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Contributors: Douglas McIntyre Jon C. Ogg

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Monday, August 07, 2006

How to Hedge a FileNet Bet

Stock Tickers: FILE, MROI, IBM

FileNet (FILE) is a name that has been around in takeover circles on and off, and we have covered this as a Cramer takeover name and even mentioned in our own potential takeover names. The stock is up another 2.8% today at $35.66 on speculation that a deal may be imminent.

After reviewing the past chart, there is something worth noting. This stock has been stuck in a sideways trading band of $25 to $30 for the last 18 months, yet here we are at $35.66. We are not trying to pan a deal on the company or to refute any such deal, but prudence may be worth a thought here. Should you just sell your shares to lock in your gains? That is for you to decide. But we would like to point out that you can essentially hedge the downside of your gains if you want to. The stock does have options contracts at the $35.00 strike price for August and for September. If you think a deal may come imminently then you would only care about August, but if you think it may just be brewing and want to take a longer “wait and see” attitude you can look at September or beyond. The puts would give you the right to sell FILE at $35.00. The August 35 Puts (expire August 18) are currently $0.85 and the September 35 Puts (expire September 15) are $1.50. So if you bought the August Puts you would essentially be locking in a worst case sale price of $34.81 and if you bought the September Puts you would essentially be locking in a worst case sale price of $34.16. Please understand that “essentially” is a rough term and that doesn’t take into consideration your extra transaction costs and there are no guarantees in the financially markets.

The reason for pointing this hedging strategy out is that since we have a BAIT SHOP, one of the things we evaluate is what is the minimum shareholders would be willing to accept and what is the minimum the company would accept. Above we noted the previous trading band of $25 to $30 that has been in place for 18 months, but what we didn’t indicate was that the shares had been much lower than that for the years prior to 18 months ago. You have to go back to the bubble days of 2000 and part of 2001 to get any higher stock prices for FILE.

So, what would it take to buyout the company? There is no way to predict what management would demand, but ANY shareholder who invested in FILE over the last 5 years would be profitable if the buyout came at current prices. So you can presume that shareholders would not fight a deal if it came at today’s price. Employees and management may fight a deal if it doesn’t reward them, but any acquirer would likely be smart enough to take this into consideration. There are ways to mitigate any shark repellent the company may have, but it increases the takeover price even if it doesn’t give direct additional benefits to shareholders. The top 10 investment management firms have essentially a 50% stake in the company.

There is no way for an outsider to know if FILE is or is not truly in play right now. We do not have any inside information either way, but there is a common sense way to protect your share gains if all the talk ends up without any substance. The stock is now trading with a P/E of 36 with trailing earnings of $0.98. If the street estimates end up being accurate with EPS for Fiscal December 2006 estimates at $1.14 and Fiscal December 2007 estimates at $1.30 then the forward P/E ratios are 31.2 for 2006 and 27.4 for 2007.

IBM trades with a P/E of under 15 now, and its recent MRO Software (MROI) purchase target now has a 27.9 P/E after it jumped on the merger news. Using a simple P/E comparison is only the first of about 10 metrics to use, but it is a benchmark and the most common starting point that shareholders will use. MROI only has a market cap of $672 million now after the merger, and FILE is at $1.5 Billion in market cap. FILE has over $400 million in net assets after backing out all liabilities and it has essentially no long-term debt that would leverage any transaction beyond the obvious.

Is a deal really in the works? Who knows, but there is a way to lock in some implied gains if you aren’t very sure.

Jon C. Ogg
August 7, 2006
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