Friday, January 11, 2008

Arbitrage Play: Potential 42% Gains at Traffix, Inc.

According to the Efficient Market Theory Hypothesis (EMT), it is difficult—if not impossible—to outperform the market by consistently picking “undervalued” securities using fundamental analysis, for EMT postulates that the market price of securities always fully reflects all available information.

Additional EMT research suggests that the market reacts quickly and in an unbiased manner to the announcement of bid-related takeover deals (i.e. on average, EMT correctly assess the financial impact and implications of the news and adjusts its valuations bases and assumed probabilities in an unbiased method).

Behavioral economics has demonstrated time—and again—, however, that not all investors react rationally to similarly received information. Ergo, investors might process identical information dissimilarly, for some may expect a scuttled deal; whereas other investors, analyzing the same information, might predict a successful deal.

In the view of the 10Q Detective, securities arbitrage challenges the EMT framework, especially when price discrepancies arise from a corporate takeover announcement, where a price spread can arise between the market price of the stock being acquired and the actual buyout at the takeover price. The risk for the arbitrageur is that the deal collapsed prior to the merger date.

The 10Q Detective currently holds a
long position in shares of Traffix, Inc. (TRFX-$5.45), a premier interactive media company.

On September 27, 2007, New Motion, Inc. (NWMO-$14.00), a digital entertainment company providing a broad range of online and mobile content services announced that they had entered into a
definitive agreement to merge in a stock for stock merger with Traffix.

Under the merger agreement, New Motion will issue 11,917,520 shares of its common stock to Traffix’s stockholders. As a result of the Merger, each outstanding share of the Company’s common stock will be converted into the right to receive 0.683 of a share of NM common stock based on the Company’s capitalization as of September 24, 2007. In the aggregate, on a fully diluted basis, New Motion shareholders will retain approximately 55% of the shares of the combined company on a fully diluted basis, with Traffix’s shareholders receiving shares constituting approximately 45% of the shares of the combined company.

In a joint statement, the boards said: “the combined companies will have the resources to create a vertically integrated ‘Mobile Entertainment Network’ that can play a major role in the mobile industry.”

The combined entity seeks to expand upon and solidify an innovative business model New Motion has created over the past year. The model evolved in part as a byproduct of working very closely with Traffix as a commercial partner:
  • First, the merger will create a true mobile entertainment network that owns a wide range of digital content, exclusive premium billed mobile subscription services and wide online distribution.
  • Second, the combined entity will be well positioned to serve the growing trend where consumers access digital content online, want to interact with those same or associated services on their mobile device, and are willing and able to pay for the ability to do so.
  • Third, by owning a diverse online distribution network, the combined entity should be to lower its effective cost for acquiring mobile subscribers while creating a larger audience, which could then be further monetized with third party advertising.
  • Fourth, management(s) note that in a difficult credit environment, the new company will have at the time of closing a strong and healthy balance sheet that will enable the company to actively seek additional accretive acquisitions.

The transaction values Traffix’s share base upon New Motion’s Wednesday closing price of $14.00 at $9.56 a share, more than a 42% premium over Traffix’s closing price on Wednesday.

Graduates of courses in Finance and Investment Banking would surely be warned off from potentially investing in an arbitrage play with such an out-sized reward premium. Sometimes, however, it might be best to heed the words of Humorist Mark Twain (1835 – 1910): “I never let schooling interfere with my education.”

Subject to the customary regulatory clearance and shareholder approval, the plan is to consume the merger by the close of the first quarter of 2008.


Eddie Thomas said...

To be an arbitrage play, wouldn't you have to do something with NWMO on the other end?

Anonymous said...

I'll definitely be taking a closer look at this company.

I actually owned TRFX a while back, back when I didn't have a clue what I was doing. It seemed like they had more cash on their balance sheet than the market realized, so I bought it. It never really went anywhere so I eventually sold it.

On a side note, I just featured your blog over at my blog. I think your's is one of the more interesting finance blogs out there. Keep up the good work!

-John (Investing for Everyone)

David J. Phillips said...

One might look to short NWMO/however--the float is too thin. I would prefer to capture the discount surrounding 'risk of merger.'

Jay said...

by the very definition of risk aribtrage (capturing solely the risk of the merger; eliminating other risks) you must short NM.
Bit surprised you think otherwise.

Check prices today. both are down sharply. (esp. NM for some reason or other)

Cogitator said...

Yes, eddie thomas and Jay are right. As I commented on your Seeking Alpha post: You aren't performing merger arbitrage by just going long on the target company. (That would be sufficient for a cash deal.) This is a stock-for-stock transaction, so you need to short shares of the acquirer.

If you can't find shares to short, just forget about the position. It's not arbitrage.


Happy Landlord said...

This has turned into a real *hit show.

The combined company is now trading for less than either one was on a stand alone basis.

I guess this is "negative arbitrage?"