Merger Securities and Special Situations - Greenblatt Advanced Plays

When a company gets acquired, shareholders usually get cash. Simple. But sometimes they get a strange basket of securities – preferred stock, warrants, debentures, contingent value rights. Things with long names that nobody wants to understand. And that is exactly where the money is.

Markets are efficient at pricing things that are simple and popular. They are terrible at pricing things that are complicated, small, and unwanted. Five real situations where buying what everybody else was throwing away produced extraordinary returns.

Super Rite Foods – Bus Fare Into the Big Leagues

In January 1989, the chairman of Super Rite Foods, a grocery chain, announced a going-private transaction. Management wanted to buy out all public shareholders through a leveraged buyout. After a bidding war, the final deal: 25.25 dollars cash, 2 dollars face value of preferred stock paying 15 percent annually, and warrants giving shareholders a 10 percent ownership in the new private company.

The cash was straightforward. But the preferred and warrants? Tiny pieces of paper attached to the main event. Each shareholder got only 2 dollars of preferred and a fraction of a warrant – one for every 21.44 shares held. Investment bankers valued the warrant piece at 25 to 50 cents per share. Pocket change.

So shareholders sold. Without thinking. Preferred traded at 50 to 60 percent of face value. Warrants traded around 6 dollars each.

But the proxy document contained a section called “Certain Projections.” Management projected after-tax free cash flow of 5 dollars per share within three years. At ten times that, the company would be worth 50 dollars. Those 6-dollar warrants gave the right to buy one share at zero cost. If shares were worth 50, each warrant was worth 50. Even if projections were half wrong, 6-dollar warrants for a 25-dollar company is fantastic.

Two years later, Super Rite went public again. Warrants valued at over 40 dollars. Preferred recovered to full face value plus dividends. All the information was in public documents. Nobody read it because the amounts seemed too small to matter.

Viacom and Paramount – Three Pages Worth Millions

September 1993. Viacom agrees to buy Paramount Communications. Five-month bidding war with QVC. Viacom won in February 1994, buying 50.1 percent of Paramount for cash. Front-page news.

Then the story faded. But the opportunity was beginning.

The remaining 49.9 percent would be paid with practically everything except cash: Viacom common stock, exchangeable subordinated debentures, contingent value rights, and two types of warrants. Nobody wanted to understand any of it. Massive selling pressure guaranteed.

The contingent value rights were elegant. Each CVR paired with one Viacom share created a guaranteed floor of 48 dollars in one year. If Viacom traded above 48, you kept the upside. If below, Viacom paid the difference up to 12 dollars. Combined purchase price shortly after merger: 37 dollars. Guaranteed 48 in one year. Thirty percent return with limited downside.

But the five-year warrants were the real prize. Right to buy Viacom at 70 when stock was at 32. Sounds useless. Except one detail in the proxy: the 70-dollar exercise price could be paid with 70 dollars face value of those exchangeable debentures. The debentures traded at 60 percent of face value. So 70 face cost only 42 dollars. Effective exercise price: 42, not 70, for five years. Viacom had traded at 60 just ten months earlier. Sumner Redstone was betting his entire multi-billion dollar fortune on the merger.

This was sitting in a three-page section called “Paramount Merger Consideration.” Three pages most shareholders never read.

Charter Medical – Buying the Orphan After Bankruptcy

December 1992. Charter Medical, operator of seventy-eight psychiatric hospitals, had recently emerged from bankruptcy. Classic orphan stock. Old creditors became new shareholders who did not want to own a psychiatric hospital chain. Everyone selling.

Stock around 7 dollars. At that price, less than three times free cash flow. Comparable hospital chains implied Charter should be closer to 15. A 50 percent discount to peers.

Why so cheap? Bankruptcy stigma. Still-significant debt even after restructuring cut it from 1.6 billion to 900 million. The orphan stock effect – forced sellers, no analyst coverage.

Industry was genuinely difficult. Managed-care providers were squeezing psychiatric stays from 30 days to under 20. But insiders owned significant stock and options. Company was stabilizing. Outpatient services growing. Charter planned to sell its conventional hospitals, reducing leverage.

The margin of safety was enormous. Even if worth 10 instead of 15, buying at 7 still works. Under three times free cash flow needs no heroic assumptions.

Within a year, the stock tripled. Sold for a large gain. Smart move – held longer, the stock went nowhere for three more years. Sometimes the best trade is taking your profit and walking away.

Greenman Bros – Getting Noodle Kidoodle for Free

Started with a trip to a toy store. A new chain called Noodle Kidoodle – educational toys and crafts for children. Great concept, crowds, the kind of experience that could scale nationwide.

Parent company was Greenman Brothers, trading just above 5 dollars. Mainly a wholesale distribution business – middleman between manufacturers and 7,000 retail stores. Marginally profitable. Boring. Noodle Kidoodle was a new venture.

What made this a value play, not a growth bet: Greenman had book value over 8 dollars per share. Most assets were cash, receivables, inventory – liquid stuff. Almost no debt. At 5 dollars, the market valued the company below liquidation value of just the distribution business. Noodle Kidoodle was priced at zero.

Even a 40 percent haircut to book value yields 4.80 per share. Downside: maybe a dollar. Upside if Noodle Kidoodle worked: enormous.

Three conditions made this work. Limited downside from distribution assets. A business to restructure around – sell distribution, keep retail. And a catalyst – growing stores would force management to fund expansion, most likely by selling the boring half.

Stock went nowhere for a year. Then in May 1995, Greenman announced it was investigating the sale of its distribution business. Overnight, boring distributor became fast-growing retailer. Stock moved to 11 in two months, 14 within four. Sold between 10 and 11. A double, from buying a boring company below its boring-business value.

General Dynamics – The Restructuring Machine

June 1992. General Dynamics announces a Dutch auction to buy back 13 million shares – 30 percent of outstanding – between 65.375 and 73 dollars. Stock had already risen from 25 to 71 under a restructuring led by William Anders, former Apollo astronaut.

Easy to dismiss. Late to the party. But one detail on the front page of the tender document: management was not selling a single share. Stock tripled from 25 to 71. Executives had over 20 million in paper profits. Company offers to buy at premium prices. Insiders refuse to sell. People who know the business best are saying 71 is still cheap.

Restructuring was far from complete. Four core businesses kept, everything else being sold. Already divested computer operations and Cessna for nearly 800 million. Missile business sale for 450 million more. All non-core businesses to be sold by end of 1993. Proceeds distributed to shareholders with favorable tax treatment.

Even after spending 950 million on the buyback, over 1 billion in cash would return to shareholders. Subtracting expected cash from the stock price meant remaining core businesses were valued at a 40 percent discount to other defense contractors.

Dutch auction closed at 72.25. Two weeks later, Buffett announced he had bought 15 percent of the company. Even after that endorsement, stock traded between 75 and 80 for two months. Plenty of time.

By end of 1993, shareholders received over 50 dollars per share in distributions, and the stock – after distributions – traded above 90. Total value: over 140 dollars. More than a double in 18 months, after the stock had already tripled.

The Patterns

Five situations, five structures, same dynamic: markets systematically underprice things that are complicated, small, stigmatized, or attached to something more popular.

Merger securities get dumped because they are too small relative to the cash portion. Post-bankruptcy stocks get sold because creditors want out. Hidden businesses get ignored inside boring parents. Restructuring value gets discounted because people assume easy gains are taken.

Every case used public information. Proxy documents, SEC filings, tender materials. The edge was willingness to read what everyone else threw away.

Key Takeaways

Merger securities are systematically underpriced. When a deal pays mostly cash plus a small basket of securities, those securities get dumped without analysis. But 6-dollar warrants worth 40 are not small amounts. Read the proxy, understand the terms, do basic math.

Post-bankruptcy orphan stocks have structural sellers and no buyers. Creditors become shareholders who do not want to be shareholders. No coverage, no interest, bankruptcy stigma. None of which relates to whether the business is worth 7 or 15 dollars. Check free cash flow, insider ownership, peer valuations.

Hidden assets create free options. Buy below the value of the boring legacy business and the exciting growth business comes free. That eliminates the biggest risk in growth investing – overpaying. But you need a catalyst, or you wait forever.

Insider behavior is the strongest signal. Management not selling during a 30-percent buyback. Insiders owning significant stakes in a post-bankruptcy company. These are actions backed by real money, not opinions.

Take profits when your edge disappears. Sold Charter Medical after a triple, avoided three flat years. Sold Greenman after a double, once it became a “hot” stock. When the structural mispricing corrects, your reason for holding is gone.