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To: ms.smartest.person who wrote (732)	11/13/2001 6:47:07 PM
From: ms.smartest.person	Read Replies (1) \| Respond to of 5140

Briefing/Stock Brief: Hewlett / Compaq Arbitrage Play 08-Nov-01 11:31 ET [BRIEFING.COM - Robert J. Reid] Much has been made over the past few days on the Hewlett Packard/Compaq deal. In this Brief, we take a closer look at the deal and consider it as an arbitrage play. Trouble in Paradise A battle is brewing over Hewlett-Packard's (HWP 19.18) bid to buy Compaq (CPQ 7.99) . Earlier this week, a coalition of Hewlett family members controlling more than 5% of HWP's stock said they plan to vote against the deal. Yesterday, a member of the Packard family agreed with the Hewlett family's choice not to support the merger. HWP's board says full steam ahead on the deal. Since the deal, HWP has been up sharply while CPQ has sold off. Much of this is due to the Street's view that this is a bad deal for HWP. The lower margin PC business of CPQ would pressure earnings for HWP. However, a lot of it is due to traders unraveling their arbitrage play. Arb Play Hewlett-Packard is offering 0.6325 shares for every share of Compaq. HWP currently trades for $19.18, which when multiplied by 0.6325 = $12.13 per share which is currently a 52% premium on CPQ. Clearly, traders believe the deal is in jeopardy. In arbitrage plays, you generally buy the company being acquired (CPQ) and short the acquiror (HWP). Here's how it works: sell short 63.25 shares of HWP and buy 100 shares of CPQ. Selling 253 shares of HWP short (4x63.25) and buy 400 shares of CPQ (4x100). The 253 share short sale gives you $4,852 in cash, then buy 400 shares of CPQ, which costs $3,196. This results in an automatic profit of $1,656 as long as the deal goes through. This will be your 50% profit regardless of how the stocks trade in the months leading up to the closing of the deal. As you can see by the chart below, pessimism about the deal has been slowing increasing over the past few weeks. The Sep 11 attacks caused a lot of concern, but the arb spread narrowed somewhat after that. But the spike at the end shows that a lot of traders think this deal is dead. Arbitrage Spread <http://www.briefing.com/graphics/stkbrief/20011107arb.gif> Who Can Vote? Cons: The Hewlett family's announcement spooked traders, but they own less than a fifth of the shares. It was especially troubling because Walter Hewlett is a Board member and voted in favor of the deal just two months ago. Also, by going public before talking behind close doors with other Board members shows he is adamant about killing the deal. CEO Carly Fiorina could save face by backing out by citing concerns with European regulatory commission, which will likely require the companies to spin off assets in Europe. Pros: It will not be easy to kill the deal. Generally, a large block of individual shareholders do not take the time to vote. This means that the families will need to convince about two-thirds of the institutional holders to get a majority. The Board seems determined to push the deal through regardless of the founding families. A large break-up fee increases the likelihood that this will at least get to a vote. Also, this deal is the defining moment for controversial HWP CEO Carly Fiorina. It makes her leadership look poor if she does not get the deal done, so she'll be doing everything she can, especially working the phones to institutional holders. We looked at who controls the company illustrated in the chart below. <http://www.briefing.com/graphics/stkbrief/20011107arb2.gif> It's a Coin Flip We view the chances of the deal going through as 50/50. But for a 50% return, that's not bad odds. If you're not interested in the arb play, consider simply buying Compaq. The stock has a book value around $6.50 per share which should provide decent support and if CPQ could trade at half of Dell's p/e multiple next year, it would be a $14 stock. Conclusion Regardless of the vote, the uncertainty is clearly a positive for Dell, IBM, Sun as it will create opportunities for its major competitors to gain market share. In the case of Dell, there was already uncertainty among its customer base -- now the Hewlett family is encouraging HWP management to deemphasize PCs. Imagine being a customer, who would you buy from? In sum, arb plays are not as scary as they sound. There's a lot of uncertainty around this one, but hopefully this brief offers insight on how to evaluate other pending and future deals. Please feel free to share your comments or ask questions of rreid@briefing.com. <http://www.briefing.com/images/Briefing/bullet_top3.gif> Back to Top Copyright © 2001 Briefing.com, Inc. All rights reserved. Used with permission of briefing.com