Arbs see CME boosting bid for Nymex

Merger arbitrageurs expect CME Group Inc.’s bid for Nymex Holdings Inc. to succeed, but they also believe the Chicago derivatives powerhouse will have to sweeten its offer for the parent of the New York Mercantile Exchange.

The CME is offering $36 in cash plus 0.1323 of its share for each Nymex share. At the CME closing price of $457.65 on Tuesday, the offer values Nymex at $9.15 billion, barely a 3% premium over Nymex’s $8.89 billion market capitalization.

“It (arbitrage spread) is trading too tight at 3%. Anything below 6% shows speculation the target will get price improvement, get a ‘bump,’ as we say, or close early, and that it (an early close) is unlikely,” a trader at a New York hedge fund specializing in merger arbitrage said, noting that some Nymex shareholders are hoping for the CME to sweeten its offer by $2 billion.

While merger arbitrage is relatively straightforward and common, if the deal falls through, the strategy can result in losses because the stock price of the acquirer typically bounces back but the target company stock slips.

“A lot of people think it’s a low-risk deal, but that does not necessarily mean it is because there is an antitrust risk here,” the trader, who asked not to be named, also said.

Hedge funds, including Kinetics Asset Management Inc., Pleasantville, N.Y., with 1.69%, and Wellington Management Co., Boston, with 1.07%, are among the institutional holders of CME. Kinetics also owns 1% of Nymex, while asset manager Loomis, Sayles & Co., Boston, owns 1.42% of the energy exchange. In addition, hedge funds Duquesne Capital Management Co., Pittsburgh, and Citadel Investment Group LLC, Chicago, own 1.13% and 0.74% of Nymex, respectively.

With oil markets on a roll, shareholders and members of Nymex, the world’s largest energy exchange feel they should get more than a mere 3.6% premium over its market value — or not merge at all. Either prospect weighs on the CME, whose shares have lost more than a third of their value since their all-time high of $714.48 on Dec. 10. Major pension funds such as the New York State Common Retirement Fund, Albany, own CME stock. The $154.4 billion fund owns a 0.5% stake. French insurer AXA SA, Paris, is the single largest investor in the CME with 11%.

“The only way I see the CME getting the votes needed is to pay the $11.3 billion it offered,” Nymex investor Gary Glass said in an e-mail circulated on Monday, following comments by Nymex Chief Executive Officer James Newsome who expressed confidence the merger will go through.

Mr. Glass’s valuation is based on the theoretical value of the deal on Jan. 28, when CME and Nymex announced they were in merger talks. The then-$11.2 billion price tag for the oil-trading giant, based on the CME’s prior closing price, represented an 11% premium above Nymex’s market value at the time.

But market conditions and the exchanges sector have greatly changed since then. Both CME and Nymex stocks lost 18% on Feb. 6, when the Justice Department, responding to the Treasury Department’s request for comments about financial reforms, questioned the monopoly of futures exchanges which control both trading and clearing.

On March 17, the day the merger agreement was officially sealed with the blessing of the Nymex board, the deal’s value had dropped to $9.4 billion — and further to just $8.9 billion intraday while the CME stock dropped to a 52-week low of $399.01. Prior to entering the merger agreement, the CME had also already obtained the backing of Nymex’s single largest shareholder, private equity firm General Atlantic LLC, Greenwich, Conn., which owns 6.6% of the stock.

Nymex shareholders have already pressured the exchange into holding a special meeting on June 3 to discuss the merger, which is subject to regulatory approval and requires a vote by the majority of shareholders of the two exchanges and three-quarters of Nymex’s 816 members with trading rights.

Three shareholders — Cataldo Capozza, Polly Winters and Joan Haedrich — have also initiated three different lawsuits in the Delaware Chancery Court, Wilmington, to stop the merger. The three cases seek class-action status and allege the Nymex board of directors did not negotiate in good faith. One of the plaintiffs is seeking depositions from another exchange’s top executives, who allegedly had earlier made an offer for Nymex that could have been as high as $14 billion. Information on which exchange and executives was not available.

While soaring oil prices justify a good offer for Nymex, its stock already trades at a lofty 37 times earnings. Also, because of a 2006 exclusive trading agreement with the CME, the oil exchange cannot be a source of electronic trading revenues for a potential acquirer until 2016. “Nymex should accept the CME offer as the company is worth more with the CME than stand-alone,” said analyst Diego Perfumo at financial sector consultant Equity Research Desk, Greenwich, Conn. “I do not think the CME needs to raise its share bid, but it will need to raise it to trading right-holders. I expect the CME to raise the cash to those holders from $612,000 to $750,000.”

As part of the merger agreement, Nymex has committed itself to buying the trading rights for $612,000 each or a combined $500 million.

Mr. Perfumo pointed out that Nymex has a better chance of thriving under the CME’s wing than on its own, as its main competitor, the IntercontinentalExchange Inc., Atlanta, just received approval from British regulators for its ICE Clear Europe clearinghouse. The vertical clearing model would help ICE better compete globally.

The CME has its own problems, which may cap its appetite for Nymex at a much higher price. One of its flagship equity contracts, the Russell 2000, is moving to ICE no later than September, which will translate into lower revenues for the Chicago exchange. It is too early to predict whether a new CME equity futures contract, based on the Standard & Poor’s 600 index, will make up for the loss of the Russell 2000 futures until that migration is completed. But analysts note that changing the behavior of investors whose portfolio is benchmarked to the Russell small-cap index, is a challenge.

“While Russell is showing early positive signs at ICE, CME’s alternative, the S&P 600 index futures, is not,” analyst Edward Ditmire at investment bank Fox-Pitt Kelton Cochran Caronia Waller LLC, New York, wrote on Tuesday in a note to clients. Mr. Ditmire, who has an “in-line” rating on the CME stock, lowered his price target by 3% to $569.

If that weren’t enough uncertainty, both Nymex and ICE could see a decrease in trading volumes and revenues if the Senate passes the Consumer-First Energy Act of 2008, a bill introduced last week that includes a proposal to raise margins on energy futures to pre-empt speculation.

Contact Isabelle Clary at [email protected]