CF Industries: What to Do When the Fertilizer Hits the Fan
Take advantage of emerging opportunities as companies fight for control.
More Deserving, Less Fulfilling
Before getting to some possible trades, let's run through the story.
Back in early October, Agrium (AGU) made an unsolicited bid of $98 a share for CF Industries, which was trading around $85 a share at the time. Despite the 15% premium, CF quickly rejected the offer. A few weeks later it made its own hostile bid for rival Terra Industries (TRA). The now-sweetened offer works out to around $40.50 a share, or about 20% from when the overture was first made. Terra, like CF to Agrium, said no, believing it, too, should command a higher price.
In a sector ripe for consolidation, each player views itself as the most deserving, and therefore is unwilling to pair off with another partner unless it takes the lead role. But this off-putting behavior could have all of them standing alone, leaving industry giant Potash (POT) -- which itself, is rumored to be a target of BHP Biliton (BHP) -- able to gain further market share.
All this should come to a head in the next few days as Agrium/Terra is putting it to shareholders for vote this Friday. That decision should set the table for the next few moves.
However this plays out, there are two things I expect to happen in the near-term: First, I don't think anyone is going to substantially raise their offering price, meaning that both CF and Terra should remain below $100 and $41 per share, respectively. Second, as clarity is gained, implied volatility in the names should move lower.
The looming merger activity has also caused a reverse skew of both the horizontal and vertical kind. That IV in the front month is higher than the back months, and there's a clear demarcation at the takeover prices in which strikes above have a significantly lower IV than the strikes below the proposed price.
In CF Industries, the implied volatility has been drifting higher for the past few weeks; it now stands near 75% in the November series and around 55% in December and later months. In both cases that's higher than the level that preceded the company's November 4 earnings report. Typically after an earnings report, IV would decline substantially. But with these news items pending, premiums have remained elevated.
To take advantage of these expectations for price cap and a decline in implied volatility, I'm looking at buying a ratio spread in the December calls and then also purchasing a few cheap November calls as a short-term protective measure.
For example, with CF Industries trading around $82 a share, you can buy one December $90 call at $2.40 and sell two Dec. $95 calls at $1.25 a contract. That's a 10c net credit for the 1x2 ratio spread. The proceeds can be used to buy some November $95 calls, which are trading around 15c, cheap on a dollar basis, to gain a speculative bet that CF changes its mind and a deal is done this week. If that does occur, and the price is $98 a share, both the November calls and the December ratio spread will realize a hefty profit.
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