Is Ariel Investments' Merger-Arb A Gamble?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

WMS Industries (NYSE: WMS) saw its stock soar over 40% in January on the news that Scientific Games (NASDAQ: SGMS) would purchase the company for $26 per share in cash. The stock currently trades around $25, suggesting 4% upside still remains if the deal goes through. Both companies are makers of lottery and gaming hardware and software (see which hedge funds love WMS).

The mutual fund management firm, Ariel Investments, appears to be betting that the deal does go through, upping its stake in WMS to over 4.29 million shares, or 7.9% of the company's outstanding shares (check out all of Ariel's stocks). Other big-named investors who dove into WMS Industries following the announcement includes BlackRock, now owning 4 million shares, and Artisan Partners with over 2.9 million shares.

Merger-arbitrage is usually a game individual investors don’t dabble in, given the higher risk and large sums of capital required to make it worthwhile, but if you were a merger-arb player, assuming the deal takes another twelve months to finalize, the annualized return would be near 5%, but not without inherent risks that the deal falls apart and the stock tumbles to pre-announcement levels.

Other major gaming and tech companies include International Game Technology (NYSE: IGT)Bally Technologies (NYSE: BYI) and SHFL entertainment (NASDAQ: SHFL)All three of these stocks appear to be seeing their stock lifted as a result of the WMS buyout, with each up over 10% year to date. International Game has recently reaffirmed its 2013 guidance for earnings to come in at $1.20 to $1.30 per share, above analysts' average EPS estimate of $1.22. Bally's recent quarterly results set record quarterly revenues as the highest in history. The company also upped its EPS guidance to $3.20 to $3.40, where analysts' consensus is $3.33. Other notable game company, SHFL, has been active in the acquisition industry, snatching up Chinese electronic gaming maker ProTec Games. For WMS, recent quarterly results showed that the comapny missed estimates, posting EPS of $0.15 and missing consensus by $0.01. While other gaming companies are showing growth in product sales, WMS' product sales dropped by 13%. 
 
The WMS-Scientific deal is interesting, especially considering that WMS (being acquired) is being acquired for $1.5 billion, where Scientific Games (acquirer) has a market value around $780 million. The buyout is also all debt. The merger is great for WMS investors that bought into the company after mid-2011, but not so great for investors that added the stock to their portfolio before then. Prior to mid-2011 the stock traded well in excess of $26 per share for a couple of years:
 
<img src="http://media.ycharts.com/charts/3fc964d605de84815462b375a014e455.png" />


It is unlikely another bidder will come in and make a play for WMS. This is exhibited by the fact that the stock still trades 5% below the actual buyout offer, where Scientific is the only likely suitor for the buyout, making some investors still uneasy as to whether the deal will go through. 

It does appear that Scientific already has financing for the deal, planning to utilize a seven year loan to finance the buyout. On the flip side, the risk is inherent for Scientific shareholders, where the new company will have a debt to revenue of almost 2x, yet shares have been relatively flat since the announcement. The deal is likely a positive for both companies when considering their recent performance. 

Both companies have been experiencing steady revenue declines, and so by combining the companies, hopefully synergies will allow the company to better weather the declining gaming industry demand, which has pressured revenues of late:

<img src="http://media.ycharts.com/charts/f8b318d1593a38fb5eb6deeb0c0ac18f.png" />


Although there is speculation that Scientific could pull out of the deal, Ariel is betting the deal will come to fruition. The multiple is 6.0 times WMS' trailing twelve month EBITDA, whereas, according to Bloomberg, similar deals have been done at a median EBITDA multiple of around 8.5x. The P/E ratio for WMS has also been in decline, and the recent buyout P/E of 24 is above recent multiples:

<img src="/media/images/user_15651/1_large.jpg" />

Although the combined companies should be better positioned for the long-haul, should you be an owner of WMS over the interim, playing the merger-arb opportunity presented? If so, use caution; other suitors, such as Bally and International Game, carry little cash (relative to their market cap) and likely will not make a play for the company, but Scientific already has the debt raised (see why you should sell Scientific Games). 

 


mhargra has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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