Sunday, December 16, 2007

Porsche AG's Volkswagen takeover

by Ricardo Cabral

First version: November 19, 2007
This version: December 16, 2007 (Text in italics added December 30th, 2007)

Porsche AG's two and a half year campaign to take over Volkswagen AG (VW), a DAX30 and EuroStoxx50 stock, and create an European car and truck giant nearly 20 times its size, with over €135bn of sales, is a daring bet in high finance.[i]
However, the takeover has not been casuistic or innocent. Porsche's actions under CFO Holger Härter show flawless execution, exactly what one would expect from a manufacturer of niche high performance cars. The initial build up of a 27.4% stake in 2005 and 2006 was well timed and achieved on the cheap. The March 2007 low-priced VW takeover offer, which aimed to fail, but allowed Porsche to raise its stake to 31%, reveals innovativeness. But it is the current move, which shows the brilliance of the strategy pursued by Porsche.

The basic assumption when a firm acquires another is that it wants to pay the lowest price possible. What better way for Porsche to achieve its goals than by aiming for exactly the opposite of what the market expects it to do, and to do it in plain sight. In my view, Porsche's objectives were best served by having Volkswagen’s share price rise the maximum extent possible.

On November 28th, 2007, Porsche announced record profits of €5.7bn of which €3.6bn were gains from options investments on VW shares. Based on the half-year letter to shareholders, analysts estimate that €3bn were achieved in the second half of the 2006/2007 fiscal year (FY). To be able to earn €3bn from options, considering the VW share price change from around €85 on January 31st to around €132 by July 31st, Porsche would have had to hold options contracts equivalent to holding about 650 000 “in-the-money” options contracts between these dates. Such large number of contracts, if fully exercised, would correspond to about 65 million shares, or about 22% of the voting capital of VW, and would represent nearly 50% of the total number of Eurex option contracts for VW, 85% of which were puts. This high proportion of puts was unusual. The number of put and call options contracts on any given stock are normally similar.

Porsche could not have made so much money with options had it held a much smaller number of contracts or “out-of-the-money” options. Indeed, since it would be nearly impossible to hold that many options that remained in the money during the entire period, it is likely that Porsche held far more options contracts for only part of the period, and that it used a particular type of options contracts, so-called “deep in-the-money naked puts”. For example, if Porsche sold a €130 “deep in-the-money naked put” contract when the VW share price was €100, it would have received a premium in excess of €30 per VW share, or €3000 per contract. This contract would confer to the buyer, the right to sell 100 VW shares to Porsche, at the price of €130 per share. That means Porsche would not have had to spend any money in building its large options investment.

According to Eurex exchange’s regulations, there are no restrictions to the size of “naked puts” contract holdings, unlike other bourses and its own practice before 2003. On the other hand, so-called “long call” option contracts, which confer the right to buy the share at a given price, face positions limits equal to 25% of the free-float.
[ii] The regulations have been in place since 2003 but were explicitly laid out in an July 2004 circular, which also substantially increased positions limits. This was a surprising policy change, as investments in “naked puts” affect the price of the underlying shares in a similar manner to “long calls” options.

Large sales of “deep in-the-money naked puts” by Porsche would have had the effect of moving the underlying VW share prices higher as if Porsche had directly acquired additional VW shares. This happens because the buyers of the put options, on the other side of the Porsche trades, either own shares or hedge their put options investments by acquiring shares. These buyers would be unwilling to part with their VW shares at prices lower than the exercise price of the puts they had previously acquired. In practice, Porsche would control, by proxy, a large number of VW shares.

Only about 41.4% of the VW shares were theoretically available for trading to start with, the so-called free-float. However, if you account for the large Porsche’s holdings in the options market, and holdings by exchange traded funds (ETFs), which may own up to 25% of the free float, the true percentage of VW shares available for trading was probably well under the 15% minimum required by Deutsche Börse for a DAX30 stock. As a result, small changes in the volume of traded shares would have exacerbated VW share price changes. In fact, the large Porsche’s holdings of VW shares and options may have allowed one or more unknown entities to corner the market for VW shares, leading to large VW share price increases, and to the large Porsche’s options profits.

VW shares rose by 50% to close to €200 between July 31st, the end of Porsche’s FY, and November 1st, during a period of turmoil in worldwide stock markets, in the context several news reports and interviews in Der Spiegel and other newspapers about Porsche’s stated interest to acquire a majority stake of Volkswagen by January 2008. Therefore, assuming Porsche did not unwind its options portfolio before late October, I estimate that Porsche is sitting on top of at least an additional €3.5bn to €4.0bn of profits from options in the first half of FY 2007/2008. According to a Nov. 29, Financial Times article “Porsche profits by CFO’s hedges”, traders have estimated similar options profits in this period.

On November 3rd, a Der Spiegel article indicated that due to conflict with the VW unions and the high price of VW shares, Porsche had decided to postpone the acquisition offer for VW beyond January 2008. In addition, the Der Spiegel referred that CFO Holger Härter preferred to realize Porsche’s options gains since current VW share prices were too high. A Porsche spokesman later stated that it had already cashed in most of its options. To do so, Porsche probably bought back the put contracts it had previously sold, realizing large gains in the process, and with the result that the VW share free float would have increased again.

If my analysis is correct, Porsche’s 31% share of VW, considering the after-tax gains from options investments, did not cost Porsche anything. At current market prices Porsche’s stake in VW is worth about €14bn. But I think the important point is that, while insiders have gained substantial sums, the general public and some investors on the other side of the Porsche trades will make large losses, even if some of these losses have not materialized yet.

While Deutsche Börse and the Frankfurt stock exchanges regulator do not come out of this affair in good light, Porsche has thus far shown perfect command of the German stock exchanges regulations and intricacies. Therefore, there is no doubt in my mind that Porsche’s behaviour has been legal. Nonetheless, it seems as if normal investors have been deceived by the deficiencies in Eurex regulations.

Finally, whatever its next move may be, Porsche seems to have forgotten the dictum often attributed to Abraham Lincoln: “You may fool all the people some of the time; you can even fool some of the people all the time; but you cannot fool all of the people all the time”.

P.S.- Some opinion makers in the US and Europe argue that firms should not be required to report quarterly earnings reports, as they result in businesses having an excessive short-term focus. I believe this case shows that the opposite is true. Porsche fought Deutsche Börse’s requirement for quarterly earnings reports. They release a puny 6-page half-year brief to the shareholders, with little details available. Only with the release of its 2006/2007 FY Press Release on November 12, is it possible to infer Porsche's actions, and that with a delay of three and a half months on the end of their FY. Surely, this does not aid the cause of market transparency. Insiders must have had a feast this last year.

[i] VW has large stakes in the truck makers MAN AG and Scania.
[ii]Eurex Circular 097/04: Position Limits – New Mode of Calculation as of August 2, 2004”, Eurex Deutschland, 2004, (accessed: Nov. 2007)

Copyright Ricardo Cabral, 2007. All Rights Reserved.
This article may be reproduced with appropriate attribution.