From a merger arbitrageur's perspective the likelihood of completion of a Men's Wearhouse (NYSE:MW) - Joseph A Bank (NASDAQ:JOSB) merger appears to be as predictable as a coin toss - it could easily go either way. However, recent legal developments have created a profitable opportunity.
A quick overview of JOSB's defenses. Jos. A. Bank has a poison pill in place. In recent years poison pill provisions have been removed in certain cases either through a consent solicitation, which an activist investor or acquirer sends directly to shareholders, or through a proxy fight, where the challenger manages to replace the directors on the board with pro-merger directors, who then remove the poison pill. Neither of those is possible here: consent solicitation is not allowed in JOSB bylaws, and the Board is staggered, meaning only several of the directors are up for reelection each year and the board cannot be replaced in a single election. An acquisition of Eddie Bauer by JOSB (paid in part cash part JOSB stock) can also be considered a type of defense as it will make Joseph A. Bank overleveraged and much less desirable and further it will put 16% of JOSB's stock in the friendly hands of the outdoor retailer's private equity owners, while simultaneously diluting the holdings of current JOSB shareholders, some of which have been pressuring the board to merge with MW. Finally, JOSB has started a self-tender offer, which is conditioned on the closing of the Bauer acquisition. Jos. A. Bank will re-purchase $300 million of its stock at $65.00 - a price higher than the $63.50 currently offered by Men's Wearhouse in its tender offer for JOSB. This repurchase serves two purposes. Both tender offers expire in March and that will cause the tendered shares to be divided between the two competing offers, which is important because one of the conditions for MW's hostile tender offer is that at least 90% of JOSB shares are tendered. At the same time, the self-tender will buy out many of the dissident pro-sale shareholders who otherwise will be voting against the board at the annual meeting.
Due to JOSB's near impregnable defenses the board cannot be pressured into selling unless they want the deal. The defenses the board has in place may simply be a very ingenious way to squeeze the maximum price Men's Wearhouse is able to pay. If that is their strategy, then it has worked - MW has already raised their bid from $57.50 to $63.50 (which JOSB has also rejected after hours on Thursday) and further indicated that it may pay $65.00 if allowed to do limited due diligence. Men's may even pay a couple of dollars more if a friendly deal is ultimately agreed upon. On the other hand JOSB may have been showing their true colors all along, saying MW's offer undervalues the future growth potential of their company and the incumbent board's strategy will ultimately create more value for the shareholders. After all, JOSB has revealed their vision for long term growth through the pending acquisition of Eddie Bauer to be followed by $300 million self-tender offer at $65.00.
Men's Wearhouse's efforts to create pressure for the board from JOSB's own shareholders has received a lot of coverage in the press, but has failed to influence the target thus far. Men's Wearhouse also filed a lawsuit in the Delaware Chancery Court alleging that the Jos. A. Bank board breached its fiduciary duties to put shareholders first by adopting measures to "thwart" Men's Wearhouse's tender offer. Under the lawsuit, Men's Wearhouse seeks to prevent Jos. A. Bank from proceeding with the Eddie Bauer acquisition and wants the Jos. A. Bank board to revoke its poison pill. Delaware case law shows that the courts will allow a poison pill and other takeover defenses to remain in place to help the target company negotiate a higher price or consider other alternatives. However the court will not look kindly to measures that completely preclude a deal regardless of price. Vice Chancellor J. Travis Laster determined that Men's Wearhouse made a "credible basis for believing that the Eddie Bauer transaction is defensive" and that it was in response to a "hostile bid" according to a court transcript. The judge further determined that the suit will be fast-tracked and ordered JOSB to immediately submit certain relevant documentation.
It is the opinion of several leading legal experts, including Corporate Law Professor and widely-read New York Times columnist Steven M. Davidoff, that the court is unlikely to decide in favor of the acquirer due to the fact that JOSB left themselves a clever "out" in the body of the Purchase Agreement with Eddie Bauer. That document contains a clause which allows JOSB to back out of the purchase if JOSB receives a "superior proposal" that will make it more beneficial for JOSB itself to be acquired. Of course it is up to the Board to decide at what price an offer for their shares will be superior to their current direction: remaining independent and buying EB. But the point is that JOSB can now rightfully claim that buying Bauer is not a purely defensive move designed to kill the MW takeover and keep the incumbent board in charge, because the board still has the option to sell should the price be raised high enough. The Delaware judge will announce his final decision on March 25.
And this court-imposed delay is what creates an arbitrage opportunity. While the final resolution of this deal is still anybody's guess, the delay creates a certain temporary stability which can be exploited with options. It should be clear by now that closing the Eddie Bauer deal would be the one irreversible event that would kill the MW - JOSB merger. But we can be certain that JOSB cannot complete its purchase of Eddie Bauer until the court decides the case. Certain option strategies such as covered calls or a Bull call spread can profit nicely in situations where the price is stable or rising.
The March JOSB calls expire on March 22 - several days before the Delaware court will announce its decision on March 25. JOSB has been very stable for the last two days (February 26 and 27) since the judge announced he will hear the case, trading right around $60. The March $60 calls currently are the best candidate for selling as their price ($2.35 on February 27) consists mostly of time value. An investor can buy the shares at $60 and sell the $60 calls (covered call;) or buy lower strike calls, say the March $50 ($10.40 on February 27) and sell the $60 calls against them (bull call spread.) If the share price is at $60 or higher at option expiration, the covered call's potential profit is 3.9% (47% annualized) and the bull spread could bring 18.75% (225% annualized.) The bull spread is a leveraged version of the covered call and accordingly any losses would also be likewise magnified.
Finally, I want to go over the 3 possible outcomes for the above position and their likelihood. First and most likely, the price will wobble around this level as everyone awaits the court decision. As an illustration, Goldman Sachs which is the underwriter for the cash portion of the consideration JOSB will pay for Eddie Bauer has scrapped its February 27 deadline for providing loan commitments and has not announced a new deadline, likely waiting on the court ruling before proceeding. Second, there is a good possibility that the price may go higher - either because MW raises its offer yet again or because the two suit retailers may finally come to an agreement.
There is also a chance that the deal may die. For the time being, this can only happen if Men's Wearhouse decides to abandon the pursuit. Judging by the eagerness that MW has shown so far in using every move in the takeover book, i.e. attempting private negotiations first, then public letters, followed by a hostile tender offer and now a lawsuit; backing out is the last thing on their mind. Further, MW's largest shareholder Eminence Capital which has been a very vocal supporter of the merger has indicated its great satisfaction with Men's Wearhouse's constantly escalating efforts to acquire Jos. A. Bank, and has promised its support for MW's current board and executives at upcoming shareholder meetings. The MW board would not want to disappoint this very active 10% shareholder, which does not shy away from proxy contests and legal action when displeased.
Disclosure: I am long JOSB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: I am long JOSB March $50 calls and short JOSB March $60 calls
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