Tuesday, October 28, 2008

Constellation Energy (CEG) Merger Arbitrage Opportunity

One of the four techniques implemented by Benjamin Graham was merger arbitrage. There’s been some good evidence that this strategy has worked for several decades for some value investors such as Graham and Buffett, producing double digit returns.

Buffett had a nice discussion on his arbitrage experience with Arcata Corp in the 1980’s in his 1988 letter to shareholders.

To evaluate arbitrage situations you must answer four questions:
(1) How likely is it that the promised event will indeed occur?
(2) How long will your money be tied up?
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

This leads us to the potential acquisition of Constellation Energy by Berkshire’s MidAmerican Holdings. George from Fat Pitch Financials was the first to alert his readers on this opportunity. The merger has already been announced in September at a price of $26.50/share in cash. In addition, MidAmerican provided an immediate $1 billion cash infusion to Constellation Energy through the purchase of preferred equity. The definitive agreement has been approved by both companies’ boards of directors and is subject to, among other things, shareholder and customary federal and state regulatory approvals.

The transaction is expected to close within nine months from September 19th announcement date. The agreement expires nine months after its execution but may be extended by either company for up to three months.

If the deal does not materialize for some reason or another the stock could easily drop precipitously, as the company might face a drop in its debt ratings and loss of confidence from its trading partners. I do believe however that if the deal with Midamerican were to be canceled, EDF might still step in and make a competing offer, but the terms might not be as good for CEG’s shareholders. EDF did offer $35/share previously, but Constellation’s board rejected the offer and chose Berkshire’s MidAmerican Holdings offer instead. Given the ample liquidity that Berkshire Hathaway has at the moment I do believe that the merger has a higher chance of occurring.

I would be considering purchasing CEG on dips below $23.50. One definitely has to be nimble with this position however; therefore I would look into exiting some or all of my positions in CEG on spikes above $25.50. This is highly speculative position, which is geared towards absolute performance. CEG currently pays a quarterly dividend of $0.4775/share, which makes up for an annual yield of 8.20%.

For updates on Constellation and MidAmerican check out this website. In addition to that check the PRELIMINARY PROXY STATEMENT AMENDMENT filed with the SEC from this link.

Full Disclosure: I am long CEG

Relevant Articles:

- Constellation Energy Group (CEG) merger arbitrage opportunity
- Dangers of the Greedy Limit Order
- Berkshire Hathaway Historical Total Return Performance
- Buffett's Berkshire Hathaway Stock Portfolio Holdings
- Warren Buffet - The richest investor in the World

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