KLM merger runs into turbulence

Benj Gallander and Ben Stadelmann
Friday, April 30, 2004

It was a tense week in Contra land. On March 18, we wrote about our investment in KLM Royal Dutch Airlines and the upcoming merger with Air France. When the official offer came through, Canadian shareholders were shocked to find that brokers would not accept their instructions to tender their shares, as the transaction excluded residents of Canada and a number of other countries.

A call earlier this week to Linklaters, the legal firm that advised on the deal, indicated that Air France was talking to the Ontario Securities Commission about allowing the offer to go ahead here. Time was of the essence, as the offer deadline is May 3, and a Dutch court just struck down a bid to push back the deadline to May 26. Talk about a race to the wire!

Some might ask, “Why the fuss? Wouldn’t it be simpler and safer to sell KLM shares into the market and buy back the Air France American Depositary Receipts as soon as they become available?” That was a straightforward alternative, and one that eliminated the potential risk of getting stuck with delisted shares, but the strategy also had a couple of drawbacks.

First, there are two sets of transaction costs to pay. Even with a discount broker, these add up. But the trickier issue is evaluating how much an investor loses by not receiving the Air France warrants.

The exchange offer swaps 10 shares of KLM for 11 shares of Air France plus 10 warrants. The conditions on the warrants are a little complicated. Three warrants entitle the holder to buy two shares of Air France at 20 euros. The holder must wait a minimum of two years before the warrant can be exercised, and they are valid for a maximum of a year and a half after that. So, assuming that the warrants get issued with the completion of the deal next month, their maximum life span would be until about December 2007.

That’s a long time to wait for the right to buy a stock. Even LEAPS call options only extend to 2006. So what are the warrants worth? That’s a tough nut to crack, but it is possible to make a guess. By comparing KLM’s current trading price of 17 euros with Air France’s 14.69, given the 10-for-11 ratio, one can calculate that the implied price of the warrants is .84 euro.

Direct comparisons are impossible, but to put this in perspective, Southwest Airlines, one of the few US carriers that is reasonably healthy, is trading at $14.31 (US). The call option with a strike price of $20, expiring in January, 2006, costs $1.15. The differences aside, given that the Air France warrants have a life span nearly two years longer, and should therefore command a much higher time premium, it is pretty obvious that Mr. Market is being very stingy in valuing those warrants.

If they are undervalued, we want them — that’s the kind of value hounds we are. But the only way to get them is to tender to the offer, which made for some nail-biting while the regulators got their ducks in a row. Simple, eh? And now that the offer has been made available to Canadians, we’re in the game.