The Piramal Arbitrage

There is a unique opportunity to make a profit out of an arbitrage situation with regard to two Ajay Piramal controlled companies.

Background - In 2007-08, Ajay Piramal spun off the New Chemical Entity, the entity doing research on new chemical and biological molecules that could evolve into blockbuster drugs in the future, out of what was then the pharma company Nicholas Piramal, and into Piramal Life Sciences Limited (PLSL). Nicholas Piramal was subsequently renamed Piramal Healthcare Limted (PHL). In mid 2010, Ajay Piramal pulled off a coup of sorts by selling the domestic formulations business and the Diagnostics business of PHL (which together accounted for almost 60% of PHL's then revenues) for fairly high valuations, and netted PHL about Rs 17,740 cr from this slump sale. Out of this amount, about Rs 10,200 cr was paid up front in 2010, and the balance of about Rs 7,540 cr is to be paid over the next 4 years. This future payment, which is not contingent on any conditions being fulfilled, has a net present value of approximately Rs 6,500 cr (keep this number in mind), discounting at a rate of 10% per annum.

The opportunity - The NCE unit, which is currently part of PLSL is now to be demerged back into PHL, for PHL stock. The proposed price is to issue 1 PHL share for every 4 PLSL shares currently held by the existing PLSL shareholders, for giving up the future potential of the NCE business to PHL. As of Friday, 22nd July's closing prices, PHL stock closed at Rs 400 a share, while PLSL closed at Rs 94.85 a share, both on the BSE. The demerger proposal is to be put to vote in a shareholder meet on 9th August 2011. Upon shareholder approval, the share exchange will be done on a Record Date to be decided by the boards of PHL and PLSL. So here is the arbitrage opportunity - going long on 4 PLSL shares, and short 1 PHL share (or multiples thereof) - if things work out as planned, there is a guaranteed profit of a little more than 5% (less transaction costs) to be made in less than a month. Of course, in life, nothing is guaranteed or risk free. The risks here are that the deal does not receive shareholder approval on 9th August for some reason, or the Bombay High Court disallows it or delays it for some reason - I estimate the probability of either event happening to be small.

But here is how I would play this trade - While a conservative investor would be well advised to go along with the above arbitrage opportunity and net a (almost) risk free 5% with cash deployed for less than a month (which annualizes to 60%), without caring about the underlying details of the businesses, a more intrepid investor might want to look under the hood and take a slightly different approach. Stock market price quotes are opportunities to buy small portions of great business at sometimes really favourbale valuations, that would never be possible if you were negotiating with the owners for an outright purchase of the whole business. Of course, this is assuming that the managers of the business are honest and treat all shareholders (including minority shareholders) alike. With this assumption, I do not see any difference between buying only a small portion of a business as compared to buying out a whole business. In Ajay Piramal's case, based on past track record, I would venture to state that this is a reasonable assumption to make. Based on closing prices of July 22nd 2011, the market is valuing PHL at just shy of Rs 6,700 cr. So if one were to buy PHL for Rs 6,700 cr today, one will, over the next 4 years, be eligible to receive an aggregate sum of Rs 7,540 cr (with an NPV of Rs 6,500 cr) as balance payouts from the slump sale done in 2010. So the payouts alone should recoup the intial investment. But in the balance, after recouping the investment, you are still left with the operating businesses of PHL, which had a revenue of Rs 559 cr and a profit after tax of Rs 71 cr in Q4FY11 (March 2011). Note that these businesses have immense potential to grow revenues and profitability in the future and you are getting these businesses for virtually no price. On top of this, PHL also had an investment income of Rs 130 cr in Q4FY11, which is just sweet gravy on the top.

So to sum up, at the current quoted price (Rs 400 on the BSE), PHL is an absolute bargain. PLSL represents an opporuntity to buy into PHL at a further 5% discount. Keep an eye out for these two stocks - a further divergence in their valuations (lower PLSL prices and higher PHL prices) will magnify the bargain in this opportunity, at least until the demerger happens.