Similar to the FCEC/TOBC merger from a few months back, small community bank mergers can provide a tremendous source for arbitrage profits.

Jacksonville Bancorp Inc (JAXB) and Atlantic BancGroup Inc (ATBC) are two tiny micro-cap banks that agreed to merge back in May.

Due to their small size – a market cap of $13m and $2.6m for JAXB and ATBC respectively – the transaction seems to have flown under most investors’ radar and offers attractive returns for patient individual investors who are able to pull off the trade – at least in theory.

Merger Background

On May 10, 2010, JAXB and ATBC signed a definitive merger agreement where ATBC, along with its subsidiary Oceanside Bank, would be acquired by JAXB.

Both banks operate locations in the greater Jacksonville, FL area. According to ATBC’s CEO,

“We believe that a well-capitalized local bank run by local people will offer our customers and our shareholders the most benefit in the long run. This is truly a unique opportunity. “

To help finance the transaction, JAXB also announced a stock purchase agreement with a group of four investors, led by CapGen Capital Group, to provide $30m in new capital through the sale of newly issued shares of JAXB common stock.

Deal Terms

Under the original merger agreement, ATBC shareholders would receive 0.2 shares of JAXB common stock plus cash consideration of up to approx. $0.65 subject to the sale of certain assets.

These assets were eventually sold on June 30 for $700k in cash, or approx. $0.56/shr.

JAXB would also plan on issuing 3m new shares at $10.00 to the new investor group to finance the transaction.

Subsequently, the merger agreement was modified on September 17 to increase the amount of capital raised from the JAXB stock sale, to a total of $35m at a per share price of $9.00.

This modification also served to set the cash consideration of the merger agreement at $0.67.

Final Stock Exchange Ratio: 0.20 JAXB common stock for each share of ATBC common stock

Cash Consideration: $0.67 per share of ATBC common stock

Regulatory Approvals

Like most banking transactions, the merger requires approval from a number of different governing bodies, including the Federal Reserve Board, the Florida Office of Financial Regulation, and the FDIC.

After Federal Reserve Board approval, the companies must wait 15 days before officially completing the transaction. The OFR approved the transaction on September 22, with the Federal Reserve following on October 14.

Shareholder Approval

To complete the transaction, at least 70% of ATBC’s shareholders must vote to approve the transaction.

Executive officers and management of ATBC hold 15.46% of outstanding stock, with the only other large shareholder being Apex Investment Management, with 9.91%.

ATBC’s shareholder meeting was scheduled for October 28, but the company hasn’t yet posted any news regarding the results of voting.

JAXB’s special meeting of shareholders is scheduled for November 9 in order to vote on the sale of stock to accredited investors in order to guarantee the financing for the transaction.


ATBC & JAXB - Merger Arbitrage Returns

To lock in the arbitrage spread, investors would purchase shares of ATBC and short shares of JAXB according to the merger ratio.

While the timeline is still uncertain, management believes that the transaction will be closed in the fourth quarter of 2010.


Financing – The merger relies on investors committing $35m in fresh capital to JAXB in order to pursue this transaction. If these investors walk away – due to economic conditions, further deterioration in ATBC’s business, etc – the transaction could fall apart.

Approvals – ATBC’s management team only controls 15.46% of outstanding stock, leaving some risk for shareholder approval.

However, ATBC’s board determined that the bank would need to pursue a strategic transaction or merger in order to survive. While the bank recently reported a quarterly profit, it remains on shaky ground – the failure of the merger would have severe consequences for existing shareholders.


The biggest factor in this transaction is that both banks are very thinly traded.

JAXB hasn’t traded for the past several days, although there was a decent amount of activity the week of Oct 14-22, with several thousand shares changing hands.

Low trading volume makes it difficult to find JAXB shares to short in order to complete the other side of the merger arb.

The bid-ask spread could also be a factor that cuts into expected returns.

With these factors, the implementation of this arbitrage opportunity could be difficult for most investors – although attractive on the surface, this merger shows the importance of checking ‘paper theory’ with actual trade execution.


No positions

After 3 years and over $35m in losses, Sparton Corp (SPA) took a giant leap forward in 2010, evidence of a strong turnaround by the new management team.

SPA struggled through several bad years due to a variety of causes: underutilized and unused manufacturing facilities, lax management, inflexible long-term contracts and overall recessionary pressure.

Despite these difficulties, the underlying business had potential, and based on latest results, the stock remains undervalued with strong potential for future growth.


Sparton operated at only 25% of operating capacity for period of time after management decided to move business to an inefficient facility in Jackson, MI (where the company HQ’s and management were located), instead of keeping it at a modern facility in New Mexico.

In addition, quality concerns led to substantial losses within the DSS segment as Sparton was forced to eat the losses on fixed price contracts.

Finally, in mid-2008, the company’s largest shareholder, Lawndale Capital Management, initiated a proxy fight citing concerns regarding Sparton’s corporate governance and board composition – new directors were nominated, along with a recommendation for hiring an experienced turnaround management team to shakeup the long-entrenched and underperforming management group.

Soon after, a rockstar turnaround team was put into place, starting with the hiring of a new CEO, Cary Wood, in November 2008.

The new team instituted a number of initiatives for controlling costs during a tough business climate and setting the strategic vision for the company’s future, including:

  • Cutting staff by 6% during the course of 2009
  • Freezing pension plan accruals and 401(k) matching contributions
  • Closing several plant facilities and consolidating others
  • Initiating lean manufacturing principles throughout the company’s locations
  • Eliminating unprofitable long-term contracts
  • Setting long-term growth strategy, including identifying core business segments

These changes were necessary and significant step in the right direction.

Business Segments

Management also consolidated and organized the business into three segments:

Medical Device Operations – contract design and development for complex electromechanical devices for medical device customers

Electronic Manufacturing Services (EMS) – contract manufacturing and prototyping for industrial customers seeking quality-assured products such as flight control systems, security systems, lighting, and defense

Defense & Security Systems (DSS) – design and production of defense programs, focused on sonobuoys, an anti-submarine warfare (“ASW”) device used by the U.S. Navy and foreign governments. NoteSonobuoys are consumable devices with a life of less than 8 hours and the Navy requires a constant supply – Sparton is one out of only two companies capable of manufacturing these products.


For fiscal 2010, total sales were down 22% to $173.98m, as the company walked away from unprofitable contracts with several major customers, primarily within the EMS segment.

Despite the sales decrease, the company blew out its income targets, turning in four straight profitable quarters after reporting pre-tax losses for the previous twelve. Overall, net income jumped to $7.44m compared to a loss of $15.75m in 2009.

These results were more than double management’s incentive goals, as the business returned to profitability significantly ahead of schedule.

Further, these results were accomplished despite continued restructuring expenses in 2010 ($4.1m compared to $7m in 2009). The good news is that all restructuring activities appear to have been completed as of June 2010.

Gross margins averaged 15.9% in 2010 with encouraging improvements in all three business segments. Operating margins are tight (3.3%) but should continue to rise.

In fact, the company’s EMS segment reported an operating loss in 2010, with a terrible fourth quarter. However, management raised its margin guidance for this segment going into 2011, a positive sign for the segment’s prospects.

CROIC (14.8%) and ROE (11.6%) are both solid and should increase as well.

As part of the turnaround plan, Sparton aggressively paid down debt, reducing it from $22.96m in June 2009 to only $1.92m a year later.

In addition to producing solid free cash flow ($7.9m), the company also has an unused $20m credit facility, and over $30m in cash on the balance sheet (with another $3.2m in restricted cash about to be released).

Once the restricted cash is released, the company will be have almost $33m in net cash, giving the stock an EV of under $40m.


Uninhibited Growth

Even with the stellar results, the company still has room for improvement – an easy change will be the reporting of clean operating results going forward in 2011.

Restructuring/impairment charges and other operating expenses (related to carrying costs for facilities – now sold) added up to $5.78m, offset by $3.12m in gains from the disposition of these assets.

Removing these expenses will add almost $0.27 per share to 2011 results.

In addition, SPA announced the resumption in marketing programs, an area neglected for several years:

“in the near term, a new marketing initiative will center around identifying our brand and brand position, developing new selling collateral materials, enhancing our trade show image and presence, and modernizing Sparton’s website architecture and technology – all done with a level of professionalism that will fully support and improve the selling effort.”

Finally, Sparton is also recommitting itself to R&D activities around creating proprietary product lines within the DSS segment, a potential (and high margin) boost to future profits.

Smart Acquisitions

In August, Sparton announced the acquisition of the contract manufacturing business of Delphi Medical Systems for $8m.

The acquisition is expected to add $32m in additional revenue. Delphi has two manufacturing facilities that could eventually be consolidated, and management believes that margins could be improved a similar range to corporate (13-15%).

Since the purchase also covers Delphi’s inventory, the acquisition is a steal, and will allow SPA to broaden its reach into the Western U.S.

Investor Roadshow

Despite the turnaround, many investors are still unaware of this micro-cap stock.

Management appears to be attacking this situation by going on the road – with investor presentations scheduled in Minneapolis (Oct), Dallas (Nov), Connecticut & Baltimore (Dec), along with stops in California, New York, and Philadelphia.

Sparton’s corporate presentation presents a compelling story, and the market should react favorably to the stock’s potential.

2011 Estimates

SPA - Financial Breakdown 2010-2011

Using the average of these two estimates, and my forecasted EPS for 2011 comes in at $1.27/shr.


SPA - Stock Valuation

The current EV/EBIT ratio is 6.5 – very cheap for a profitable and growing company.

SPA’s current P/E ratio is 9.18. While it is hard to find a close competitor, SPA’s industry has an average P/E ratio of 16.

Applying this P/E multiple to the current share price and EPS numbers yields a target value of $12.

Using this same multiple but a 2011 estimated EPS of $1.27 would imply a per share price of $20.


Cary Wood and the rest of the management team have done an incredible job of focusing the company and recovering from a string of bad years – it is a true turnaround story with plenty of opportunity going forward.

The Delphi acquisition should be immediately accretive, and Sparton will continue to drive profitability by improving margins across the business units.

Conservatively, the stock should return 50%+ over the next year or two.

Building on 111 years of history, Sparton Corp has big plans:

“Sparton will become a $500 million enterprise by fiscal 2015 by attaining key market positions in our primary lines of business and through complementary and compatible acquisitions; and will consistently rank in the top half of our peer group in return on shareholder equity and return on assets.”

It’s an audacious goal, but one that will richly reward shareholders who are along for the ride.

I’m adding SPA to the Value Uncovered portfolio at today’s closing price of $6.85.


Long SPA

Weekend Values – October 24, 2010

Posted October 24th, 2010. Filed under Investing Links

As usual, here are a few value investing ideas from the past few weeks:

Arbitrage Opportunity – Brookfield Infrastructure Partners (NYSE:BIP) takeover of Prime Infrastructure Group (ASX:PIH)

Similar to other arbitrage opportunities posted here (see UBET/CHDN and FCEC/TOBC), this merger is a combination stock & cash deal expected to close in early December.

The transaction spans both the US and Australian markets so investors must take into account currency fluctuations in addition to the normal merger arbitrage risks.

However, it appears to offer attractive returns for the sophisticated investor who can take advantage of the mispricing.


“A Low-Risk, High-Return Micro Cap Spin-off with a Turnaround Twist”

A guest post on AAOI, this investment analysis combines several of my favorite traits in value investing: micro-cap underfollowed stock that is a spin-off from a larger company.

Using normalized numbers, the stock trades right at or a little under 1x EBITDA, obviously extremely cheap.

According to the author, a conversation with Howard Jonas, CTMMB’s CEO and largest shareholder, led to the following exchange regarding the author’s ownership in the company: “how did you get so much… I wish I owned more..”

The St. Joe Company (JOE) – Short Thesis

A number of presentations were made at the recent Value Investing Congress, but potentially none were as explosive as David Einhorn of Greenlight Capital on the St. Joe Company (JOE).

Entitled, “Field of Schemes: If You Build It, They Won’t Come,” Einhorn’s presentation is 139 slides packed full of information on his short thesis – it was powerful enough to move the market with JOE’s stock dropping almost 20% in the two days after Einhorn’s presentation.

To make things more interesting, another famous investor, Bruce Berkowitz at Fairholme Capital Management, is on the other side of the trade. It is an interesting case study that will be worth watching as it unfolds.

Owens Illinois (OI)

Another slide presentation from the Value Investing Congress, this time by Alexander Roepers of Atlantic Investment Management.

OI is the world’s largest maker of glass bottles, described as “a fortress with a massive moat.”

The business has high barriers to entry (usually local monopolies, long-term customer relationships, global scope, etc), and Owens Illinois seems well positioned to profit as glass packaging demand continues to grow.

Atlantic provides a price range of $27-$45 per share, substantial upside to OI’s current price.

Voting Power in the Activist’s Hands

Shareholder activists can be an incredible catalyst for unlocking returns in many of these undervalued stocks.

This is a great post describing the power of voting control for activist investors, and how buying and selling choices (whom to sell to, whom not to sell to, etc) can have a major impact on future decision making.


No positions.