RacerX33's Blog : Speculative Takeover Play

I had planned to write my next article on my top 5 current bargain picks, but I'm going to postpone that one. I just came up with a potential trade and I'd like to get some feedback on it.

The Idea:
Sell POT
BUY AGU Diagonal Bull Call Spread

The Rationale:
I have decided to close my POT position. I still have a final bid target of $160/share, but I don't know how long that will take to materialize. Additionally, by staying in I run the risk of BHP pulling their bid altogether.
If that were to happen, I expect POT would drop to at least the pre-bid price of about $110. I figure the potential gain from here would only be about 7%, while the potential loss would be about 26%.

Once those funds are free, I would like to redeploy them into another potential target. I believe that AGU is a great potential takeover target. First, POT could launch a bid for AGU as a way to make it more difficult for BHP to buy them out. AGU would be a natural fit for an acquisition by POT. They share the same line of business, and are both based in Canada. Second, another outfit could make an offer on AGU. With the renewed interest in potash I believe that we could see some more takeovers in this arena.

According to a 2007 report by Ernst & Young, the average long-term takeover premium for US companies is 24%. I know that this isn’t an exact fit for this situation, but I think it gives me a pretty good starting point. To leave some room for error, I'll assume a 20% premium in the case of an AGU takeover. This would put AGU's price at about $80/share.

As an added bonus, AGU has been climbing nicely, and appears to be technically strong. At the same time, AGU has not had a substantial run-up since the POT bid.

The Trade:
(I'll ignore commissions for the sake of simplicity)
Sell (1) Sep $70 Call @ $1.25
Buy (1) Oct $65 Call @ $5.00
Net Debit $375

There are two possible outcomes at September expiration:

Scenario #1 – The price stays below $70 through September expiration
The Sep $70 expires worthless, and I’m long the October $65 at a cost of $3.75

Scenario #2 – The price moves above $70 before September expiration
Realize a profit of $125 or 33%
-OR-
Buy to close the September $70, and stay long the October $65

Assuming the Sep $70 expires worthless, here are the potential outcomes at October expiration:

AGU <$65 – Loss of $375 or (100%)
AGU @$70 – Profit of $125 or 33%
AGU @$80 – Profit of $1125 or 300%

I'd love to hear your comments on this trade idea.