Analysis: Monsanto Risk Arbitrage

Disclaimer

This document contains an independent analysis of Monsanto Co. (NYSE: MON). Information on my investment philosophy can be found here.

Disclaimer: The author is currently long MON. All of the views expressed in this document are solely those of the author, and do not reflect the view of any other person or company. I am not receiving compensation for it. I have no business relationship with the company whose stock is mentioned in this document. All investments involve the risk of permanent capital loss. I encourage everyone to do their own due diligence and to reach their own conclusions. Under no circumstances should this document be considered an offer to buy or sell any securities mentioned within.

Background

On May 10th, Bayer AG offered $122 per share in cash to buy Monsanto Co. The CEO of Bayer gave all the normal rationalizations for making the offer: boosting earnings, cost savings, taping growing demand, etc. It also didn’t hurt that Monsanto’s name would most likely be abandoned after the deal, and with it the “worlds most evil company” stigma.

Monsanto turned down the deal arguing that it undervalued the company and didn’t adequately address the regulatory execution risk inherent in the acquisition. Since then, Bayer has increased the offer three times, finally settling on a price of $128 and a break up fee of $2 billion paid by Bayer to Monsanto in the event that the deal fails to get regulatory clearance. Monsanto accepted the terms on September 13th, and the deal is expected to close by the end of 2017.

As of November 11th, Monsanto was trading for  about $98.50, roughly 30% below the buyout offer.

Valuation

In buyout situations, the value of the target company is based on the probability that the deal goes through and the time it will take to go through. The underlying fundamentals of the company take a backseat to the buyout price.

In this case, we can start by looking at what Monsanto was trading at before the first offer on May 10th. Taking the 20-day average, we get a pre-offer price of about $91.10. Add in the $2 billion dollar break up fee, and we get a base price of about $95.66. This is our estimate of the value of Monsanto if the deal were to disappear today. In reality, failed deals usually result in knee-jerk reaction that can overshoot to the downside.

Assuming that the deal goes through sometime by mid 2018, and applying a 5% discount rate, the value of the deal today would be about $119. At today’s price of $98.50, the market is pricing in the odds of the deal going through at about 12%.

Considering the size of the deal and the current trading price, I’m pretty sure every major merger arbitrageur in the industry has taken a look at Monsanto and decided to pass. It’s not hard to blame them. Since the beginning of this year, $400 billion worth of corporate mergers have been withdrawn in the United States alone. There was Staples and Office Depot, Halliburton and Baker Hughes, Pfizer and Allergan, Anbang and Starwood, etc.

In fact, Merger arbitrage was one of the worse performing investment strategies this year. Long time readers of this blog know that I have a contrarian streak when it comes to the market as a whole giving up on an asset class. Additionally, the market hasn’t been very good at handicapping the odds of government action in recent months – just look at Brexit.

So what are the odds of the Monsanto deal going through? Speaking on the Q4 conference call, the CEO of Monsanto had this to say:

The unique thing about this transaction is there is very little overlap. So you’re bringing together a seed business and a crop protection business and I think we can bring these two businesses together with much better insight for the grower by using digital agriculture.

So, I can’t speculate on regulators or opine on how regulators are going to view this. I think it’s a really unique combination and the focus on this will be driving the innovation curve.

Proving the lack of overlap between the two businesses to regulators will be the main hurdle in this deal. In the context of the other consolidation deals going on in the space, China National buying Syngenta and the Dupont Dow Chemical merger, Monsanto is mainly involved a seeds business and Bayer is mainly a pesticides business. Furthermore, Monsanto’s business is about 80% focused on the United States, while Bayer makes most of its money abroad.

Let’s take the conservative side of the odds and say there is a 40% chance that the deal goes through and a 60% chance that the deal fails. In other words, a 40% chance that we make a 20% return (119/98.50 – 1) and a 60% chance that we lose 3%. (98.50/95.66 – 1). The expected value of buying today would be a 10% return. Of course, this depends a lot on the assumptions made, and if the deal does fall through, the large likely selloff could take years to correct.

Conclusion

The asymmetric nature of the current risk return structure in Monsanto makes it a good buy. Today’s prices are so low relative to the buyout offer, that the best case scenario might be the deal falling though and a resulting knee-jerk sell off sending Monsanto’s stock price into the low 80’s. I would be a heavy buyer in this scenario.


(Update 1/25/2017: I sold out of this position today. At current prices, the market is pricing in a 61% chance of the deal going through. This is a far cry from the 12% chance the market was pricing in when I opened the position. I’ll leave it to someone with more knowledge of the situation to chase the last dime, as I was only in the position because of the extreme discount. The selling price of $110.00, combined with the dividend of $0.54, brings the total pre-tax return to 12.2% over the three month holding period.)

Mon Return.png

References:
http://www.nytimes.com/2016/05/12/business/dealbook/hedge-funds-look-for-hard-hats-in-a-year-of-collapsing-mergers.html?_r=0
http://seekingalpha.com/article/4010367-monsantos-mon-ceo-hugh-grant-q4-2016-results-earnings-call-transcript?part=single
http://www.wsj.com/articles/bayer-boosted-by-recently-launched-drugs-1477466756
http://www.investopedia.com/news/why-monsanto-bayer-merger-will-close-mon-bayry/

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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