Why This Bidding War is Heating Up

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Many investors believed that it would be just a matter of time before another player jumped into Kohlberg Kravis & Roberts's (NYSE: KKR) bid for Steinway Musical Instruments (NYSE: LVB). Their collective wish came true with the Aug. 12 announcement that privately-held investment firm Paulson & Company had decided to raise KKR's offer price by more than 10 percent. The new proposal is widely regarded as superior to KKR's initial offer and is now the odds-on favorite to win the bidding war. Given the tight deadline that Steinway has imposed on its own "shopping period," KKR will have little time to mount a proper response.

This new offer holds out the renewed promise of arbitrage. At the same time, its slightly higher value threatens to undermine long-term investors' gains. Although it is likely that Paulson will succeed here, it is theoretically possible for another bidder to emerge and throw the situation into chaos once more. First, a summing-up of the major players is in order.

The world lacks a great number of publicly traded musical instrument manufacturers. Steinway shares the spotlight with Kimball International (NASDAQ: KBALB), a more technologically savvy firm that focuses on producing electric instruments like keyboards, guitars and recorders. By contrast, Steinway focuses on more traditional instruments like its signature grand pianos, baby grand pianos and stand-up instruments. Since Steinway has its own set niche, and has been able to keep margins high.  However, the declining cost of realistic-sounding electric instruments and changing consumer tastes have forced Steinway to compromise its historical business model. Both firms must deal with competition from low-cost international firms like Yamaha and others.

Although KKR has no particular interest in the music business, it does invest in firms that fit Steinway's basic profile. Since it prefers small-cap and mid-cap players, Steinway is a natural pickup for the private equity firm. Of course, the same could be said about Paulson & Company. 

In any event, Steinway and Kimball are very similar in size. Whereas the former firm has a post-offer market cap of $493 million and an enterprise value of about $413 million, Kimball has a "non-inflated" market valuation of $428 million and a book value of $324 million. In 2012, the Massachusetts-based company earned $33.4 million on revenues of about $359 million. Meanwhile, Kimball earned about $20 million on revenues of $1.2 billion. Of the two, Steinway is clearly more profitable and probably offers a better return on investment for its eventual owner. The fact that it has $2 in cash for every $1 in long-term debt is a nice incentive as well. 

How the New Deal Is Structured

Under the terms of the new deal, Paulson will offer $38 per share in cash to current Steinway shareholders. This compares to KKR's previous offer of $35 per share. In sum, Paulson's bid has a value of just under $480 million. At Steinway's current per-share price of $39.60, the new offer represents a significant discount of over 3 percent. Investors are clearly expecting another bidder to come through at the last minute.

War in Review: Where Things Stand

At the moment, it is highly unlikely that KKR's original offer will be sufficient for Steinway's management team and shareholders. It is less clear whether or not Paulson's offer will stand. The pending "re-offer" deadline applies only to KKR, and it is widely known that up to a dozen other firms are interested in Steinway. While KKR may have lost its chance, there is talk of even higher offers from international firms like Samick Musical Instruments of Korea. Since the terms of Steinway's agreement with Paulson are unclear, the Massachusetts company may not be in a position to entertain other offers. At the same time, it would probably explore its options in the event that an even juicier bid emerges.

Which Bid Is Better?

There is virtually unanimous agreement that Paulson's offer is superior to KKR's. Both firms are well-known private equity companies that have proven records of success in the small-cap space. According to many market-watchers, Steinway's growth prospects are looking increasingly rosy thanks to the development of a culturally aware middle class in Asian powerhouses like China, Vietnam, Thailand and India. Since both offers are equally straightforward, there are no "catches" in Paulson's bid that could derail it at the last moment. Unless a third party jumps into the fray, Steinway is Paulson's to lose.

Probable Outcome and Investment Thesis

At this point, it would be fair to assume that Paulson will win this bidding war. However, the outcome is not assured. A number of firms continue to circle Steinway from a distance. Some may be able to realize extensive synergies from the deal and would probably be willing to pay a premium for the company as a result. Given its generalist approach to investing and lack of obvious synergies with Steinway, Paulson may not be willing to go higher than its current offer.

In sum, investors cannot earn an arbitrage premium for Steinway at these levels. However, those who believe that Paulson will not have the final word should position themselves accordingly. In the event of a per-share offer of $41 or $42, the piano-maker's stock will take another leg up. For long-term investors, the best course of action might be to sit back and let this situation play itself out. Over time, there should be plenty of entry points for enterprising traders.

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