Of course, 'bid arbitrage' is a misnomer because these situations are not risk free, as a true arbitrage must be. The arbitrage only kicks in if the bid is successful. That's never a certainty until it goes unconditional and, in the case under review, we don't even have a formal bid on the table. Still, at least we have an indicative one. A consortium, led by private-equity investor CVC, will offer 500p per share cash for buses and trains operator National Express, and it will go formal just as soon as the directors of the company under siege recommend it. So will they?
Obviously, I think they are likely to, because I have bought 6,000 shares in National Express at 466p each for the Bearbull Speculative Portfolio. But, first, let's consider where the directors are coming from. The slightly exaggerated response is to say from two years of them making a complete Horlicks of everything they have touched. Sure, hindsight is wonderful, but now we can see that corporate hubris is at the root of National Express's troubles. In particular, just two years ago National Express won the franchise to operate the InterCity East Coast rail franchise from London's King's Cross to Scotland. "We have won with a bid which is ambitious, deliverable and structured to generate shareholder value," crowed the now-former chief executive, Richard Bowker, in August 2007 as National Express's share price stood at £11.38.
Ambitious, yes; deliverable, no. But more of that in a moment because, also in 2007, the bosses took the group on an acquisition binge that doubled its net debt to £911m during the year. Still, all looked so rosy that, early in 2008, its former chairman, David Ross, who resigned later that year, pledged "to increase our dividend by 10 per cent per annum for the next three years", adding that "this reflects the board's confidence in the group's future prospects". Yet by the end of the year net debt had risen further to £1.2bn and, as trading faltered, fears grew that National Express would break its debt covenants. This now looks unlikely, but that's partly because the company first slashed - sorry, to use the board's word, "re-based" - its dividend, then axed it altogether.
Worse still, in July, just 19 months after National Express started running the East Coast rail franchise, the directors announced that the group would walk away from it when the funding that its special-purpose subsidiary, NXEC, had committed to the project was exhausted. The board reckoned there would be no knock-on effect on the group's other rail franchises (running services in East Anglia and commuter trains into London from Essex). They may be wrong. At least the transport secretary, Lord Adonis, hissed between his teeth at the time that "I note that the parent groups of previous franchise failures are no longer in the UK rail business." Then he lectured National Express: "It is simply unacceptable to reap the benefits of contracts when times are good, only to walk away from then when times become more challenging."
All of which indicates that National Express has no future whatsoever as a train operator in the UK. And that's a problem because, in 2008, that activity provided 48 per cent of the group's £2.8bn revenue and 31 per cent of its £264m operating profits. At best, National Express will lose its other franchises when they expire. At worst, it will lose them much sooner, yet still have to meet various financial commitments to extricate itself, which it can ill afford.
As a result of National Express's discomfort, CVC has pitched its 500p offer, which, in the absence of a competing bid, cannot be raised, tightly. So tightly that shareholders may be tempted to reject it even after National Express's board has recommended it. After all, shareholders may reason that, even with the rail business given a zero value, CVC is still only offering £765m for the equity of a bus and coach operator that generated £1.4bn of turnover in 2008 and £183m of operating profits.
Well, yes, except that we must not forget how a shrunken National Express may struggle to cope with that debt burden - now down to £978m - and various rail-related obligations that may arise. At the very least it will need a big injection of new equity and its institutional shareholders may well conclude that such investment would be better directed at National Express's rival, Stagecoach. After all, it has agreed with CVC to take over National Express's UK rail and bus operations and - crucially - has got the Department for Transport's blessing to run National Express's lucrative East Anglian and London commuter franchises while leaving the loss-making East Coast franchise in the state's hands.
Sure, there is more downside if CVC's bid fails than my 34p-per-share profit if it succeeds. But obviously not, I reckon, on a risk-weighted basis. And my guess is that National Express's shareholders will want to take what's on offer from CVC and move on.
