Identix Inc., - IDNX - An arbitrage opportunity

Arbitrage also known as “riskless profit” is the most satisfying way to make money that I have experienced. It comes without much of the hassles of speculation and takes a lot of uncertainty of the stock market out – more often than not, you know exactly what return you are going to achieve and by when you will achieve the same in an arbitrage situation. At a very basic level, an arbitrage refers to the simultaneous purchase and selling of an asset in order to profit from a differential in the price. And to make it difficult for the retail investor, any financial professional can start talking to you about statistical arbitrage vs. market arbitrage vs. convertible arbitrage vs. index arbitrage and about futures spreads and box spreads – maybe even just so you think this is very difficult. And maybe it is. But there is always that simple case of “Merger Arbitrage” that any retail investor can use to make a nice return on investment. This is a popular hedge fund strategy, with which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit.

So are there risks? Absolutely. Nothing is quite riskless. Risks include the merger no going through thanks to variety of reasons including say the LBO (Leveraged BuyOut) firm backing off the deal to the deal not getting the regulatory and anti-trust approvals. But in most cases, the situation is very straight forward and you know when a deal is going to go through and you know when a deal “may not” go through – and you are best served keeping far away from them. There are plenty of arbitrage deals to make money out of – no need to chase the doubtful ones.

Personally, I have never lost money in an arbitrage deal – ok, I lie, I panicked on two occasions and lost money, but in both cases would have made money had I simply not panicked. Panic is the retail investors’ first enemy. To give a little more detail on those two occasions – HLYW and ABS. Hollywood Videos traded at a nice spread of more than a $1 on a $13 investment and when the LBO firm backed out, HLYW plummeted to $9.5 and I was happy to take the bounce off a $11.5 renegotiated price and cut my losses, though I was fully aware that a bidding war was going on with MOVI and BBI also bidding for HLYW. Sure enough, had I even waited a week, I would have made not just the $1 spread I was aiming for, but $1.5 for a sweet 47% annualized return. I repeated the mistake again with ABS – a company that has clearly announced it was for sale but rejected the $26 bid – the stock dropped to $2.5 below my cost basis and I cut my losses again only to read the news (released minutes before I author this blog) that they are in talks to accept a slightly higher bid.

In any case, the most important thing here is to depart with the lesson learnt from these two mistakes and the answer is found by thinking about the fundamental reason for my panic. Both Albertsons and Hollywood Videos are companies that I would never ever dream of buying even if someone paid me to do the same (ok, I lie again – if someone paid me, maybe I would buy them depending on what they paid). Which leaves me with a basic rule – stay away not just from deals that have a risk of falling through, but also from stocks that are fundamentally bad and arbitrage is the only thing going for them. To date, I have played the merger arbitrage game 27 times and made a decent 12-29 % annualized return in each of those cases.

Now that we have the arbitrage rules out of the way, what’s the best arbitrage situation in the market as of today. IDNX. Viisage Technologies announced a buyout of Identix Inc., for an all stock deal (which is second best for merger arbitrage next to all cash) – you get 0.473 shares of VISG for every share of IDNX and the merger is set to close in the first half of the year with a few websites slapping a date of 5/17/06 for the scheduled close of this merger. As with all stock mergers, you short the acquirer and buy the acquired and most discount brokerage houses (I use TD Waterhouse and absolutely love it and am anxious about the Ameritrade buy out – I like my TD Waterhouse the way it is – please don’t change it) automatically match up your short with the new shares of the acquirer received upon closure of the merger and all positions are closed. On Jan 12^th, I went ahead and shorted 2365 shares of VISG at $16.60 each and for the $39270 received, bought 5000 shares of IDNX for $35150 and pocketed the $4120 spread for about a 25% return (are you salivating yet?!!) if this deal closes in 6 months which I am pretty positive that it will.

A curious retail investor (or maybe a skeptical one) had questioned my post on the Yahoo! IDNX message board touting this great arbitrage deal.

“doctorsmith99” asked: “what's the risk on this spread? seems like you could just multiply the shares involved by 100x and pocket a cool mill? what's the catch??”

I had responded on the message board and will include the response below to complete this blog.

Response: “All arbitrages have risk - a risk of the deal not getting approvals, a risk of a LBO firm withdrawing its bid, a risk of the acquired firm reporting bad results making the acquirer walk away from the deal etc., The reward for the risk is the spread. In this case, personally, I believe the risk is very low. So I am willing to take the low risk for a good return.

Regards making a million, here is a simple calculation. As you may have noted, the spread has increased from $8000 on a $70000 investment to $12000 on a $78000 investment on Friday's trading in which VISG was bid up a lot more than IDNX. So even better for us arbitragers.

So yes, you could make a million from this - if you had $6.5 million to buy IDNX shares, then you could make a million from this arbitrage deal - that is your catch. :-) I know I do not have $6.5 million.

And in case you are wondering, "But I can short VISGD for $7.5 million and buy IDNX for $6.5 million of it and pocket a million", well you can, as long as you find someone who will "loan" you $7.5 million for your promise to settle it in a couple of quarters when the deal closes :-) That's how shorting works - you are borrowing from your broker.

Hope this helps. Take care and good luck "doctorsmith".”

Bottom-line, the VISG-IDNX deal offers a cool spread with very low to no risk for an excellent return to the tune of 25%

Last updated: January 22^nd 2006