Important Note: This article is not an investment recommendation and should not be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.
Eighteen months after the initial announcement of the merger between Halliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI), investors appear to have finally arrived at a realization that the transaction is unlikely to receive necessary approvals. The deal arbitrage spread, which reflects the market's assessment of the merger's success, today spiked to a level that implies an approximately one-fifth chance of the deal closing, based on my estimate.
What Are The Scenarios? - Let's Ask Mr. Deal Spread
As a reminder, a market-neutral merger arbitrage position would consist of buying 1 BHI share and simultaneously selling 1.12 HAL shares short.
A long position in such a pair is a bet that the deal would eventually close and the investor would receive a payoff equal to the deal's cash component, or $19 per BHI share. The expected net profit on this trade is equal to the "deal spread" which is calculated as a difference between the current price of 1.12 HAL shares plus $19 on one hand and the price of one BHI share on the other.
If the spread is trading close to zero, one could interpret such a situation as the market expecting that the deal will close with a high probability - the low closing risk results in a thin payoff. A wide positive spread, on the other hand, likely indicates a reduced probability of the deal reaching fruition. A negative spread likely indicates an expectation of competing bids for the target.
For example, investors who initiated the BHI/HAL arbitrage position precisely one year ago, when the spread was trading at $4.60, were effectively expecting to make ~4.0% return on their initial capital commitment within less than eight months.
Based on today's intraday prices, the spread widened to ~$16.40 per BHI share, effectively reflecting investors' pessimism with regard to the deal going through.
To derive the probability of the merger's success implied in the two stocks' current prices, it might be helpful to look at the deal spread over a longer time frame. Tracking the same spread prior to the transaction's announcement in November 2014, one can see that BHI's stock underperformed HAL's stock during the first ten months of 2014 (the trend is depicted by the blue dashed trend line on the graph below). The underperformance reflected Baker Hughes's weaker operating margins, on one hand, and Halliburton's continued success in strengthening its position in international markets, on the other. The strong "currency" gave Halliburton additional leverage to make a bid for Baker Hughes.
Let's assume, for illustration, that in the absence of the merger, the underperformance would have continued and the pre-announcement spread would have reached $30-$35 range by this point. Assuming the two companies terminate the merger at the end of April, one may expect that the stocks will return to that pre-announcement relationship between the two stock prices.
However, it is important to take into consideration the effect of the regulatory termination fee of $3.5 billion that Halliburton would pay to Baker Hughes. The fee amounts to over $8 per share positive impact for Baker Hughes's stock and a ~$4 per share negative impact for Halliburton's stock. I also estimate that merger-related costs have had a net negative impact of ~$1 per share per HAL share. Based on this illustrative calculation, if the transaction were to fall apart, the spread would widen to ~$16.50-$26.50 per share.
The payoffs on the arbitrage position would look as follows:
- The deal is called off: a negative ~$0-$10 per BHI/HAL spread pair, or ~$5 at the midpoint.
- The deal goes through: a positive ~$16.50 per BHI/HAL spread pair.
Comparing these payoffs, the probability of success implied by the stocks' current prices appears to be in the 0%-38% range, or around 20% at the midpoint.
The estimation is obviously illustrative, as it is difficult to make a good guess of each risk arbitrageur's view on the two stocks' trading levels if the merger is terminated. However, it is clear that investors' confidence in the deal's success has eroded.
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.