2007, which is mainly related to the sale of ASAP, which allowed a significant reduction of debt. Unfortunately there was a large negative non-cash fair value change of €12.2 million. profit tax expenses were €3.9 million, and CE expects the effective tax rate to be 20% for this year

After looking at the separate elements of the results the total picture looks like this:



This net result of €8.5 million translates in a net result per share of €0.05. It is clear that CE is focusing on organic sales, special items and fair value changes to demonstrate that results are quite encouraging, but in the end this net result is the number that is relevant for shareholders.

When I was watching and listening to the presentation I could not help but think that the main point of the exercise was to demonstrate that shareholders should not accept the offer from Staples, at least not with the current value. Quite an effort was made by CE management to show that the strategic plan is well underpinned, and can lead to the desired targets of 6% organic sales growth for the period 2006-2010 and EBITDA above 7% by 2010. They also admitted however to the US market experiencing an unhealthy market decline, and the strategy needing growing economies to be successful. Without a strong increase of the US-dollar and price increases in Australia the task seems very difficult to me.

The presentation also showed that a lot of effort still has to be made, and many things have to go right, before the mission will be accomplished. I don't think that the market is prepared to value the company on the basis of a promise of improvement, but will value the company based on actual delivery, and unfortunately delivery in Q1-2008 does not justify yet a high value based on a stand alone strategy.

For the full year 2008, CE gave guidance for revenue between €5.7-5.8 billion and an EBITDA margin of 5.6%-6.0%. This means an EBITDA amount of between €319-348 million. Depreciation and Amortization are expected to be €100 million, and interest expenses €85 million. If we add the fair value changes to this, net result before taxes would be around €122-151 million. If we take a 20% tax rate, net result would be between €98-121 million or €0.54-0.66 per share. It also means that CE will have to earn an average net result of €30 million per quarter for the remainder of the year. If we compare this with the net result of €8.5 million for this quarter that seems quite a task.

I am afraid after all this my conclusion has not changed much. I still believe shareholders should prefer an acquisition by Staples for a price above the current offer. I believe there are many risks to the strategic plan of CE, and we need much more convincing by solid quarterly results that the strategy is working. Unfortunately this takes time, and leaves room for disappointment. If I would accept the lower limit of the net result of €0.54 per share as achievable, a risk free offer now of 16 times this profit sounds quite appealing.

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Option-Charged Savings for Current Market Conditions

Many investors still perceive options as instruments which are used for outright speculation on the direction of a certain underlying value, with the opportunity to make fast and large profits, but also the chance to lose the initial investment as fast, or even faster. This is particularly the case when an investor weighs the alternative outcomes between, for example, an investment of $1,000 in 20 Wal-Mart (WMT) shares or the purchase for an equivalent amount of 4 call options expiring in April with an exercise price of $50, which currently have a price of about $2.50 per option.

When on the expiration date the share price of Wal-Mart has increased to $55, profit on the shares position will be $100, while the options will have doubled in value. But if the share price has not increased to a level above $50, the whole investment in options will be lost.



This is just one way of using options; in truth, there are many ways in which options can be utilized while defining investment strategies. It is even possible to construct risk-free options positions, where the return should be equivalent to the return on a risk-free cash instrument. In practice this is not easy, since investors have to pay transaction costs, but mainly because of the fact that part of the advantage will be lost due to the spread between bid and ask prices of options.

If there is a choice between highly speculative positions on one side and risk-free positions on the other side, it must be possible to choose a position between these extremes that corresponds with the risk/reward expectations of an investor at a given time. However, it needs to be clear that it is not possible to achieve additional returns without incurring additional risks. Every investor has to ask himself always if certain risks are acceptable, and if the compensation for accepting these risks is adequate. The interesting thing about using options is that in principle almost every view on a certain underlying value can be translated into an investment strategy.

The possibility to sell put options in order to increase the return on cash positions will be discussed here. With this strategy the risk must be accepted that on the expiration date the underlying value must be purchased at the strike price. Under the present stock market conditions this can be an interesting strategy, since there are already so many negative expectations in share prices. The major indices are substantially down from the levels at the end of 2007, and this has been accompanied with a sharp increase of option premiums. The compensation for absorbing negative share price risks has increased, while the chance that we have come closer to the bottom may have increased.

With this strategy I prefer to choose shares of companies with a solid long term performance and a good dividend yield. In case shares with these characteristics have to be purchased through exercise of the options, there is a reasonable chance that at the price level at which the underlying shares must be purchased, they are a good long term investment.

As an example I have chosen Wells Fargo & Company (WFC), which is considered to be one of the stronger banks. It is also a major holding of Berkshire Hathaway (BRK.A), giving it the support of investor Warren Buffett. At the time of writing the share price of Wells Fargo was $32.60, giving it a dividend yield of about 3.8%. The table below shows how the achievable returns relate to the chosen strike price of put options expiring in January 2009.



In the most cautious scenario, put-options with a strike price of $15 could be chosen. When an investor sells these options, he runs the risk that on the expiration date in January 2009, shares must be purchased for a price of $15. Compared to the current share price this is a discount of 54%. An amount of $14.76 needs to be invested in order to have this $15 available at the expiration date. The option premium contributes $0.65 while the investor must add $14.11 from his own funds. This amount is more than adequate for any margin obligations on the short position. On the expiration date in December it is possible that either the investment with accrued interest of $15 is fully available again to the investor, or that he is obliged buy shares at a strike price of $15.

When the share price is above $15, the investor will keep his money and he will have achieved a return of 6.3% in about 10 months, which is 7.6% on an annual basis. This is a substantially higher return than would have been achieved with just keeping the cash holdings invested in money market instruments. In case the share price has fallen below $15, the investor must purchase the shares, and may achieve a dividend yield of 8.3%, when dividends have not been adjusted. This is well above both cash returns, and the current dividend yield.

When a strike price of $20 is selected, the annual return can be increased to 10.3%, while a price decrease of Wells Fargo shares of almost 39% in the next 10 months is still acceptable, without jeopardizing the calculated return.

An even higher strike price can be selected, with the possibility of higher returns. The vulnerability with respect to price movements of the underlying shares will however become much greater, and therefore also the chance that a price decrease of the shares will lead to a forced purchase of the shares through the exercise of the put options. For an investor who is actively looking for a good entry point for purchasing the shares this may be attractive, aided by high option premiums. For an investor who is seeking additional returns with moderate risks, these higher strike prices will most likely be less attractive.

Disclosure: None

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The final price for Corporate Express

Imagine you go to the casino and spot a big bucket filled with 100 balls. There are 51 red balls and 49 blue balls. Next to the bucket there is a sign which informs you that you can guess the color of a randomly drawn ball for $1. If you are right, you will receive $2, but if you are wrong you will lose your bet. A rational investor will take a seat next to this bucket and will not leave anymore. By consistently betting on a red ball being drawn, he can calculate a 51% chance of achieving a return of $2 and a 49% chance of a return of $0, which gives an expected return of $1.02 for an investment of $1.

We can apply the methodology of this simple probability calculation to determine what the expected value of the acquisition by Staples of Corporate Express will be. In this case there are a couple of complications, and we need to make some extra assumptions to make the calculation.
The easy part is determining the value of the bet, which is equal to the actual stock price of Corporate Express. At the time of writing this was about 7.80 Euro, a premium of 7.5% in comparison with the offer from Staples of 7.25 Euro. Subsequently we can calculate how much a rational investor wants to receive when the acquisition is finalized. I assume closing of the acquisition will not take place before the end of May, which means that Corporate Express shareholders will have received a dividend of 0.21 Euro before this closing. The rational investor, who is only concerned with probability calculations, will expect to receive at least an amount of approximately 7.87 Euro at the end of May, assuming an interest rate for short term Euro deposits of 4%. At the end of April, he will already have received 0.21 Euro, which implies that the remainder of 7.66 Euro has to come from his bet on the outcome of the draw from the bucket of balls.

We still need to determine the probability of the outcomes and the values of the outcomes of the draw. Since Corporate Express was trading in a range of 5.00 - 5.50 Euro before the offer from Staples, I assume the share price could drop to 5.00 Euro again, if the acquisition fails to take place. I assign this outcome a probability of 20%. We still don’t know the value of a successful offer, but we do know that the rational investor wishes to receive at least 7.66 Euro. Knowing this, we can calculate the value of the expected offer, which has a chance of 80%. The calculation is (7.66 – (0.20 x 5)) / 0.80 = 8.33. With this offer price, an investor has a chance of 20% to receive 5 .00 Euro, and a chance of 80% to receive 8.33 Euro. This gives an expected return of 7.66 Euro, exactly his minimum requirement. Including dividend, the offer would have to be 8.54 Euro.
If we would assign a chance of 70% to a successful offer, the acquisition price would need to be 9.02 Euro, while an expected chance of 90% of success gives an acquisition price of 8.17 Euro.

The conclusion is that the rational calculating investor, who is presently considering to take a position in Corporate Express for a price of 7.80 Euro, and who assigns a 80% chance of success for the acquisition to take place, expects a final offer of 8.54 Euro, including dividend. If the offer fails, this investor will expect the share price could drop back to 5.00 Euro.
I believe that most current shareholders of Corporate Express are rational calculating investors, and that they believe a revised offer needs to be at least somewhere in the 8-9 Euro range to be successful. If Staples is serious about its intentions to acquire Corporate Express, it is hard to imagine that they would not have expected that an increased offer would be required. If this is the case, the indicated range should not come as a surprise either.

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BofA/Countrywide Merger Arbitrage Opportunity

On January 11th, Bank of America (BAC) announced a definitive agreement to purchase Countrywide Financial (CFC) in an all-stock transaction valued at approximately $4 billion. Under the terms of the agreement, shareholders of Countrywide will receive 0.1822 shares of Bank of America for each share in Countrywide. At the time of announcement, parties expected the deal to be completed in the third quarter of 2008.

This merger agreement followed an investment by Bank of America in Countrywide, announced on August 22nd of last year, in which Bank of America made a $2 billion strategic investment in Countrywide. This was done through a 7.25% non-voting convertible preferred security, with a conversion price of $18 per share. With the merger announcement almost five months later, Countrywide is valued at just over $7 per share.

Arguments have been made both in favor of the deal and against the deal. The main argument in favor of Bank of America is that they are acquiring Countrywide at a very attractive price, with a valuation far below book value, while they get access to the mortgage capabilities, including distribution networks of Countrywide. These assets are expected to be very profitable again once the dust in the credit markets settles. Bank of America also expects substantial cost savings from the merger. The argument against the deal for Bank of America is the fact that there still may be more and unpredictable losses to come, while also the completely different corporate cultures may be an issue.

The argument in favor of the deal for Countrywide is that they really had no choice and would have gone into bankruptcy without a bailout from Bank of America, who already came to the rescue in August last year. The argument against the deal for Countrywide is the fact that the company is sold far below book value and that the purchase price does not properly reflect the profit potential of the company. In other words, what may be a good deal for Bank of America shareholders may be a not so good deal for Countrywide shareholders.

Although I am fully convinced of the intentions of Bank of America, it has been argued that the SEC filings can be interpreted in such a way that Bank of America effectively has a call option on Countrywide. The argument is that there is enough wording in the document to allow Bank of America to walk away from the deal if dramatic adverse developments take place in Countrywide before closing of the deal. Interestingly enough, Countrywide also seems to have a put option on Bank of America, as Bill Miller noted in his latest letter to shareholders of the Legg Mason Value Trust. Shareholders of Countrywide can still turn down the deal and even at a later stage a potential termination fee of $160 million, or 4% of the current deal value, does not seem insurmountable should business developments increase significantly and a better opportunity presents itself to Countrywide shareholders. The proposed merger agreement explicitly allows for the possibility to negotiate a restructuring of the transaction and resubmission to Countrywide shareholders, in case they do not approve of the current proposal. If the deal were to indeed fall through, Bank of America would, of course, still have its $2 billion investment in Countrywide, which would otherwise disappear when the merger does take place.

With this background in mind, and realizing that we are still many months away from closing, an awful lot can still happen with respect to the turmoil in financial markets that may influence the final outcome of this deal. Maybe it would be interesting to turn to the market in order to determine how the current deal is perceived. The graph below (left) shows the discount of the actual share price of Countrywide measured against the actual share price of Bank of America, multiplied with the conversion factor of 0.1822. The graph on the right is almost a mirror image of the other graph, but represents the value that can be realized by short selling 1 Bank of America share and buying 5.49 shares of Countrywide. At finalization of the merger, this position in Countrywide shares should generate exactly enough shares of Bank of America to offset the short position.



At the end of trading on January 11th, the closing share price for Countrywide and Bank of America was $6.33 and $38.50 respectively. With the conversion factor of 0.1822, the theoretical value of Countrywide shares was $7.01, meaning that Countrywide ended the trading day with a discount of -9.8% to its acquisition price. In the week after the announcement, this discount increased sharply to a level of -24.3%. When Countrywide announced the results for the fourth quarter of 2007 on January 29th, Bank of America confirmed its commitment to buy Countrywide and called the announced losses “consistent with our due diligence”.

Subsequently on January 31st SRM Global Fund announced it had acquired a stake of 5.48% in Countrywide, and believed that the merger agreement significantly undervalues Countrywide. The price discount rapidly decreased to a level of just -7.4%. Since that day, the discount has increased again and has been within a range of -10% to -15% for the last 4 weeks, with a level of -12.9% at the end of February. The graph on the right side shows that after the announcement on January 11th, positive cash flow could have been generated of $3.76, followed by low of $3.32 and high of $8.75 in the period until the end of February. This shows that new information and different perceptions in the market about the likelihood of the merger, even in the short period since the announcement, have already lead to significant opportunities and risks.

A similar merger arbitrage position as described above can also be constructed with options. Instead of short selling Bank of America shares, an investor can sell call options and buy put options with the same maturity date and exercise price. In the same way, Countrywide call options can be purchased and put options sold as an alternative to buying the shares. The following example shows the different outcomes, based on observed prices on Friday afternoon, February 29th.

Bank of America shares were trading at a price of $39.92 and Countrywide was trading at $6.22.With these prices, the sale of 1 share of Bank of America and the purchase of 5.49 shares of Countrywide gives a positive cash flow of $5.77. With the use of options the following could be achieved:

Sell 1 Call BAC Jan’09 40 @ 4.90 +4.90
Buy 1 Put BAC Jan’09 40 @ 6.60 -6.60
Buy 5.49 Call CFC Jan’09 5 @ 2.00 -10.98
Sell 5.49 Put CFC Jan’09 5 @ 1.00 +5.49
Net cash flow -7.19

The maturity date of January 2009 was selected because it is after the third quarter in 2008 and it is the first month with expiry of options in both Countrywide and Bank of America. In this example, it is assumed that the merger is effective immediately after the expiry of the options, but this is not very relevant. In case the merger takes place before the expiry of options, the positions can be reversed and a similar return as calculated here will be achieved.

On expiry and exercise of the relevant in-the-money options, the investor will pay 5.49 x $5 = $27.45 for the Countrywide shares and receive $40 for the delivery of Bank of America shares. These shares will net against each other in the merger closing and the investor keeps the difference of $12.55, which is $5.36 higher than his initial investment. The difference between the value of $5.77 and this calculated $5.36 is caused by the effect of dividend, time and price spreads.

The advantage of the options strategy is that an investor may tweak the structure to reflect his own preferences and / or expectations, by changing maturity dates, strike prices and number of options traded.

It is possible that the discount of the Countrywide share price versus the acquisition price will become very stable while gradually moving to 0% as the planned finalization date in the third quarter approaches. With the current uncertainty in financial markets, and the certainty that much knowledge and many new facts will come to the market in the months ahead, I would however not be surprised if we still see quite some movement of the discount before we reach the final outcome of this merger. As we have seen, the level of this discount will have a significant effect on the returns that can be achieved with a merger arbitrage position on this deal.

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