Does the Duke Energy Corp.’s (NYSE: DUK
) recently announced acquisition of Progress Energy Inc. (NYSE: PGN
) represent a merger arbitrage opportunity? On January 10, 2011, DUK announced that it would acquire all of PGN’s common stock in a deal valued at approximately $13.7 billion. Each share of PGN stock would be exchanged for 2.6125 shares of DUK stock.
Announcement Day Impact
The acquisition announcement
came before the markets opened. DUK traded down for the day from an opening of $17.68 per share to a closing of $17.58, and down from Friday’s close of $17.79 per share. PGN close on Friday was $44.72 per share. The following table shows the spread between the deal’s value of PGN and the share’s price based on the 2.6125 exchange rate. The acquisition reflected a 3.9% premium to the previous close, which represents a very small premium for an acquisition.
Implied Acquisition Premium over Time
2.6125 x DUK
Both stocks traded down about 0.6% for the day and based on the proposed deal should move in sync. The SPDR Sector Select Utility ETF (NYSEARCA:XLU
) also traded down 0.3% that Monday. SPDR S&P 500 Trust ETF (NYSEARCA:SPY
) traded up 0.3% for the day. The large decline in DUK suggests that the market was not excited about either the prospects of the acquisition ultimately being completed or the benefits of the proposed merger.
Since the announcement date, the premium has climbed to as high as 5% on January 21, 2011. It then drifted down to a low of 1.54% on February 11, 2011, just 2 days after DUK’s ex-dividend date for its quarterly dividend of $0.245 per share. This suggests that expectations of a completed merger reached their highest likelihood. Since then the premium has widened back to its current mark of 3.9%.
So, the question is-- what is the profit potential from going long PGN and short DUK with the expectation that the merger will occur? This is typically viewed as merger arbitrage since, in effect, PGN is worth 2.6125 shares of DUK. However, it is not 100% certain this will happen, so you might not get 2.6125 shares of DUK. There are also additional transaction costs and other considerations around dividends and the cost of shorting.
DUK and PGN Statistics
Closing Price 3/11/2011
Market Capitalization ($ billions)
Dividend Yield (TTM)
Most Recent Ex-Dividend Date
Next Anticipated Ex-Dividend Date
Short Interest (Feb 28 2011)
Source: Yahoo!Finance. The next anticipated ex-dividend date was 91 days after the last one.
There are several costs and factors to consider to putting on this arbitrage:
- Dividends - From a dividend perspective, PGN has a slightly higher yield and pays its dividends in advance of DUK. Assuming no change in dividend, one long share of PGN would entitle the owner to $0.62 in early April. The 2.6125 short shares of DUK would obligate the shorter to pay $0.64 (=$0.245 x 2.6125) in early May. So, this pairs trade would create a small dividend cost if the transaction closes later in May after both ex-dividend dates. Furthermore, according to regulatory filings, PGN will not increase its dividend, while DUK is still allowed to do so. This explains a portion of the current premium.
- Transaction Costs – This type of bet will require 4 trades which we assume will incur a commission of $20 per trade. You will also get hit with the typical bid-ask spread 4 times as well. Assuming both stocks are relatively liquid, this might only be 2 cents per share, per trade. Again, these items close the premium gap.
- Stock Borrowing Costs – In order to sell DUK short, you’ll have to borrow the shares from your broker-- which potentially incurs some costs beyond the dividend liability. However, since the short interests in both stocks is relatively low, these costs might not be so difficult. For heavily shorted stocks, these costs would be much higher. For this article, I’ll assume these costs to be zero to see if the arbitrage would work. In reality, there would be some cost.
- Interest on Cash – Shorting a stock often provides cash proceeds that, in theory, you can earn some sort of interest rate on. However, there are two issues with this 1. Some brokerage accounts will not credit you with this interest, and 2. This interest is probably close to zero anyways – perhaps .1% on an annual basis at best. For this analysis, I will ignore any cash interest on proceeds from shorting DUK.
The set up will assume going long 1000 shares of PGN and short 2612 shares of DUK. All the above costs will narrow the premium gap.
Setting up the Arbitrage
3/14/ 2011 Open
Assume 3/14 open is 3/11 close
Bid Ask Spread
The short gives you the bid and long requires the ask
Brokerage Transaction Costs
$20 over 2612 shares of DUK and $20 over 1000 shares of PGN
Stock Borrowing Cost
Assumed to be 0.
Unexpected issues assigned to one side
Next Quarter's dividends
Creates at least 2 cents of loss
Assigned to cost of PGN
Creates about $1,416 of potential pre-tax profit
The first observation is that the premium is eroded by almost 22% through transaction costs without assuming any cost to borrow DUK. With a gross exposure of just over $94,196, the investor is chasing $1,416 of potential upside before costs during the unwind-- assuming the transaction occurs.
There two major issues with this strategy. The first is that the merger does not go through, which could result in an increase in DUK price on that announcement and a decrease in PGN price.
The merger could fail from three cases, which would impact how termination fees occur and how the stocks might behave afterwards. This is my own speculation and approximation.
- External agencies block the merger and is not attributed to actions of either DUK or PGN. Under this case, I’m assuming that there is no exchange of terminations fees and the deal falls apart. The stocks would then revert to their independent market values, which might mean a slight increase for DUK (assumes it recoups .6%) and a slightly larger decrease for PGN (assumes it loses 2%)
- DUK withdraws – this would obligate DUK to pay PGN $675 million, which is approximately 5.0% of PGN’s current market value. Assume PGN gains 2% from transaction fee benefit net of merger benefit loss and DUK gains .3% some loss from transaction fee, but eliminates integration issues and risks. This is a potential overstatement of what could happen to PGN.
- PGN withdraws- this would obligate PGN to pay DUK $400 million, which is approximately 2.9% of its market capitalization. This is the worst situation for this arbitrage since PGN stock would lose the merger benefit and have to pay a fee to DUK. Perhaps PGN stock loses 2% related to transaction fees and 2% from the merger benefits for a 4% loss. DUK would gain .1% from transaction fees and perhaps recoup its .6%, as noted earlier.
Stock Impact from Failed Merger
Source: my own estimates as described above
The first observation is that DUK seems to benefit from a failed merger. However, upon merger, there might be greater upside gains. The second observation is that it seems pretty costly for PGN to walk away from the transaction. Its break-up fee is greater as a percentage of market capitalization than DUK’s break-up fee.
Assuming there is no change in stock prices, the three merger failure scenarios could occur and a successful merger could be completed. This works through similar math as before to account for transaction costs. In a successful merger, the $1,416 of potential profit could be eroded depending on if you have additional transaction exit costs and cannot deliver the 2612 shares of DUK from PGN against the initial short position on DUK.
Pre-tax Profit by Scenario
Fails Case 1
Fails Case 2
Fails Case 3
Source: Calculations based on assumptions.
The first observation is that 'Fails Case 2' is still profitable, which may or may not make sense intuitively. This is driven from the fact that if DUK terminates it has to pay PGN a large fee. Being long PGN and short DUK results in a benefit on both sides that could be enough to offset the other impacts of a failed merger. Perhaps for assessment this should be assumed to be zero, or even a negative. Assigning somewhat arbitrary probabilities to these cases shows the expected profit.
Expected Pre-tax Profits
Probability Set 1
Probability Set 2
Probability Set 3
Probability Set 4
Fails Case 1
Fails Case 2
Fails Case 3
Expected Pre-tax Profit
Source: Calculations based on assumptions.
The first observation is that the trade appears to be break-even at a 50% merger success probability, which seems pretty reasonable.
The second major issue is that as a casual investor trying this play you are competing with larger investors who have advantages in terms of lower transaction costs, capturing the interest on cash, and lower stock borrowing costs. Hence, to win, one would have to believe the merger has a higher probability than other investors.
This could be an interesting play but one concern is that the premium is not shrinking, but has been widening over the last couple weeks. Does this mean the merger is facing some troubles or is it a better opportunity to try to capture this arbitrage? There are potentially other more cost effective ways to short DUK and go long PGN through options. The next major point is that if there are meaningful stock borrowing costs for DUK, the potential profit would be reduced and a break even expected profit would require a much greater probability of a completed merger. If the time to merge drags on too long, there will be additional premium erosion from the differential in dividends between the two stocks. This would be exacerbated by a DUK dividend increase.
- If you think the merger will go through, this could be a good arbitrage opportunity. Given the low acquisition premium on PGN, the downside seems more limited.
- If you think 3rd party agencies will block this merger, being long DUK might produce some upside since the market did not react favorably to the initial announcement.
- If you think DUK will terminate the agreement, being long PGN could benefit since it might stay even based on fees netting loss of the merger benefit. It would also put PGN back in play. Previously, there had been chatter about Dominion Resources Inc. (NYSE: D) seeking to acquire PGN or DUK
Probably the worst case scenario would be if PGN announces that it is terminating the merger plans and Dominion then announces that it will acquire DUK for a substantial premium. At that point, hopefully, one would have unwound the short DUK position.
Disclosure: I am long SPY.
Additional disclosure: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.