ArbitrOption's Best Idea in the Universe: Montage Technology (MONT)

 This information is provided for educational purposes only, and is intended to be an example. It does not constitute investment advice. As with all investments, there are associated risks and you could lose money investing. Prior to making any investment, a prospective investor should consult with her or his own investment, accounting, legal and tax advisers to evaluate independently the risks, consequences and suitability of that investment to their personal financial circumstances.

 

Published 8/14/14

Current Favorite: Montage Technology Group, Ltd. (MONT)

  ArbitrOption's investable universe is populated by risk arbitrage and special situation opportunities with three basic characteristics:

- the pending corporate event must be disclosed by the company's management or Board of Directors (no rumortrage) - the pending corporate event must have an estimable process duration and terminal value, and - the company must have exchange-listed options with suitable expiration dates and strike prices

Montage Technology is the best investment opportunity in ArbitrOption's universe because the following investment process is expected to produce returns more than NINE TIMES better than ArbitrOption's equity-trading peers.

ArbitrOption’s investment process can be broken down to five stages:

1.Idea Generation 2. Investment Research 3. Trading 4. Portfolio Management 5. Exits

The following describes how this investment process is being applied to the investment opportunity in Montage Technology.

1. Idea Generation

Montage Technology (MONT) received an unsolicited offer to be acquired for $21.50 per share from Shanghai Pudong Science and Technology Institute (PDSTI) on March 10th, 2014. Three months later, on June 11th, 2014, MONT announced that it had agreed to be acquired by PDSTI for $22.60 in cash per share, a 31.7% premium to MONT’s March 7th closing price of $17.16. The June 11th press release noted that, “Details regarding the record date for, and the date, time and place of, the special meetings will be included in a press release when finalized.”

Disclosure of a pending corporate event by a firm’s management or Board of Directors is a requisite step to be included in ArbitrOption’s investable universe. The following chart of MONT's stock price from 3/7/14 to 8/11/14 shows the movements in the stock price since the unsolicited offer on March 10th.

This chart shows MONT's trading prices from 3/7/14 to 8/11/14.

2. Investment Research

MONT’s initial press release contained partial answers to the questions ArbitrOption asks during the investment research phase. In it, the company disclosed that “[t]he transaction is subject to approval by the shareholders of Montage, and antitrust and other regulatory approvals.” Unusually, the press release did not provide an expected completion date for the transaction.

A copy of the merger agreement was filed at the SEC on the same day the transaction was announced. Article 9 of the merger agreement discussed the conditions necessary for the merger to be completed. These conditions include approval by:

- at least two-thirds of the votes cast by shareholders entitled to vote - the National Development and Reform Commission of the PRC - the Ministry of Commerce of the PRC - the State Administration of Foreign Exchange of the PRC - the PRC Anti-Monopoly Bureau

The merger agreement also discloses, in clear terms, that PDSTI will have immediately available funds to complete the transaction. PDSTI has a loan commitment letter from Bank of China Shanghai Branch. Section 7.06 (f) of the merger agreement states, “[PDSTI] acknowledges and agrees that neither the obtaining of the Financing or any alternative financing, is a condition to the Closing, and reaffirms its obligation to consummate the transactions contemplated by this Agreement irrespective and independently of the availability of the Financing or any alternative financing, or the completion of any such issuance…”.

MONT and Shanghai Pudong Science and Technology Institute are not competitors. In light of the absence of any anticompetitive implications in this transaction, there is negligible concern about the possibility of a delay due to an extended antitrust investigation. ArbitrOption initially estimated the transaction would be completed by the end of December 2014. MONT and PDSTI will have to gain antitrust and shareholders’ approval before the transaction is completed. The companies have not provided the date of their application to the PRC Anti-Monopoly Bureau, but the process includes a filing, an acceptance of the filing by the Bureau (which occurred 40 days after the filing in the recent Chindex transaction), a 30 day phase 1 review of the application and, if necessary, an additional 60 day phase 2 review period.

Although there is no concern about an antitrust investigation, the PRC Anti-Monopoly Bureau is notoriously understaffed and application reviews are commonly extended into phase 2. Using an estimate of July 31st for the date of the filing, one can sketch out the following timeline:

• 7/31/14:    Filing
• 9/10/14:    Acceptance of filing
• 10/10/14:  Phase 1 expires
• 12/11/14:  Phase 2 expires

Because MONT is organized under the laws of the Cayman Islands, the proxy approval process was expected to occur on an accelerated schedule relative to that of firms domiciled in the US. Whereas ArbitrOption usually expects to see the definitive proxy filed within 90 days of the acquisition’s announcement for US companies, Cayman Island firms are able to file the definitive proxy within 30 days and hold the shareholders vote 30 days after the filing. ArbitrOption expected that MONT shareholders would vote on the acquisition by PDSTI by mid-August.

That estimate proved too conservative in this case. The preliminary proxy was filed on July 1st, 20 days after the transaction’s announcement, and the shareholders’ meeting was held on July 31st. 99.4% of shares voted were in favor of the transaction. If the acquisition is completed successfully, PDSTI will acquire shares of MONT for $22.60 in cash. A review of available options indicated that it would be appropriate to invest in option pairs expiring in January by buying options with a $21 strike price and selling options with a $22.5 strike price. This position will be profitable so long as the acquisition has been completed or MONT stock is trading above $22.50 when the options expire.

3. Trading

In order to achieve an annualized return greater than 10% and a risk/reward ratio for the option trade that is superior to that of the stock, the maximum price that ArbitrOption could buy a January ’15 $21 / $22.5 call spread would be a debit of $1.21. That price is found by taking the lesser of a) the maximum price that would allow a 10% annualized return, or b) the price that matches the current risk/reward ratio of the stock.

Annualized Return

In order to generate a 10% annualized return, an event that lasts 141 days (the number of days between August 12th and December 31st) would have to produce a 3.12% gross return. The maximum price at which this call spread could be purchased and still allow for a 10% return is $1.45.

Underlying Math

10% / (365 / 141) = 3.12% $1.5 option spread / 1.0312 = $1.45 maximum price to achieve 10% annualized return.

Risk/Reward

At $21.40, with a success value of $22.60 and a failure value of $16.50 based on the pre-deal price, the risk/reward ratio in the stock is 6.10/1.20, or 5.1x. The maximum price that could be paid and still produce a superior risk/reward ratio is $1.25.

Underlying Math

1.25 risk / 0.25 reward = 5x

Since June 11th, 2014, ArbitrOption has bought January expiration $21 / $22.5 call spreads that risk 4.9% of the portfolio’s value at prices that will produce a 55.34% return on investment if MONT is acquired or closes above $22.50 in January 2015. On an annualized basis, the return will be 99.5%.

4. Portfolio Management

Since the initial 0.5% position was added on June 11th, ArbitrOption has been monitoring developments. Option pricing has become more attractive since the initial position was added, allowing the firm to lower its dollar-cost-average while increasing the position.

ArbitrOption’s portfolio management rules set an upper limit of 10% risk per merger arbitrage situation. In light of the international exposure in MONT’s business operations and the critical role of foreign regulatory approval processes, ArbitrOption is content to monitor the situation and increase its position only at anomalously good pricing opportunities.

5. Exit

The acquisition of MONT is still awaiting completion of the review by the PRC Anti-Monopoly Bureau. The transaction is not conditioned on financing and has already been approved by MONT shareholders. As was the case with the earlier acquisitions of Spreadtrum and RDA Microelectronics, it is highly likely the deal will close shortly after the completion of the antitrust review in China (if the review clears the transaction). An investor who bought the stock on June 11th would have paid about $21.40 per share to earn $1.20, or a return-on-investment of ranging of 5.6% for exposure to the same risks as those of the option spread. If successful, ArbitrOption’s approach will yield a return on investment almost NINE TIMES greater than that of the stockholder.