A buyout offer is usually a dream scenario for a penny stock investor. More often than not, a buyout offer on one of your portfolio holdings means a hefty price premium and limited downside risk until the deal completes. But what happens when a company makes an offer to acquire one of your holdings at less than market value? Here’s how to handle a failed stock buyout.

That’s exactly what happened last week with Cascal (NYSE: HOO), one of the companies that we recommended to our Penny Stock Fortunes readers back in June 2009.

Cascal is a water utility based in the U.K. The company provides water and wastewater services to more than 4 million customers in seven countries. Cascal’s international exposure is what made it especially interesting for investors looking for high growth at the time we recommended it — by entering new markets, the company managed to expand its sales 10 times faster than the rest of the industry. And since our decision to add the company to our Penny Stock Fortunes portfolio, it’s been a strong-performing play, giving readers the chance for 77% gains as of this writing.

But Cascal hit a sour note last Monday when a large water utility firm made an offer to buy out the company’s common stock. How’d it happen?

On April 26, Cascal’s board summarily rejected a buyout offer from Sembcorp Industries Ltd., a $4.6 billion utility, energy and water company domiciled in Singapore. Despite the normally positive connotations of a buyout proposal, the offer that Sembcorp put on the table was more of a nightmare scenario for Cascal’s management, who have delivered 143.64% gains to shareholders in the last 12 months.

“Cascal is not seeking to sell itself at this time. Sembcorp’s announced two-tiered and below-market offer appears to be intended to force shareholders to sell their securities at an inadequate price or risk both a reduction in the consideration offered to them and a loss of access to a liquid market for their securities,” said Michael Wager, Cascal’s special committee chair.

Sembcorp offered a cash buyout of $6.75 in cash — or $6.40 if the company couldn’t get ahold of at least 80% of Cascal’s shares — despite the fact that shares of Cascal traded for more than $7.60 the day before. In a sense, that’s a bit like going to an art auction and watching as customers bid up the price of a painting $30,000… $31,000… $31,500… before getting everyone’s attention and bidding a paltry $29,000.

There’s just no incentive to sell a fundamentally sound company below market value.

As such, Cascal’s management has rightfully reported Sembcorp’s offer as an inadequate and coercive attempt to take control of the company.

But there’s more to the story than that. On April 26, Sembcorp bought out former parent company Biwater’s 17.9 million shares of Cascal, which means that the company currently owns 58% of Cascal. Biwater was looking for a way to liquidate its shares to take care of its own financial issues — and was willing to take the discount to market value. Shareholders shouldn’t be so willing.

Understanding Your Recourse As an Investor

So, what’s an investor to do when a botched buyout offer takes place?

In this case, Cascal’s management is taking point by refusing the buyout offer and suing Sembcorp for the coercive practices that spurred a double-digit decline in the stock. Although a handful of investors sold off emotionally following the news, it actually makes sense to hold onto shares in this scenario.

Now that Sembcorp owns a substantial portion of Cascal’s stock, the company is in a tight spot. Sembcorp wants to take Cascal off the NYSE and take full control of it as a subsidiary. In order to do that, management will need to lure at least 95% of shareholders into its pocket — a number they’re unlikely to get with their current offer.

If Sembcorp somehow gets the 95% control it needs to squeeze out smaller shareholders, it’s likely that EU courts will force the company to put a much larger payout in our pockets. Instead, it’s more likely that Sembcorp will offer a more reasonable amount for shares or risk losing power over its hostile new subsidiary.

The Research Matters…

We’re still up considerably on Cascal, and ultimately, we believe that we’ll be able to generate additional returns in the company thanks in large part to the folks at the helm. In our situation, the difference between Cascal’s fight against Sembcorp and management capitulation all came down to research.

Investors often underestimate the impact that a solid management team can have in steering a company in the right direction. When you’re doing your initial investment research on any stock, small or large, make sure that the company’s management team is experienced and has its interests aligned with your own.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

May 6, 2010

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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