The deal essentially brings together the world's leading cloud and professional networks under one house. The number of synergies is exciting when you think about it. Individuals are usually working or using one of these two worlds by using Office or Dynamics for CRM (Microsoft) and using their professional network to grow relationships (LinkedIn). This deal brings these two worlds together.
Is LinkedIn a merger arbitrage candidate?
Even with Microsoft's "less than stellar" acquisition history, we'll see if there is opportunity as a Merger Arbitrage Candidate. Let's dive in and find out!
Microsoft has more than enough cash on its balance sheet ($105 billion), and plenty of access to capital given its stellar balance sheet. Although Microsoft could theoretically buy LinkedIn 4 times over, the company will fund the new acquisition from new debt because the tech giant would open itself up to a massive tax bill by repatriating cash from overseas.
With this being said, we do not see a high probability of failure given Microsoft's strong capital position, the lack of regulatory interference and the all-cash deal that is easily covered by Microsoft's excess cash and ability to borrow the $26.2 billion.
The deal is said to close by the end of the year (6 months); both sides appear to be excited about the deal and the synergies involved and there seem to be no regulatory hurdles. This should help pave the way for a smooth transaction.
LinkedIn is currently priced at 64.5x FCF, which gives an implied yield of 1.55%. It seems to be overvalued at current cash levels, but the synergies involved make it difficult to calculate a real ROI. Also, we doubt there will be any additional suitors for the company as it would set off a bidding war. There are few, if any, companies that would be able to compete in a bidding war with Microsoft.
And let's now forget there are many uncertainties around potential mergers, such as anti-trust approvals, multiple government reviews, changes in market conditions, shareholder approval and due diligence. If the deal was not completed, we would expect prices to drop to the pre-deal price of $130 or a loss of $62.50. We give the deal a 95% chance of being complete, based on the parties and terms of the buyout offer which we stated above.
At the recent quote, the stock is trading at $192.50 per share, $3.50 below the announced cash offer of $196 per share by Microsoft. We calculate our expected return with the probability of a favorable deal ($3.50 x .95 = $4.39). And we subtract that from our expected loss with the likelihood of that loss occurring (62.50 x .05 = $2.15). This is the expected weighted return which gives us a potential return of 0.97% or $2.24 per share. To calculate our annualized expected return we divide that by the expected time of holding in years (6 months = .50). This gives us an annualized expected return of 0.21%.
Co-founder Reid Hoffman called the deal a "re-founding moment for LinkedIn." As a merger of two great companies, it looks incredibly attractive. As a merger arbitrage deal, we do not see a high probability of failure given Microsoft's strong capital position and the lack of regulatory interference. However, from a merger arbitrage opportunity, this appears to be unappealing at current levels with a potential 0.21% annualized return profile. The risk does not justify the return in this case.
If you were inclined to participate in the potential for a higher bid (which we don't expect), we'd typically look to purchase out-of-the-money call options as cheap and far out as possible. In this case, we'd look at the November 200 Calls for 0.30. The deal looks like it will be finalized without a hitch, but we don't see a high probably for an increased bid due to valuation and other bidders not wanting to bid with Microsoft.
WARNING: Merger-arb can be tempting for investors to use leverage to increase their annualized return on high probability events… Resist the urge! Many Wall Street firms conduct merger-arb as their main business, and they will normally have 50 or more merger arbitrage investments at any one time. They understand that if a couple of deals go badly, the winners will more than take care of the losers.
Merger-arb can be a very crowded strategy at times. Similar to value investing, it can be cyclical and go in and out of favor over time.
The key to merger-arb is to focus on the few deals that are highly probable (ideally ALL cash deals) with minimal regulatory hurdles and an acquirer with a great capital base. And if you're new to merger-arb, watch a few deals play-out over various industries to get an understanding of the deals.
If you do invest in merger-arb situations, conduct proper due diligence and make sure to spread your risk appropriately. If you are so inclined to learn more about these types of special situation, I highly recommend Graham's writing on arbitrage in his Security Analysis book.
Frank Sands | John Griffin | Ron Baron
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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.