Saturday, September 22, 2007

Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

Reader's Question: In July, LKQ Corp. (Nasdaq: LKQX) offered $48.00 per share for Keystone Automotive (Nasdaq: KEYS) in an all-cash deal. Keystone is currently trading around $47.65. The merger is contingent upon approval by Keystone shareholders on October 10. Do you feel that the deal will go through? I am a Keystone shareholder and have voted "no."

Deal Background

For the benefit of any who have not been following the details of this deal, here's a chronology according to the September 5th proxy statement for the merger: Our story begins in December 2006 when Joseph Holsten, CEO of LKQ Corp. (Nasdaq: LKQX), phones Richard Keister, CEO of Keystone Automotive (Nasdaq: KEYS), to arrange a meeting. At dinner on January 18, Mr. Holsten broaches his interest in pursuing an acquisition, which leads to a meeting involving these two CEOs and the chairmen of their respective boards on March 2, when Keystone's shares are at $32.00. Since both companies are active in the replacement auto parts market--Keystone as a leading distributor of aftermarket collision auto parts and LKQ as a provider of replacement parts including recycled parts from salvaged cars--the merger is expected to produce abundant synergies, creating new efficiencies and marketing opportunities for the combined enterprise.

LKQ's initial price indication is $37 to $39 per share, half in cash and half in LKQ shares, which Keystone directors, now having engaged JPMorgan as advisor, formally reject on May 3, when Keystone's shares close at $37.57. Supported by JPMorgan's opinion that Keystone would be undervalued in the low-$40s, the Keystone team states (posturing?) that Keystone is "not for sale" and, even if it were, LKQ's indication of value is "significantly less than the intrinsic value of Keystone."

On May 7, LKQ raises its offer to $45 all-cash. The following day, the Keystone team discusses the situation and concludes that, besides LKQ, "no other automotive aftermarket supplier or other strategic industry participant would likely have an interest in acquiring Keystone due to, among other things, the differences in their business models with that of Keystone." Thereafter, JPMorgan turns to private-equity buyers, and a short list of six interested parties is whittled down to one potential buyer who offers $46 to $48 per share on June 15, contingent on arranging financing for the purchase.

On June 19, LKQ again raises its offer, now to $47, based on 60% cash and 40% stock, which Keystone counters with $49 all-cash. Over the ensuing month, Keystone decides to reject the private-equity buyer's offer, reasoning that LKQ is further ahead in the due diligence process and would be more likely to close given the financing commitment LKQ has already obtained from its bankers. Further negotiation between Keystone and LKQ leads to agreement, and Keystone's board approves the $48 all-cash deal on July 16, when Keystone's share price closes pre-announcement at $43.61.

The day of the merger announcement, July 17, Keystone's shares close at $46.80, up just 7%, while LKQ's shares jump 15% from $25.38 to $29.09. During the next two months through the close of trading this past week, LKQ's shares rise another 21% to $34.44, while Keystone's share price crawls up barely 2% to $47.67, just shy of the $48 all-cash buyout price. In short, while acquiror LKQ's shareholders have enjoyed an impressive 36% gain since the deal was publicly announced in mid-July, acquiree Keystone's shareholders have seen a much smaller 9% gain (see graph). With acquiror's shares having risen more than acquiree's, which is just the reverse of typical acquiror-acquiree share price action following merger announcements, something seems amiss. This unusual price behavior leads me to suspect that further surprises could follow.

How Should Keystone Shareholders Vote?

Apparently, the market is assigning kudos to acquiror LKQ in this deal, who manages, if the deal goes through at $48 as planned, to buy Keystone "on the cheap" and benefit from the resulting synergies between the two companies' businesses. Keystone shareholders, with their upside capped at $48 per share, certainly appear to be getting the short end of the stick. Indeed, there are some (viz., 4% shareholder Rockhampton Management and an analyst) who have already spoken out, insisting that the Keystone board failed to represent the best interests of the shareholders in negotiating and accepting the deal. However, rather than go down the path of discussing who's right or wrong, let's focus on the question at hand: Will the shareholders approve the $48 buyout deal on October 10?

As I see it, there are four possible outcomes:

1. New buyer enters bidding: By the terms of the merger deal, Keystone may terminate the agreement by paying LKQ $30 million plus expenses up to $1.4 million, which amounts to about $1.90 per share based on 16.6 million shares outstanding. This implies that any new buyer would need to offer at least $50 per share to enter the bidding at this stage. Similar to what occurred in the Blackstone Group's buyout of Equity Office Properties in February, it is possible that a qualified and serious second bidder surfaces over the next few weeks prior to October 10, forcing LKQ to raise its offer to above $50 per share to stay in the running. If a bidding war develops, the buyout price could run as high as $60 per share or more, in a combination of shares of the acquiror and cash. Possible bidders include auto parts distributors and retailers, recyclers and steel companies, and private-equity firms. The same private-equity buyer who bid earlier in the process could re-enter the bidding, and I have to believe that, however respectable JPMorgan's banking contacts are in the auto-related and private-equity sectors, there could very well be other potential buyers who, for whatever reason, are only now considering the situation seriously.

2. LKQ pre-emptively raises offer: If LKQ begins to sense that the Keystone shareholders could reject the deal in the October 10 vote, LKQ may wish pre-emptively to raise its offer to $50 per share or a bit higher to "sweeten" the deal to make sure that it gets approved. In my opinion, based on the attractive synergies the merger promises, LKQ will be better off in the long run following through with the deal, even if at a slightly higher price, than shortsightedly tolerating a rejection by Keystone shareholders and walking away with a $30 million consolation prize in hand.

3. No new offer and shareholders reject $48 buyout: If fewer than half of the Keystone shares are voted in favor of the deal, the $30 million termination payment will kick in, resulting in a one-time loss to Keystone of about $1.90 per share. That's, of course, an undesirable outcome; however, through deal disapproval, there's also a potential positive: Keystone's share price could actually rise a few dollars, based on the market's realization that the $48 buyout price was too cheap to begin with. Meanwhile, LKQ's share price would almost certainly fall, giving up part of the 36% gain from its pre-announcement price level, since the synergies of the merger would no longer be available. At this point, the stage would be set for a brand new round of buyout talks, this time with all parties having a better understanding of the value of Keystone, the synergies of an LKQ-Keystone combination, the market's consensus view of the situation, etc.--and I believe that all of this information, now public, should work to the advantage of Keystone shareholders.

4. No new offer and shareholders approve $48 buyout: In my opinion, a simple "yes" vote to approve the deal as it now stands would lead to the worst possible economic outcome for Keystone shareholders, since the share price is capped at the $48 buyout price. Each of the alternative scenarios above provides a means for Keystone shareholders to realize higher value for their shares.

Basically, the market has "spoken" through the unusual acquiror-acquiree price behavior of LKQ and Keystone shares following the July 17 deal announcement, revealing very clearly that Keystone is worth more than $48 per share, even though there remains some skepticism regarding a mechanism for Keystone shareholders to realize this value--hence, Keystone's share price still sits marginally below $48 per share. The market seems to be telling us that, despite factors in Keystone's business such as the Ford patent litigation risk and the question of whether State Farm will re-commence authorization of aftermarket parts, fundamentally the alternative auto parts market is a viable growth opportunity for LKQ, Keystone and other companies in their business niche.

I wonder whether the Keystone shareholders--the largest among them being Artisan Partners (7.6%), T. Rowe Price (6.9%), Wells Fargo (6.1%) and Wasatch Advisors (6.1%)--will collectively make the proper choice on October 10. Fortunately, control now rests in the hands of these shareholders, who, in my opinion, would only be shortchanging themselves by voting for the merger as it is currently priced. If, over the next few weeks, no new buyer surfaces and LKQ does not pre-emptively sweeten the deal to guarantee approval, then I believe Keystone shareholders will do themselves a favor by rejecting the $48 offer.

Potential Upside

While the actual outcome of the vote is difficult to predict, it is very possible that either another buyer surfaces and/or LKQ sweetens its offer on or about October 10, giving Keystone shareholders a more attractive deal to approve, significantly above the current $48 per share offer price. With Keystone's shares trading below $48, it appears that the market is suggesting that no higher bid will come. Though this might end up being the case, I note that market opinion can change very quickly, once the slightest hint of renewed buyout deal activity begins to flicker on traders' screens.

As an investor or speculator, what's the best strategy to follow? If the $48 deal as written closes by scheduled vote on October 10, anyone holding Keystone shares will realize a return of about 70 b.p. (= 48.00/47.67 - 1) over the three-week holding period from today through settlement shortly after October 10. Although 70 b.p. may seem small, it annualizes to a rate of about 12%, which is actually a very respectable worst case return. If any of a number of events lead to an elevated buyout price, a windfall gain of at least a few dollars per share could result, driving returns considerably higher. By the way I see it, there is essentially a "free" call option embedded in Keystone's current below-$48 share price, and the payout of this option could very well surprise on the upside.

(Disclosure: The author presently has no position in any of the companies mentioned in this article.)


Anonymous isuzu auto parts said...

Ford has made a patent claim against Keystone, This is the second patent claim that Ford has made against Keystone. Ford filed a similar complaint with the ITC in April 2005, claiming violation of its design patent for the Expedition grille. The complaint was later withdrawn. According to Keystone, the company was able to show that the design had been published prior to Ford's patent application.

Should Ford prevail, the case would have a significant impact on the aftermarket parts market, and not just in the automotive industry. Federal courts have been wrangling with aftermarket anti-trust and patent cases for several years, sometimes with contradictory results. Most recently, printer manufacturer Lexmark invoked the Digital Millennium Copyright Act in an attempt to prevent manufacture of off-brand printer cartridges.

The ITC has referred the Ford case to an administrative law judge, who will schedule and hold an evidentiary hearing later this year. The judge will make an initial determination as to whether there has been a violation. An opinion is expected by the end of the year.

According to the ITC, the Commission will set a target completion date within 45 days after instituting the investigation. ITC remedial orders in section 337 cases are effective when issued, and become final 60 days after issuance unless disapproved for policy reasons by the U.S. Trade Representative within that 60-day period. These ruling could then be appealed in U.S. Circuit Court of Appeals.

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