Covad Communications Group Inc. (AMEX:DVW) fell almost 5% today to aprice of $0.79 on double the normal trading volume.  But shares fellalmost 10% on Monday to $0.83, on normal volume.Back on October 29, 2007, the company announced that was being acquiredby private equity firm Platinum Equity.  This $1.02 price was almost a60% premium to the October 26 closing price, although the 52-weektrading range was $0.60 to $1.54 and Covad was over $2.00 in early 2006.

If you track pending mergers or merger arbitrage, you know that it’s time to start getting worried about a pending merger when you see two back to back price drops in the shares of the acquisition target.  That holds true even if it is a $1.00 stock (or less).  We track these spreads for identifying opportunities (or trouble) for our Special Situation Investing Newsletter subscribers.

This merger is subject to shareholder approval, and the fed filing from yesterday still notes the following: After careful consideration, our board of directors has unanimously determined that the merger agreement and the merger are advisable and fair to, and in the best interests of, Covad and its stockholders. Our board of directors has unanimously approved the merger agreement. But the proxy format also shows the following: Your vote is very important, regardless of the number of shares you own.  The merger agreement must be adopted by the affirmative vote of holders of a majority of our outstanding common stock entitled to vote at the special meeting. Therefore, if you do not return your proxy card, vote via the Internet or telephone or attend the special meeting and vote in person, it will have the same effect as if you voted “AGAINST” approval of the adoption of the merger agreement.

Platinum Equity is a private equity firm that has acquired many smallerplayers in legacy technologies with established brands where thecompetition has moved on down the road to the latest and greatest, butwhere there is a need for the underlying technology or businesses.That is my opinion anyhow, and they are not technology and IT focusedonly.  They do own modem maker US Robotics and most PC’s still have adial-up modem included (likely as an insurance policy to access dial-upaccounts if major broadband networks become unavailable), and thebroadband and dial-up modem businesses might be able to be offeredcheaper in a wider package to Covad’s DSL and T-1 clients for voice,data, and VoIP packages.

On Monday I called Platinum Equity in New York and L.A. and aspokesperson returned my call and said that nothing has changed on thePlatinum end.  He also told me that since Covad is a public company hecouldn’t really make any comment on anything speculative and encouragedme to get an answer from Covad since they are the public company.Unfortunately, I still have yet to hear anything back from Covadofficers nor from their investor relations.  It’s very rare, even onsub-$1.00 mergers, to see a merger-arb spread widen out this much.  Itis usually a signal of some trouble.  Unfortunately I have only beenable to get one side of the story.  Without having the answers fromCovad this is a situation where we would consider it fluid andunfinished business.

I have also tried to reach some of the larger money management firmsthat hold significant stakes in percentage terms to see if they werevoting for the merger or abstaining/against the deal.  Unfortunately,no such answers have yet been found and getting an answer out of theseguys may be like pulling teeth out of a piranha.

It is always possible that FCC regulations forcing the Bells to allow these smaller telecom and data providers (we used to call them CLEC’s) could be an issue.  But that is just one more mark of conjecture because the larger telecoms frequently ask (and have current petitions) that ask the FCC to let them self-regulate access and fees or to change their pricing structure.

Lastly, I have even gone through various online stock chat rooms to seeif there were any serial posters trying to drive it down or to see ifthere was any smoking gun out in the ‘chat’ public.  As usual and as Iexpected, the bulk of the posts contained little important informationand were evenly broken up by those who were either very positive orvery negative.  There are many bullish posts and many bearish posts inthe chats, but I didn’t see any smoking guns that the bulls or bearswould want to be using the betting dollars on.

The fact is that the merger at the announcement date was noted as having an "expected closed date in the second quarter of 2008"and that is quite a long time for a $304 million merger to close.  Evenif there aren’t any darker forces working publicly against the mergertide here there is a lot of calendar and plenty of volatility in themarket for shareholders to get spooked here.  The mid-November shortinterest was listed as 4.81 million shares, but the prior shortinterest was listed as 8.779 million shares on the short interestreport before this.

In conclusion, it sounds like the merger is still on but the tradingaction in the name seems suspect. I’d also point to the fact that itrose sharply Friday and a lot of the move Monday could have just been acorrection of that move.  But before hanging onto that with too muchconviction, today’s close of $0.79 is actually the lowest close sincethe $0.64 close from before the private equity buyout was announced.

This actually fits into a unique position for 24/7 Wall St.  Covad is a special situation under review for our subscriber-based special situation investing newsletter,although the dollar price and the inability to hedge the risk makes usless confident in openly endorsing this one without some reservations.Because of its share price, this will likely be covered in oursubscriber-based "10 Stocks Under $10" newsletter this coming weekend.

If this is just a mis-priced arbitrage situation because of the low dollar amount and because of the low priced, then some traders and merger-arb investors will clean house.  This spread today represents a 29.1% merger-arb premium to an unspecified date in Q2 2008.  That would be a very abnormal merger-arb return.   

Jon C. Ogg
December 4, 2007

Jon Ogg can be reached at [email protected]; he does not own securities in the companies he covers.

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