Google’s On2 Technologies Acquisition Is At The Mercy Of Merger Arbitrageurs

December 8, 2009

We live in an era of bumps in merger payments that the buyer thought had been negotiated, and Google (GOOG) is about learn this the hard way in its $106 million acquisition of On2 Technologies (ONT). As the stock market continues to rally shareholders whose companies get acquired are depressed to see that they are stuck with stale valuations from the time their mergers were first negotiated. In the meantime, Facet (FACT), Diedrich’s (DDRX), Hiland and others see their buyout prices bumped up. So we have sympathy for the owners of On2 Technologies who refuse to vote in favor of the acquisition of their stock by Google for $0.60 worth of Google stock.

That’s not $0.60 in cash but $0.60 worth of stock independent of Google’s stock price. The problem is that $0.60 worth of Google stock are a lot fewer shares today than back in August when the merger was announced. Google has since risen from the $450s to the $580s, or 29%. The merger consideration has remained constant $0.60. Had management negotiated a fixed exchange rate of, say 0.0013 shares of GOOG for each ONT, then shareholders would receive $0.77 worth of Google stock for their shares now.

The flipside of a constant merger consideration is that it has become much less dilutive for Google. Instead of issuing roughly 235,000 shares based on Google’s August share price, Google will now have to issue only 182,000 shares (assuming the VWAP for GOOG will be around $580).

Management is in a frenzy to line up enough votes to get the deal approved in the December 18 shareholder meeting. Every day another SEC filing is made extolling the advantages of the deal and threatening the dire consequences if shareholders vote it down. This is a clear sign that they lack votes to close the deal.

Merger arbitrageurs are the joker that will determine the outcome of the shareholder vote on December 18, The arbitrage community holds a significant share of On2. Technologies. We attribute holdings some 15% of the shares to holdings by arbitrageurs, based on our analysis of 13F holdings data collected by Whale Wisdom:

Name Holdings on 06/30/09 Percentage on 6/30 Holdings on 09/30/09 Percentage on 9/30 Change in shares

6,545,681 3.71% 6,545,681

5,313,966 3.01% 5,313,966

2,631,744 1.49% 2,631,744

2,290,893 1.30% 2,290,893

2,147,252 1.22% 2,147,252

1,803,675 1.02% 1,803,675

1,604,076 0.91% 1,604,076

1,348,228 0.76% 1,348,228

1,026,059 0.58% 1,026,059
BARCLAYS GLOBAL INVESTORS UK HOLDINGS LTD 1,003,273 0.58% 999,683 0.57% -3,590

722,969 0.41% 722,969

722,466 0.41% 722,466
DIMENSIONAL FUND ADVISORS LP 424,063 0.25% 423,263 0.24% -800
HARRIS FINANCIAL CORP 305,000 0.17% 305,000
GEODE CAPITAL MANAGEMENT LLC 185,014 0.11% 272,299 0.15% 87,285
CNH PARTNERS LLC 257,729 0.15% 257,729
UBS AG 845 0.00% 199,995 0.11% 199,150
VERITABLE, L.P. 252,400 0.15% 118,600 0.07% -133,800
BANK OF NEW YORK MELLON CORP 112,490 0.07% 112,490 0.06%
NORTHERN TRUST CORP 96,374 0.06% 110,345 0.06% 13,971
MORGAN STANLEY 49,292 0.03% 104,325 0.06% 55,033
KNIGHT CAPITAL GROUP, INC. 62,353 0.04% 62,353
HUNTINGTON NATIONAL BANK 50,000 0.03% 25,000 0.01% -25,000
FISHER ASSET MANAGEMENT, LLC 17,700 0.01% 17,700 0.01%
PRUDENTIAL FINANCIAL INC 10,100 0.01% 10,100 0.01%
WELLS FARGO & CO/MN 2,000 0.00% 3,000 0.00% 1,000
METLIFE SECURITIES, INC 2,000 0.00% 2,000 0.00%
AMERIPRISE FINANCIAL INC 1,900 0.00% 1,400 0.00% -500
VANGUARD GROUP INC 971 0.00% 1,364 0.00% 393

This was per 9/30, a full two months prior to the record date for the meeting. We would not be surprised if their holdings of shares have since doubled. As we pointed out in our book about merger arbitrage, the outcome of many mergers is driven by the arbitrage community whose holdings often reach the 30-50% range during the merger process. A study by Micah S. Officer (“Are Performance-Based Arbitrage Effects Detectable? Evidence from Merger Arbitrage,” Journal of Corporate Finance 15, No. 5 (2007), 793–812) gives examples of the percentages reached historically in some mergers.

Arbitrageurs generally try to take a quick gain and move on. With the current price of On2 Technologies the spread comes to around 20%, depending on your assumptions about commissions and the closing date. So it will be tempting for arbitrageurs to support the deal and take that quick and easy return. However, it is also possible that the arbitrage community has smelled blood and will reject the deal, challenging Google to increase its consideration. Some of the arbitrageurs on the list are of the more aggressive variety and we would not be surprised if they challenged management.

For Google, this is its first purchase of another public company. So they are still learning and probably won’t mind bumping the price, especially not if the transaction is so small that it is a mere rounding error in their financials. They simply have to increase the exchange ratio to the level they were willing to pay back in August. That would boost returns to shareholders significantly and win over the support of the arbitrageurs.

We doubt that the transaction will collapse completely. It makes sense for Google from a strategic point of view. Building their own video compression software is certainly a possibility, but in the typical tradeoff between buy or build they are probably better off acquiring a firm that has a technology that actually works. Not to mention that in acquiring On2 Technologies they can use the technology right away. Time is of the essence if they want to use video as a driver to push their Android operating system into the mobile market. Therefore, we think that Google will eventually increase the exchange ratio to 0.0013 so that investors get as many shares as they would have in August. There remains upside in On2 Technologies beyond $0.60.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which engages in merger arbitrage and owns shares of On2 Technologies. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

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