Birner Dental (BDMS) – Merger Arbitrage – 6% Upside

Current Price – $10.15

Acquisition Price – $10.62+ $0.13 CVR

Upside – 6%

Expiration Date – Jan 2019

Mid-Atlantic Dental Partners (back/mid-office service provider for dental clinics) is acquiring Birner Dental, operator of 66 dental offices in Colorado, New Mexico and Arizona (under brand ‘Perfect Teeth’). Merger consideration is $10.62/share in cash and non-transferable CVR that might pay up to $0.13/share in 18 months. 37.5% shareholders have already agreed to vote in favor of the deal. Counting the remaining insider ownership it seems that shareholder approval is already guaranteed. Topping this up with Mid-Atlantic persistence (raised their offer two times) and secured financing, I think this transaction is very likely to close on schedule. Due to multiple other bidders the downside is limited.

Shareholder meeting is scheduled for the 20th of December with expected closure of the transaction in mid January 2019. So if all works out as I am expecting, this is a way to generate 5% return in two months and then another 1% if CVR pays out.

Birner stock is illiquid, which is probably the main reason why this spread exists.

 

Rationale for the merger

This transaction is akin to vertical integration of the back-office service provider and front-office dental clinics. Birner has been struggling to operate profitably as stand-alone entity. After recent capital infusion to cure the events of default (Dec of 2017 and then Aug 2018) strategic review process was launched and the board started discussions with interested parties.

Page 40 of the proxy statement has some financial projections and expense splits. My guess is that with the acquisition by Mid-Atlantic corporate overhead will fully go away improving EBITDA from $1.8m to $5.5m. Counting only these savings Birner Dental is being acquired at 7x EBITDA, which is materially below other dental practice acquisitions (9.7x EBITDA – see pages 35-36 of the proxy) – albeit these are pre-synergy multiples and therefore not the best reference point if corporate overhead is excluded for Birner. Additional savings might also be realized  within other office level expenses due to larger scale of the merged operations.

Even more important is that Birner is currently operating inefficiently and under-earning – M&A cases noted in the proxy  had EBITDA margins at 15%-25%, whereas Birner’s margin even excluding the corporate overhead stands at 9% (projected to increase to 15% by 2022 following operational improvements). If industry average profitability levels (at 15% EBITDA margin) are achieved, then Mid-Atlantic is paying only 4x EBITDA for this acquisition.

All in all, this sounds like compelling opportunity for Mid-Atlantic and I do not think they will walk away from the transaction willingly.

 

The voting structure

• Birner has 1.9m of common stock shares, with one vote power per share and 11 shares of Series A preferred stock with about 100k voting power each. So a total amount of votes is 2.9m.

• Series A stock together with $5.5m of convertible bonds (which convert at $5/share to common) was issued to Palm entities in Dec 2017 and Aug 2018 to cure debt covenants. As a result of this capital infusion, Palm received 36.6% of voting and economic power and also put 2 people (later upped to 3) of their own on Birner’s board. Effectively, Palm has bought approximately 1/3 of the company at $5/share. Less than a year later they have opportunity to double their investment. Palm has entered into voting agreement in support of the transaction.

• Directors and executives unaffiliated with Pall own further 20% of the voting power (or 31.5% of common stock) and together with Palm entities appear to have the required majority.

• The proxy also notes that Mr Birner and Palm entities have both entered into voting agreement with only 37.5% of the votes vs combined voting power of 50%+ (as per proxy ownership table). This is due to Mr. Birner and Palm entities casting only part of their ownership towards the support agreement – not sure why, maybe that has something to do with legal aspects of the merger and voting agreements.

• Another 18.7% of voting power rests with previous Digirad shareholder group, which launch proxy fight back in spring 2017 and then reached settlement upon appointment of 2 new directors to the board. Interestingly the largest ownership in this proxy fight was by Mark A. Birner, brother of current CEO and also founder of the company.

All in all, as the board has already recommended this merger, I would expect all directors, executives and Palm entities to vote all their shares in favor of the deal – and this seems to be sufficient to pass the shareholder approval.

 

Merger not conditioned on financing

The merger is not conditioned upon receipt of financing as Mid-Atlantic has already secured $45m financing from their affiliate. The financing might be coming from S.C. Goldman & Company, which is a privately held investment firm that is focused on middle-lower healthcare and industrial businesses. There is not much more information about the firm other than that is has already invested $15m into Mid-Atlantic in 2016 and $12.5m in 2017 and it seems they really believe in this transaction if they have agreed to provide 2x larger amount than both of the previous funding rounds.

 

CVR payout

From the proxy it seems that CVR payout will be driven by litigation expenses that might be incurred in relation to the merger after the closure. So my understanding is that if the deal closes smoothly and there are no complaints from any stakeholders regarding it afterwards, then the full $0.13 would be paid out. How likely is such a scenario? I have no idea, but even without the CVR payment the spread stands at 5%.

The “CVR payment” means an amount per CVR, rounded to the nearest one, one hundredth of one cent, equal to (i) $0.13, less (ii) the per CVR permitted expenses amount. The “per CVR permitted expenses amount” means an amount, as calculated in good faith by Mid-Atlantic Dental in its sole discretion as of the 18 month anniversary of the effective time, which we sometimes refer to as the “CVR payment date,” rounded to the nearest one, one hundredth of one cent, equal to (A) the aggregate of all permitted expenses incurred or reasonably expected to be incurred after the date of the merger agreement by Mid-Atlantic Dental or its affiliates (including the surviving corporation) and us and our affiliates; divided by (B) the total number of CVRs outstanding as of the CVR payment date. “Permitted expenses” means any direct, out-of-pocket costs and expenses, net of any recoveries under insurance policies, arising out of, relating to or concerning litigation or other proceeding brought or threatened against us in connection with or relating to the merger agreement, the merger or the other transactions contemplated by the merger agreement.

 

If the acquisition by Mid-Atlantic fails

Although the downside is considerable – 50% to the unaffected price of $5.25 – it is worth noting that there were 11 interested parties, with 4 of them having made acquisition offers.

• Company A has proposed a price ranging from $9-$11, however a few weeks after signing confidentiality agreements and getting access to the secured information, they have decided to drop their offer.

• Company B offered $5.53 to $6.86 per share.

• Mid-Atlantic has initially offered $9.84, however Special Committee together with advisors, pushed for $12 and the buyer increased their offer to $10.5. Committee then pushed again for better offer and parties eventually agreed to $10.75..

• Company C has offered a price ranging from $9.8 to $10.35, but was not willing to top Mid-Atlantic offer.

So even if the deal fails, it is safe to assume that BDMS might receive another offer  with Company’s C being the most likely).