IDFB - Spirit-JetBlue And 14 Other Opportunities In The Merger Arbitrage Space

2023-11-01 00:36:04 ET

Summary

• Merger arbitrage spreads are wide.
• A number of opportunities with spreads from 10% to 137%.
• A review of the most interesting merger arb setups.

Merger arbitrage is an event-driven investment strategy centered around betting on the successful acquisition of a publicly-traded company. The spread between target company's trading price and the offered acquisition price typically reflects the risk the market sees in the transaction.

Merger arbitrage happens to be one of my preferred investment strategies. Why? Well, merger arb attractiveness stems from the fact that they:

• Have a binary outcome and offer pre-defined return/downside. This allows to more easily quantify the odds a favorable outcome.
• Are uncorrelated with the general market, thus presenting a way for investors to diversify their portfolios.
• Have a relatively short timeline, allowing for high annualized returns.

Below I present 15 merger arbs with the widest spreads currently available on the market. The list includes my analysis on each situation and the reasons for the wide spread. Additionally, you will find a downloadable PDF of all these merger arbs.

Spirit Airlines ( SAVE )

• Buyers: JetBlue Airways ( JBLU )
• Consideration: $30/share
• Spread: 137%
• Exp. Closing: H1’24
• Main risk: buyer walking away, regulatory approvals, large downside.

Spirit Airlines is getting acquired by JetBlue for $31/share in cash. This includes the $0.1 per month ticking fee payable from Jan'23 until the closing date. The transaction is expected to close in H1’24.

Until recently, the main risk and reason for such a massive spread here was regulatory approval and DOJ litigation. Following SAVE’s very bad Q3 results, an even bigger risk now seems to be that JBLU could try to wiggle out of this merger, potentially by claiming a material adverse effect on the target’s business. SAVE's operational performance has significantly deteriorated over the recent quarters, driven primarily by Airbus engine issues produced by major aircraft engine manufacturer Pratt & Whitney. SAVE anticipates these headwinds to last throughout FY24, implying that massive operating/FCF losses will continue. This has increased the risk that the buyer might attempt to back out of the transaction. However, several arguments suggest that JBLU's chances of successfully claiming an MAE in court might be low:

• The engine-related operational issues have impacted the entire industry as opposed to Spirit Airlines in particular. This is important as SAVE-JBLU merger agreement specifically carves out “industry-wide” developments from events that could trigger the MAE condition. JetBlue, Hawaiian Airlines and Wizz Air have been among the companies impacted by the engine issues. As a reference, SAVE expects to ground 26 planes in FY24 compared to 350 airplanes expected to be recalled by P&W annually.

• SAVE is set to receive compensation from P&W for the financial damages incurred as a result of engine issues. P&W has recently recorded a large compensation charge of $3.5bn. The total bill (including P&W’s revenue share partners) is expected to reach $6-$7bn, c. 80% of which would be payable to P&W’s customers, such as SAVE. Spirit’s management has recently noted that discussions with the supplier have already begun - see the quote below from SAVE’s Q3’23 earnings release. While the potential damages amount is unknown, it is likely to be at least in line with the expected lost profits.

The Company has begun discussions with Pratt & Whitney regarding fair compensation for financial damages related to the GTF neo engine availability issues; however, the amount, timing and structure of the compensation that will be agreed upon is not yet known.

• The operational issues are expected to be temporary as P&W expects engine recalls to end through 2026. Moreover, the issues will not have a structural negative impact on Spirit’s long-term earnings power after the engines are serviced over the medium term.

Another risk is antitrust hurdles. The DOJ has filed a lawsuit against the merger, and the trial is set to begin this week. The regulator has claimed that the transaction would hurt consumer prices and competition. The complaint has mainly focused on JBLU's Northeast Alliance partnership with American Airlines ( NEA ) and the overlap between JBLU and SAVE at certain airports in the US Northeast. Given that Spirit Airlines is an ultra-low-cost carrier (ULCC), the DOJ has also argued that the transaction would reduce competition and consumer choice in the ULCC market. The regulator has specifically suggested that the merger would eliminate unbundling, a practice where airline companies (primarily ULCCs) offer customers the option to pay for specific services separately.

The trial has faced multiple delays and is now scheduled to begin this week. The judge anticipates an expedited trial, with a potential ruling by year-end.

While there is no guarantee that SAVE and JBLU will prevail in the litigation, several arguments suggest that the judge might approve the merger:

• The combined SAVE-JBLU would only be the fifth-largest airline in the US behind the four dominant carriers that collectively hold an 80% market share. SAVE and JBLU have argued that the merger would in fact increase competition for the four legacy carriers.
• SAVE’s deteriorating fundamentals have prompted the company to scale back growth initiatives and announce plans to raise ticket prices. This will likely make the DOJ’s previous arguments about higher competition if SAVE remains a standalone entity weaker.
• Since the DOJ's initial filing, a federal judge ruled against the NEA partnership on antitrust grounds. In turn, JBLU announced it will not appeal the ruling and will exit the partnership. NEA’s termination is likely to eliminate concerns about JBLU colluding with American Airlines.
• Over recent months, JBLU and SAVE reached agreements to divest their assets in key overlapping airports, including LaGuardia, Boston, Newark, and Fort Lauderdale. As outlined in the pre-trial briefs, these divestitures cover 36 of the 51 overlapping routes where JBLU and SAVE both provided nonstop service. JBLU has emphasized that the companies no longer compete on 6 of the 51 routes, underscoring the competitive dynamics of these routes. Another aspect is that the divestitures were made to other ULCCs Allegiant and Frontier, suggesting that there will be no reduction in consumer choice and competition in the divested markets. Moreover, JBLU has also pointed out that Spirit Airlines is one of its smallest competitors in terms of both passenger and revenue shares in airports where JBLU offers nonstop routes.
• The DOJ's concern that the acquisition would eliminate unbundling from the market could likely be resolved if JBLU agreed to maintain an unbundled offering.

The downside in a deal-break scenario would likely be significant. SAVE’s might be facing solvency issues as a standalone entity given its significant cash burn and a large debt burden with an upcoming maturity in 2025.

Silicon Motion Technology ( SIMO )

• Buyer: MaxLinear ( MXL )
• Consideration: $93.54 + 0.388 MXL stock
• Spread: 87%
• Exp. Closing: TBD
• Main Risk: Merger termination.

This is one of the wildest merger arbitrage situations in the recent past. Silicon Motion Technology, a supplier of NAND flash controllers for SSDs, was getting acquired by its US peer MaxLinear. In July, after an unexpected approval from Chinese regulators, MXL abruptly terminated the merger, citing a "material adverse effect" due to the sharp semiconductor industry downturn since the merger was announced in 2022. SIMO has launched an arbitration against the acquirer, seeking to recover damages in excess of the agreed termination fee ($160m vs $3.8bn transaction value). The investment case now revolves around target's ability to force the buyer to adhere to the initial merger terms. The arbitration will take place in Singapore, with a resolution expected in 2025. Given that the arbitration will take place in a foreign jurisdiction with different MAE laws, it is unclear if the court will require MXL to complete the deal. Even if MXL is forced to buy SIMO, the potential acquirer might no longer have financing commitments needed to close the transaction. This could suggest that damages payable to SIMO are among the most likely litigation outcomes. There is also a possibility of both sides reaching a settlement, including re-cutting a deal at a lower price.

111 ( YI )

• Buyer: Management
• Consideration: $3.61/share
• Spread: 60%
• Exp. Closing: TBD
• Main Risk: Non-binding offer.

Chinese pharmaceuticals distributor YI is getting taken private by management (95% voting power, 67% economic interest). Merger consideration is $3.61/share after deducting ADS fees. Special committee is still reviewing the offer. Chinese non-binding privatization offers are inherently risky. However, reputable management as well as the financing for the buyout by a government-controlled entity give confidence that this offer has a higher chance of closing. Since the proposal announcement, several more reputable parties have joined the buyer consortium. The wide spread might be partially explained by the prolonged timeline as the YI’s special committee has been reviewing the bid for 14 months already. The market seems to have given up on the privatization materializing. Another reason for the market’s skepticism might be the ongoing significant healthcare industry reforms in China. The industry changes could have a material impact on the drug distributor businesses and in turn affect the buyer's willingness to proceed with the privatization. However, just 3.5 months ago management reiterated the offer and the bid price and expanded the buyers' group, which suggests that the buyout is still in the cards. YI’s management seems incentivized to complete the privatization as YI is seeking a listing on the domestic Shanghai STAR Market and delisting from the US seems like a necessary step toward this process. The relisting is needed to avoid a major redeemable equity redemption of post-IPO investment round. YI would likely fetch a significantly higher valuation on the Shanghai market, as suggested by the valuation of its peer that was recently listed in Hong Kong.

iRobot Corporation ( IRBT )

• Buyer: Amazon.com ( AMZN )
• Consideration: $51.75/share
• Spread: 58%
• Exp. Closing: TBD
• Main Risk: Regulatory approval.

Amazon is acquiring robot vacuum cleaner maker iRobot. The merger spread has gradually widened from minimal levels to over 50% due to regulatory hurdles and a potentially prolonged closing timeline. Several senators have been pushing the regulator FTC to block the transaction. The companies received a second request from the FTC back in Sep'22 and the review is still ongoing. The deal has also raised antitrust concerns internationally - the European Commission has launched a detailed probe into the transaction, with the ruling expected by Feb’24. Opposition's concerns revolve around privacy infringements and Amazon's history of anti-competitive acquisitions. Having said that, the UK’s CMA has cleared the transaction, arguing it will not lead to a substantial lessening in competition. Another positive is that IRBT was not included in FTC's recent antitrust lawsuit against AMZN. The spread might be also partially explained by steep potential downside as IRBT's performance has been deteriorating since the merger was announced, with increasing operating losses and revenues falling substantially below previous FY22 guidance. In Jul'23, IRBT and AMZN agreed to revise the offer from $61/share to $51.75/share. The change in offer price largely reflects a financing facility that IRBT has entered into to fund its ongoing operations.

PEAK Bancorp ( IDFB )

• Buyer: BAWAG Group (BG:VI)
• Consideration: $12.05/share.
• Spread: 28%
• Exp. Closing: TBD
• Main risk: Regulatory approval.

This is a merger arb setup with limited trading liquidity, making it actionable only for small PAs. IDFB, a nano-cap US community bank, is getting acquired by the holding company of one of Austria's largest banks. The merger was announced in Feb’22. The only remaining hurdle for merger closing is approval from the Federal Reserve. Initially, any opposition from the regulator seemed unlikely given that IDFB is a very small community bank, while the buyer is a reputable bank supervised by the ECB. In 2022, the Federal Reserve Board had already approved BAWAG's attempt to establish a representative office in the U.S. However, the merger has been dragging on for over 1.5 years, surpassing the initial closing deadline of Q1’23 with no updates from the regulators. Given the extended timeline, the lack of visibility into the regulatory approval process, and the broader turmoil in the U.S. regional banking sector, the spread has widened from 10% initially to over 20% since early 2023. While the delay is alarming, it might be partially explained by an overburdened Federal Reserve staff, which has been tasked with addressing several recent bank failures. During the latest conference call in mid-October, BAWAG's management hinted that the acquisition is ongoing and regulatory approval is pending. The risk of the BAWAG walking away appears minimal as the acquisition would enable the buyer to obtain a local U.S. banking license, supporting its expansion efforts in the country.

Albertsons Companies ( ACI )

• Buyers: The Kroger Co. ( KR )
• Consideration: $27.25/share
• Spread: 25%
• Exp. Closing: Q1’24
• Main risk: Regulatory approval.

This is a large merger between two grocery store chains. The main risk is antitrust approvals as the merger would combine the two biggest supermarket companies in the country, particularly in the Northwest where ACI and KR together hold a commanding market share. Antitrust concerns have been raised by a number of parties, including US senators, several states and farmer/consumer/labor groups. The buyer KR has received a second request from the regulator FTC. Recent reports suggest that the FTC is likely to challenge the merger. However, ACI and KR are confident of circumventing the regulatory hurdles with the recently announced divestiture of a large number of stores in overlapping areas. FTC has expressed concerns about ACI's previous divestiture related to another acquisition where the divested stores eventually went bankrupt. However, the buyer of divested stores is a Softbank-backed company with sufficient operating experience, scale and capital, suggesting that the story will not repeat and the divestitures might thus help ease antitrust concerns. The downside in a no-deal scenario might be partially protected given that ACI shares have drastically underperformed the market/peers since the merger announcement.

Applied Molecular Transport ( AMTI )

• Buyer: Cyclo Therapeutics ( CYTH )
• Consideration: 0.174 CYTH stock
• Spread: 24% (20% after borrow fees)
• Exp. Closing: Q4’23
• Main risk: High borrow fees and uncertainty on the final exchange ratio.

Tiny failed biotech AMTI is getting acquired by its peer CYTH. The key factors contributing to the wide spread are the high cost of hedging (23% annually at present) and some uncertainty regarding the final exchange ratio. At current levels, the borrowing fees would cut the potential return from 24% to 20% assuming the transaction closes by the end of the year. There is also a risk of a potential hedging costs spike that could further increase the costs and even result in a forced buy-in. The final exchange ratio will depend upon AMTI's net cash at the time of closing. If AMTI's closing net cash drops below $12.5m, the exchange ratio would fall below 0.174x. However, this seems unlikely as the target net cash level aligns with management’s latest cash runway guidance and already implies a likely excessive $5m/quarter cash burn rate for an empty cash shell. Besides these two risks, other closing conditions, including shareholder approvals on both sides, are expected to proceed smoothly. Approval from target's shareholders is highly likely as management owns 22% and an additional 8% is held by a former director. Any opposition from minority stockholders would be surprising, considering that the offer represents a substantial premium above pre-announcement levels. The risk of the buyer walking away is minimal given that the transaction effectively serves as an equity raise in a challenging financing environment within the biopharma industry.

VMware ( VMW )

• Buyer: Broadcom ( AVGO )
• Consideration: $71.25 + 0.126 AVGO stock
• Spread: 21%
• Exp. Closing: Q4’23
• Main Risk: Chinese regulatory approval.

This is a mammoth $61bn deal, giving chipmaker Broadcom a further push into the software industry. The transaction has already been approved by the European Commission and the UK's CMA while the FTC has not challenged the merger. The last remaining regulatory hurdle and the biggest risk is approval from China's SAMR. Over the last couple of months, SAMR was rumored to approve the transaction shortly, with the proposed remedies reportedly accepted by the regulator. However, recent reports suggest that the Chinese regulator could delay merger approval amid US recent efforts to curb sales of chips for the Chinese market. Another large merger in the semiconductor space between Intel and Tower Semiconductor was recently called off after failing to secure approval from Chinese regulators. Nonetheless, AVGO and VMW have recently stated that they expect the transaction to close shortly. Merger outside date is set to November 26 after which either party can walk away from the transaction without paying any penalties.

PNM Resources ( PNM )

• Buyer: Iberdrola ( IBDRY )
• Consideration: $50.30/share
• Spread: 18%
• Exp. Closing: Dec’23
• Main Risk: Regulatory approval.

Spanish electric utility giant Iberdrola is acquiring New Mexico-focused electricity provider PNM Resources. The transaction has received all the needed approvals other than the New Mexico Public Regulation Commission’s (NMPRC) consent. In Dec’21, NMPRC rejected the transaction due to Avangrid’s history of providing low-quality services in the US, legal investigation in Spain and the risk of increases in electricity prices. PNM-AGR have appealed the commission’s decision to the Supreme Court, claiming that the main sticking points, related to the legal investigation and alleged low-quality services provided by AGR in the US, have been either resolved or unsubstantiated. Interestingly, in early 2023 the entire NMPRC was replaced with new members appointed by the governor who has previously openly supported the transaction. The merger sides have since asked for the merger to be reconsidered by NMPRC instead of the Supreme Court, however, the Supreme Court has recently denied the request for remand. The court is expected to make a final decision on the case in the upcoming months. Earlier this year, the companies agreed to extend the merger outside date to the end of Dec'23, with the option for a further 3-month extension.

Genetron Holdings ( GTH )

• Buyer: Management
• Consideration: $4.03/share
• Spread: 17%
• Exp. Closing: Q1’24
• Main Risk: Chinese transaction.

Chinese US-listed cancer screening firm is getting acquired by a buyer consortium led by company's co-founder/chairman (combined 60% stake). Chinese management privatizations are generally risky, however, definitive agreement-stage transactions have historically been closing at a very high success rate. All closing conditions are highly likely to be satisfied. Approval from 2/3 of shareholders is nearly guaranteed given the large stake held by the buyer consortium. A condition of not more than 15% of shareholders exercising their appraisal rights is minimal given that this would require opposition from more than a third of minority equity holders. Meanwhile, regulatory approvals from Chinese regulators, including outbound direct investment approval, are also unlikely to present any issues as this is a standard privatization of a company with an operating business in China. The transaction seems opportunistic as GTH’s operational performance was expected to rebound in 2023 after Covid pressures, however, the company has not yet released any results for FY23 and shares continue to hover near all-time lows.

NeoGames ( NGMS )

• Buyer: Aristocrat Leisure ( ARLUF )
• Consideration: $29.50/share
• Spread: 15%
• Exp. Closing: May’24
• Main Risk: Buyer walking away, prolonged timeline and regulatory approvals.

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