Equity – Page 64

KCG cost of capital calculation

I will warn this is a very dry post.

The merger arbitrage spread with KCG has narrowed considerably.

When the $20 cash merger was announced the shares were trading at $19.75. There is little chance of the deal falling through or there being a superior offer.

Today KCG is trading at $19.88. The estimated close of the merger was reported to be “3rd quarter 2017”. The assumption is the mid-range, or August 15, 2017.

So there are 3.5 months until the deal closes.

12 cents appreciation is 0.6% over 3.5 months, which over the course of 3.5 months implies a 2.1% annualized rate, not compounding. This also excludes trading costs.

Because I had a small cash deficit in my USD account and a surplus in CAD, I’ve sold some shares at $19.88 to make up the shortfall. I placed it at the ask to minimize trading costs, which turned out to be 29 cents per 100 shares.

What’s interesting is my trade got hammered away, 100 shares at a time, approximately 2-4 seconds apart per trade. Interesting algorithms at play here.

I also believe Virtu (Nasdaq: VIRT) will have a more difficult time with the integration of KCG than they originally anticipate. The company cultures are significantly different and while the merger makes sense on paper, in practice it is going to be quite different. KCG was also dealing with a non-trivial data migration program on their own, from New Jersey to New York City and these sorts of technical details require highly skilled individuals to pull off without causing trading blow-ups. It might take them a year to get things stabilized after the merger is finished. KCG had huge growing pains of its own after it was reverse-takeovered by GetCo.

Home Capital / Equitable Group discussion

Home Capital (TSX: HCG) collapsed 60% on news that they are in the process (not obtained!) a secured credit facility for a 10% interest rate, and a 2.5% standby rate for the unused portion. They also announced that customer deposits have collapsed in recent days.

Needless to say, this is a huge amount of interest to be charged and the market’s reaction is fairly indicative of this being a very, very negative event for the company.

(Update, April 29, 2017 – This is a little late, but the company confirmed the secured credit facility on April 27, which including the $100 million commitment fee, means an effective rate of interest of 15% for a $2 billion borrow, or a 22.5% rate for a $1 billion borrow. The ex-chair on television said it was secured 2:1 by mortgage loans and is front-in line. Yikes!)

Equitable Group (TSX: EQB) also has collateral damage, down approximately 17%. Are they next?

No positions.

Home Capital Group, Equitable Group

Home Capital (TSX: HCG) and Equitable (TSX: EQB) have been hammered today as a result of fallout of the Ontario Securities Commission allegations that certain Home Capital Group executives have contravened the various regulations. They continue to perform damage control, today announcing their CFO (who was under the OSC investigation) will be stepping down and other various board changes.

Borrowing rates for Home Capital spiked to 26% today. Equitable, which normally has been an inexpensive borrow, had its cost to borrow rise to 2.75%.

Implied volatilities on options for HCG is also very expensive at present, around 110% for near-dated options and around 90% for a couple months out. EQB does not have options trading on their shares.

There has been an avalanche of media coverage (both in print and social media) about Home Capital and their woes. They have been pushed down to about 25% less than tangible book value.

This spill-over has not occurred to Genworth MI (TSX: MIC) at present.

The closing sale for Davis and Henderson

I’ve written a little bit about D+H Corporation (TSX: DH) in the past. On March 13, 2017 they received an all-cash buyout offer for CAD$25.50 from an international firm and there is no reason to believe this will fail.

In my opinion, DH shareholders are getting a good deal since there are plenty of storm clouds on the horizon for the company.

However, there is a lesson for me in this story even though the last time I owned shares was in 2010.

Back in October 2016 when they released their disaster of a quarterly earnings report, their stock subsequently traded as low as CAD$14.06, although realistically if you had started accumulating after their earnings disaster you would have received an average price of around CAD$15/share. I also predicted the company would slash its dividend in half (which it nearly did, from 32 cents to 12 cents a quarter) and thought the stock would get hit even further as I projected a spiral of selling by panicked investors.

This did not happen. Instead, when they announced their dividend slashing, the stock quickly went up to $16 and never looked back. The company announced a strategic review to sell out the firm on December 7, 2016 which sent the stock up to $21/share and you can see the rest of the story in the stock graph.

So in the span of six months between an earnings disaster and the buyout offer, the company’s stock price has appreciated by a factor of 70%.

In retrospect, the October quarterly report and subsequent dive in stock price (from $28.70 to $16.20) should have been an equity purchasing event, not an event to continue throwing eggs and rotten tomatoes at the corporate body.

It makes me wonder about my valuation methods and why I got this one incorrect.

I wasn’t in a very good position to invest back in October 2016 (I was mildly leveraged at the time), but even if I was in more of a cash situation I probably wouldn’t have dipped my toes until around CAD$12/share where I would have seen an acceptable risk/reward ratio.

I have performed equity and debt research on hundreds of companies. Some companies I keep current on even though I have not taken a position on them. Some companies I just look at once and don’t look at them again until years later when there is some reason for them to show up on my radar again. There are also some like D+H that I have invested in a long time ago and check in from time to time. Whenever companies like these appear again, there is always the knowledge that I have done my due diligence over a larger period of the company’s history compared to those that are freshly looking at the company. In the case of D+H, it will be sad to see this accumulated research knowledge go away, but that is life as an investor in publicly traded securities.

KCG Holdings: Bought out

KCG Holdings (NYSE: KCG) looks like it will finally be bought out by Virtu (Nasdaq: VIRT) for US$20/share, cash. They also announced their first quarter results, and according to my scorecard they did better than expected – while their bottom-line net income was slightly negative, they were significantly better on trading revenues than I was expecting. I was expecting a very lacklustre quarter due to incredibly low market volatility in the quarter. Interactive Brokers (Nasdaq: IBKR) is a regular conference call I read and they can attest to the impact of low market volatility on trading.

My investment history with KCG is quite fascinating. I did not disclose things here until October 2016, but I have been trading the stock at various times since 2013, which resulted in material performance gains, especially in 2013 (I took a fairly heavy call option position at the second half of the year). It has exhibited a narrow price range since its merger with GetCo after their August 2012 trading blow-up. The company has generally been off the radar of most investors as it received little analyst coverage and was treated like toxic trash.

Virtu has a plan to raise $1.65 billion in debt financing for the merger and also has sold $750 million in equity at $15.60/share, which should make the buyers happy considering they are now trading at $16.40/share – the market believes this will be quite valuable for Virtu. KCG’s existing 25% shareholder has consented to the agreement, which makes it very unlikely that the deal will not pass through KCG shareholder approval. Given the highly strategic nature of the acquisition, I also doubt there will be other competitors for KCG. Thus, this merger looks like a done deal.

Current trading is at US$19.75. The expected closing is in the third quarter of 2017. As the current spread between market and US$20.00 is around 127 basis points, this would imply a merger arbitrage spread of about 3.8% annualized, so I am in no rush to sell as I have nothing else to deploy my capital into.

The only other issue of concern is KCG’s senior secured debt, maturing on March 15, 2020. According to the fine print, the notes can presently be called off at 103.438 cents on the dollar and there is a required offer for 101 cents on the dollar due to the change of control (which would be redundant since the notes are trading over this in the marketplace). I would suspect Virtu would be eager to get these notes off the books as quickly as possible as they contain covenants that would otherwise restrict the KCG entity. I’ll hold onto these as long as possible but do not think they will survive much longer.