The difference between an amateur photographer and a professional is that you only see the best images of the later, but the former displays a lot of not so flawless images on his path to understanding what he needs to do better. John and I wanted to create this website to write about our process, not just our best ideas. Let’s be honest, we would probably only post a few times a year, if we were limited to writing about our best ideas.
With this in mind, I wanted to write about a special situation that I decided against, but may be interesting to some of you if your risk appetite is larger than mine or if you merely want to peek into my office to see how ideas make it to the Dust Bin Watchlist.
John and I talk about three categories of investments. The third category is special situations, which typically involve some sort of corporate event that provides a near term catalyst for the returns we are looking for. In most cases, these catalysts are not real or the business is so bad that we are hesitant to own the stock in case the “anticipated” catalyst does not appear.
This idea is clearly in the special situation camp. Additionally, I want to point out that special situations are a riskier category than the other two because the long-term nature of a business is not the clear focus of the investment idea.
This is an “unedited transcript” from a call with John earlier this week.
Matt: Have you seen this tender offer special situation? A third party is offering to buy a little over 50% of a company for $28, which is about 16% more than the current market price. And the tender offer expires in under 10 days.
John: Tell me more.
Matt: Well (a little hesitation on my part as I can already sense his Elsa-like reaction to my next statement), so, it’s a Russian payment processing company, controlled by a single Russian CEO, and the third party is a Russian bank.
Matt: John, are you there?
John: Umm, what did you think about O’Reilly’s results?
Qiwi (not Kiwi) does the following, best described in their 10-K:
“We are a leading provider of next generation payment services in Russia and the CIS. We have an integrated proprietary network that enables payment services across physical, online and mobile channels. We have deployed over 17.2 million virtual wallets, over 162,000 kiosks and terminals, and enabled merchants to accept over RUB 70 billion cash and electronic payments monthly from over 56 million consumers using our network at least once a month (aggregating consumers across QIWI, Contact and Rapida networks, without elimination of potential duplication). Our consumers can use cash, stored value and other electronic payment methods in order to pay for goods and services across physical or virtual environments interchangeably. We believe the complementary combination of our physical and virtual payment services provides differentiated convenience to our consumers and creates a strong network effect that drives payment volume across our business.”
A few necessary facts. The company is controlled by its CEO, who maintains 59.3% voting control over the company. A Russian bank, Otkritie, would like to purchase approximately 60% of the regular (non-super voting B shares), which it does not currently own and thereby increase their stake would increase their stake to around 64%. Otkritie has offered to pay $28 per share with a tender set to close within 8 days (July 14). Prior to the offer, the stock was trading around $23.50 and spiked initially upon the tender offer, but has came back below $24 as of July 6. The tender offer here could represent a roughly 16% return in a matter of days, if all goes as planned.
There are a few potential glitches.
First, the tender offer lists as a requirement that at least 20,286,207 shares are tendered. This represents approximately 49% of the shares not owned by Otkritie. This high minimum is logistically difficult in terms of getting that many people on board with a tender offer. In most circumstances, the volume in the stock would be high, and the shares would have already traded hands, going to people more likely to tender. However, the volume in QIWI has barely increased and only totals about 9m shares since the tender offer announcement. Otkritie could easily waive this requirement if they received a significant number of shares in the tender offer. One upside, however, of low tender percentage is that if Otkritie did lower the minimum due to insufficient tendering, there would not be any proration and you could tender all your shares at $28.
Moving on to some more serious concerns (a long Second, third…etc). Breaking this down into basic terms, you have a Russian bank attempting to buy a majority ownership position in a Russian payment processing network owned and controlled solely by its Russian CEO. If you want to know why the 16% spread exist, this is the main reason. I also think it is somewhat enlightening to read through some of the Risk Factors for Qiwi. I bet they are similar to other Russian companies, but I haven’t read through many, so this was a whole new world for me. I have pasted some of my favorite risk factors at the end of this post.
These risk factors are just a few of the many known unknowns, but with Russia, you have a high possibility of “unknown unknowns.”
If I were going to do this transaction, my thesis would be simple. I think Otkritie and Qiwi’s CEO are most likely trying to buy the stock at a price, which they know are undervalued based on some material information that is unknown to the market at this time. Additionally, once Otkritie and the CEO have completed the tender, they will have a combined 75% voting control over the company and will be able to execute any corporate actions without minority shareholder approval. I think this is the end goal.
Some investors are good at doing a lot of these sorts of deals, 1-2% per position, and if you do them as a basket approach, and you are good at handicapping which deals have a high probability of success, you can do well over time. If I were a special situation arb investor, this idea would probably find a way into my basket, but instead it found its way into my Dust Bin Watchlist.
Russian Risk Factors
“Substantially all of our business is in emerging markets, including Russia and Kazakhstan, where a substantial part of the population relies on cash payments, rather than credit and debit card payments or electronic banking. We believe that consumers making cash payments are more likely to use our kiosks and terminals as well as Visa Qiwi Wallet, which is most commonly reloaded via kiosks and terminals, than using alternative payment methods. As a result, we believe that our profitability depends to an extent on the use of cash as a means of payment and the reach of our kiosks and terminals network. Over time, the prevalence of cash payments is expected to decline as a greater percentage of the population in emerging markets adopts credit and debit card payments and electronic banking and as our kiosks and terminals network decreases. The shift from cash payments to credit and debit card payments and electronic banking could reduce our market share and payment volumes and may have a material adverse effect on our business, financial condition and results of operations.”
“Russia’s economy has been facing significant challenges for the past few years due to the combined effect of the ongoing crisis in Eastern Ukraine and Syria, the economic and financial sanctions imposed in connection with it on certain Russian companies and individuals, as well as against entire sectors of Russian economy, by the U.S., EU, Canada and other countries, a steep decline in oil prices, a record weakening of the Russian ruble against the U.S. dollar, a lack of access to financing for Russian issuers, capital flight and a general climate of political and economic uncertainty.”
“The Russian economy contracted both in 2015 and in 2016. At the same time, the population’s purchasing power decreased due to the weakening of the ruble, basic necessities such as food products and utilities became more expensive, and consumer confidence declined significantly, according to the Russian Consumer Confidence Overall Index reported by Rosstat. According to Rosstat, inflation was 11.4% in 2014 and 12.9% in 2015 (although it relatively stabilized in 2016 at 5.4%), while real average wages have been declining (with Rosstat’s data for 2016 indicating that the population’s real disposable income contracted by 5.9% in 2016 as compared to 2015).”
“Despite measures we have taken and continue to take, our payment system has been and may continue to be used for fraudulent, illegal or improper purposes. These include use of our payment services in connection with fraudulent sales of goods or services, illicit sales of prescription medications or controlled substances, illegal online gambling, software and other intellectual property piracy, money laundering, bank fraud, terrorist financing, trafficking, and prohibited sales of restricted products.”
“The political and economic changes in Russia since the early 1990s have led, amongst other things, to reduced policing of society and increased lawlessness. Organized crime, particularly property crimes in large metropolitan centers, has reportedly increased significantly since the dissolution of the Soviet Union. In addition, the Russian and international media have reported high levels of corruption in Russia. Press reports have also described instances in which government officials have engaged in selective investigations and prosecutions to further the interest of the government and individual officials or business groups. Although we adhere to a business ethics policy and internal compliance procedures to counteract the effects of crime and corruption, instances of illegal activities, demands of corrupt officials, allegations that we or our management have been involved in corruption or illegal activities or biased articles and negative publicity could materially and adversely affect our business, financial condition and results of operations.”
“The Russian economy has fallen into recession in 2015 and continues to suffer from ruble depreciation, inflation and capital flight, and depends highly on the global pricing of crude oil, which has fallen significantly compared to 2014.”
“The banking and other financial systems in Russia are not well-developed or regulated, and Russian legislation relating to banks and bank accounts is subject to varying interpretation and inconsistent application. The 1998 financial crisis resulted in the bankruptcy and liquidation of many Russian banks and almost entirely eliminated the developing market for commercial bank loans at that time. From April to July 2004, the Russian banking sector experienced further serious turmoil. As a result of various market rumors and certain regulatory and liquidity problems, several privately owned Russian banks experienced liquidity problems and were unable to attract funds on the inter-bank market or from their client base. Simultaneously, they faced large withdrawals of deposits by both retail and corporate customers. Several of these privately owned Russian banks collapsed or ceased or severely limited their operations. Russian banks owned or controlled by the government and foreign owned banks generally were not adversely affected by the turmoil.”
“There are currently a limited number of creditworthy Russian banks (most of which are headquartered in Moscow). Although the CBR has the mandate and authority to suspend banking licenses of insolvent banks, many insolvent banks still operate. Many Russian banks also do not meet international banking standards, and the transparency of the Russian banking sector in some respects still lags behind internationally accepted norms.”