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HP, Compaq shares gyrate on uncertainty

As if questions over Hewlett-Packard's proposed merger with Compaq Computer aren't enough, the companies' shares are being thrown around by something called arbitrage.

As if questions over Hewlett-Packard's proposed merger with Compaq Computer weren't enough, the companies' shares are being thrown around by something called arbitrage.

HP's stock price is expected to fall, while Compaq's is expected to gain in upcoming weeks as the two companies head toward a March 19 shareholder vote on their proposed merger. The volatility is based not on the perceived value of the companies they represent, but on the trading tricks as investors bet on whether or not their deal will be approved.

Arbitrage is a trading technique designed to take advantage of small differences in the price of two stocks. Investors who use this technique are called "arbs."

With most mergers, arbs typically benefit because the spread, or ratio, between the two stocks is set by the merger agreement, and therefore predictable. In the HP-Compaq deal, the spread has been volatile because of the proxy fight led by Walter Hewlett.

The merger just became more likely after the ISS, or Institutional Shareholder Services, issued its recommendation and approved the deal. That move helped close the spread some, as it made the chances that the deal will go through above 50 percent, according to analysts.

Sure enough, Compaq shares closed up 45 cents, or around 4 percent, to $11.03 Wednesday, following the ISS news. According to the terms of the proposed merger, which set a fixed ratio of 0.6325 shares of HP for every share of Compaq, Compaq should trade around $12.78 based on HP's current price of $20.20.

Bill Schaff, fund manager for the Berger Information Technology Fund, said the spread between HP and Compaq shares is large because there is still uncertainty about whether the deal will ultimately be approved. "The only reason the spread hasn't collapsed is HP has a lot of votes to get," he said.

Schaff, who owns shares of Compaq, said he expects the stock to gain a few percent here and there as it becomes clear which way the vote is going. For instance, news of new support from an institutional shareholder may give Compaq shares a boost.

Most analysts agreed. "In the short run, HP's share price should weaken while Compaq's rises as arbitrageurs add to their short and long positions," said Needham analyst Charlie Wolf.

However, given the still uncertain vote, Compaq gains are not guaranteed. "It's a little more risky for the arbs," Schaff said. "The spread will be driven down, but it'll be tough until the deal is done."

Aside from predicting share price movement, analysts are also looking at arbitrage as a way to gauge the market's opinion on the chances of the deal closing.

"Based on the closing spread of $2.45 (Tuesday), the market was assigning a 50 percent probability of the transaction being completed," Andrew T. Whittaker, a Lehman Brothers analyst, wrote in a research note. "In after-hours trading, the spread narrowed to about $1.60, clearly reflecting the belief that the merger has a higher probability of closing with an ISS recommendation.

"On balance, we believe that the market continues to be too pessimistic on the deal's chance and think the spread is fairly priced at about $1."

Most analysts agree that the company's shares are undervalued right now regardless of how the merger turns out and what the arbs do. see special coverage: Big iron: HP to buy Compaq

"With or without the transaction, it remains our view that both HP and Compaq shares are in fact undervalued," said SG Cowen Securities analyst Richard Chu. "We maintain our HP buy rating with a price target in the $24 to $27 range."

Schaff also said Compaq shares are worth more largely because the company's operations are improving, and that's his primary reason for owning the stock.

"I don't want to bet on the deal either way," he said. "If the deal doesn't go through, I still think Compaq is worth more. If the deal goes through, I get the arbitrage. Either way I win."'s Larry Dignan contributed to this report.