How to Play This Gaming Merger

 | Feb 12, 2013 | 12:30 PM EST  | Comments
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Ariel Investments, a fund managed by John Rogers, has reported a position of 4.3 million shares in WMS Industries (WMS), a designer and manufacturer of gaming machines. This is up from 1.3 million shares at the end of September 2012, and gives Ariel ownership of almost 8% of the total shares outstanding.

Scientific Games (SGMS) recently announced an offer to acquire WMS for $26 per share in cash; with the stock currently trading at just below $25, investors would receive a 4% return in the event that the transaction closed. Both companies' boards have approved the deal, so Scientific Games expects it to close this year.

If an investor bought shares at the current price with no leverage, the annualized return from merger arbitrage would therefore be over 4%; obviously, adding leverage would allow for an even higher return which would have a very low correlation to the broader market or any other asset class. However, before the deal was announced, WMS was trading at prices below $17. So if the deal fell apart for any reason, there would be a substantial downside and this would be increased by any leverage.

This downside has been exacerbated by the news that the business has been struggling recently. Just a few days ago, WMS filed its 10-Q for the quarter ending in December 2012, which was the second quarter of its fiscal year. The 10-Q reported a small decline in revenues, as significantly lower product sales offset an increase in gaming operations revenue. Product sales now make up 54% of revenue, down from 60% in the same quarter in the previous fiscal year. The gaming operations business does have a higher gross margin, but despite this factor, WMS's expenses actually increased last quarter vs. a year earlier (including R&D, SGA expenses, and depreciation). We aren't sure if this is because gaming operations tend to have higher operating costs, which offset the higher gross margins, or if WMS merely did a poor job of controlling costs in general.

With total revenue lower and expenses higher, the company recorded $.008 in earnings per share (EPS) -- down from $0.29 a year ago. We would note that, according to the 10-Q, the fiscal year is scheduled such that business tends to increase each quarter (in other words, the quarter ending in September has the lowest revenues, then the quarter ending in September, then the quarter ending in March) but revenues were actually down slightly on a quarter-over-quarter basis this year.

Scientific Games's quarterly report for the third quarter of 2012 showed $136 million in cash on its balance sheet, and only $2.2 billion in total assets. A $1.5 billion buyout (the transaction price for WMS) will require it to issue additional equity or debt securities (and it had $1.5 billion in debt outstanding as of the end of the third quarter as well). In fact, Scientific Games has a market cap of less than $800 million.

A pre-leverage annualized return of more than 4% from merger arbitrage is generally attractive, but, in this particular case, we have some concerns. WMS's business is not performing well, and Scientific Games offered a very heavy premium to where it had been trading. It's clear that the acquisition of WMS will also be complicated as Scientific Games raises the needed cash (certainly we doubt that the deal will work out well for that company). Any long-term WMS shareholders should take some profits from the recent rise in price, and those considering entering for the merger arbitrage factor should tread carefully. It's possible that waiting on further news about the acquisition -- even if the price does rise a bit in the meantime -- is a safer choice.

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