What is arbitrage? To find out, do not watch the movie by that name in which there is absolutely no arbitrage whatsoever. In 107 minutes of runtime and at a cost of over $13 million, the topic didn't even come up.
To start with, the dictionary definition is:
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.
But in common usage, "arbitrage" is typically conflated with "merger arbitrage" and is more advertising that description. Merger arbitrage is defined as:
A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. A merger arbitrageur looks at the risk that the merger deal will not close on time, or at all. Because of this slight uncertainty, the target company's stock will typically sell at a discount to the price that the combined company will have when the merger is closed. This discrepancy is the arbitrageur's profit.
My favorite description is from Cliff Asness, who recently wrote that,
The word "arbitrage" in academia means "certain profits," whereas in practical investing, arbitrage often means "a trade we kind of like."
The problem is that merger arbitrage typically misses the most salient fact of arbitrage - market inefficiency. Usually, merger arbitrage is a gamble on the time value and risk weighting of a deal without any particular reference to why that spread is mispriced. True arbitrage is riskless and the work goes into finding these few opportunities. Here is one fertile hunting ground: the periphery of merger arbitrage mandates. Most narrowly mandated funds dedicated to merger arbitrage have explicit rules around what they can own, so the opportunities that lie just beyond their reach can be mispriced.
One tactic is to look for broken deal arbitrage, which emerges when a deal breaks, especially when it does so unexpectedly. Merger arbitrage sellers press the "ask" side of the market downwards before conventional fundamental buyers are able to redo their analysis and respond with a "bid" side of the market. In such situations, it is common for shares to dip below the pre-deal price and below their fundamental value. One key question is whether broken deals resulted from a problem with the buyer or the seller. It is not always clear, but when the problem is with the buyer, it can be particularly conducive to scooping up stock beneath its deal value and beneath its stand-alone value. When credit markets are open, one can even encourage "self-help" transactions. The target of a failed deal borrows and issues a special dividend in a leveraged recapitalization that allows the public shareholder to act as the private equity would have done.
As another example, merger arbitrage firms often struggle with arithmetically hedging out mergers when there are merger securities other than existing, publicly-traded equity that is easy to short. Two of our favorite investment opportunities have been just such cases: the Grifols SA acquisition of Talecris (NASDAQ:TLCR) and the Kinder Morgan (NYSE:KMI) acquisition of El Paso (EP). In brief, Grifols did not yet trade in the US at the time of this deal and the deal consideration was partially paid in stock. So, this was particularly inconvenient for dedicated merger arbitrage funds. Our solution was an unhedged position in TLCR. We had a high level of confidence in the deal's completion and a high level of confidence in the fundamental value of the Grifols stock, which we would own following the deal's consummation. We captured a wide spread of over $5 per share and collected our shares. Here is the final outcome: the spread was kept artificially wide because of investors who wanted to - or, as per their mandate, were required to - avoid taking a directional view on Grifols (NASDAQ:GRFS)... and in so doing, avoided owning the stock as a result of the deal. What happened to that stock? As it turns out, it went up another 182%.
There were two features of KMI buying EP that made this an arbitrage worthy of the name arbitrage. First, KMI was an expensive stock to borrow, which kept the spread artificially wide. Secondly, EP shareholders were getting paid in part in a KMI warrant. The interaction of these features opened up an opportunity created by our counterparties' behavior based on narrow mandates as opposed to anything that the merging companies were doing. Since it wasn't economic to short KMI against EP, many merger arbitrage funds shorted the when-issued warrant. Because of the when-issued mechanism, shorting this warrant was easy and liquid. But therein lay the opportunity. Because they were doing what came easily instead of what was price-sensitive, this trade crushed the price of the warrants. So, while we were already EP holders, we also bought a significant number of the warrants at a price that was a fraction of the value that any warrant model would assign them. To lay off some of the directional risk of KMI, which we basically liked, we wrote a modest number of calls on the equity. In this case, the deal closed and we captured over $3 of spread beneath the merger consideration. Once the deal closed, the equity settled at a price low enough that our calls expired worthless. The warrants? We paid under a dollar for the warrants based on our average of the warrants that we bought in the when-issued market and the warrants that we bought via our EP position. Today they trade for over three times that amount.
Here is a brief thought about when merger arbitrage is and isn't true arbitrage. If a merger arbitrage fund absolutely feels the need to lay off deal risk through shorting a buyer's stock and would not otherwise participate, this is probably not true arbitrage, this is instead speculating on time and risk weighted deal outcomes. Only when such hedging is unnecessary, when one is in the rare instance of buying a security at a discount to its value in a deal or without a deal can the name "arbitrage" properly apply. Popular hedge fund strategies first emerged because conventional active money management was self-defeating. Over time, those popular hedge fund strategies themselves became self-defeating. Such is the way of markets. Now, to find a durable advantage we are left probing the spaces between the narrow mandates and agency problems rife within the hedge fund world itself.
For 2015, my favorite unhedgeable merger arbitrage opportunity is long Orbital Sciences (ORB). In this deal, Alliant Techsystems Inc. (ATK) is spinning off their sporting business and then merging with ORB in a stock-for-stock deal announced on April 29, 2014.
On April 29, 2014, ORB and ATK announced a stock for stock merger. ATK is a small aerospace and defense contractor paired with a recreational sports equipment business, primarily a gun, ammunition and accessory business. ORB is a small aerospace and defense contractor. The plan is for ATK to spin-off the recreational sports business to its shareholders, and then immediately merge the aerospace and defense business with ORB. Both companies are small compared to the likes of Lockheed (NYSE:LMT), Raytheon (NYSE:RTN) or General Dynamics (NYSE:GD), and according to their proxy ATK and ORB have been discussing combining their operations for years. This combination is designed to help them gain more scale in the industry.
What makes this particular transaction interesting?
- In this stock for stock deal and spin off, there is no way to offload market exposure or to perfect the arbitrage hedge. Instead, one must make assumptions regarding the value of the sporting spin-off, and the combined company, in order to understand what the merger is worth.
- There are no stand-alone public direct competitors to the ATK sporting business. The closest match is Olin (NYSE:OLN) which encompasses Winchester rifles and ammunition as well as chemicals. This lack of comps adds to the difficulty in valuing the stand-alone merged aerospace and defense company.
- Orbital's failed launch on October 28th is estimated to cost the company less than $10MM, but erased nearly $300MM from the company's market value.
A very public failure
The merger agreement indicates that both parties are subject to specific performance to conclude the deal when required by the contract. The US Department of Justice issued a second request on August 1, 2014. Spain approved the deal on August 28. On October 28, ORB announced that one of their rocket launches was "not successful". This was a fair assessment.
Orbital's Antares launch vehicle was carrying the unmanned Cygnus spacecraft for the purpose of delivering cargo to the International Space Station. This mission was part of Orbital's Commercial Resupply Services contract ("CRS I contract") with NASA. In the explosion just after liftoff, both the rocket and spacecraft were destroyed. Orbital estimated that its costs related to the incident are approximately $10 million, most of which ORB expects to be covered by insurance. However, as a result of the explosion, the market has erased $362 million from ORB's market value. In the same period, ATK has lost $630M or 15% of its market value. It is unclear whether this loss was a reflection of the launch failure or a result of the reduction in organic growth in the Sports segment after their announcement of earnings on October 30. Regardless, these two companies have seen their market values decline by nearly 20% since the end of October. Competitors and the S&P 500 are all generating positive performance.
ORB's contract with NASA is set-up with interim milestone payments and a final milestone payment. The interim milestones were not affected by the accident because it occurred after launch. The final milestone, worth $48 million to Orbital, will not be met. However, that entire payment is expected to be covered by Orbital's insurance. ORB's milestones with NASA are based on cargo delivery, not the number of launches. ORB has already planned the necessary missions to deliver the agreed upon cargo.
As for the merger, the day after the explosion, both ORB and ATK management teams addressed the explosion. ORB's CEO indicated that he has mission insurance and their success rate has been 96% over the past ten years. He expects a delay of somewhere between three and twelve months for the next launch. The ORB CFO said that he does not see forecasts going down. While there is no specific merger agreement provision for a launch failure, the risk of rocket failure is generally known. The merger will go forward. ATK's CFO said that they still expected to be in the earnings range that they had previously provided. On November 17, 2014, the companies put out a joint press release (which is usually a good sign in and of itself) reiterating their support for the deal. Then on December 4th, the FTC granted early termination of the HSR review. On December 17, 2014, ATK filed the definitive proxy statement. ATK and ORB shareholders will vote on this deal on January 27, 2015. This is the last deal condition under their contract. Therefore, it will probably close immediately after the vote.
The scope of this failure could have had a significant material impact on ORB and the deal with ATK. It could have resulted in missed milestones and therefore payments. It could have resulted in program cost overruns and penalties. NASA could have decided to resource the program to another supplier. But through the 6 weeks since the failure, ORB's management has been clear about exactly where they are in the recovery process and what the expected impacts are to ORB. To their credit, according to the proxy, the entire program is back on track and there is no more than $10MM of breakage attributable to the failure.
Failure in space travel happens. Companies plan for it. Successfully planning for and navigating this event should have driven the value of this management team up, not down.
What are these companies worth as stand-alones and what is the new combined ATK Orbital worth?
To determine the valuation of each component of this transaction we use a DCF methodology. Here are some of the key assumptions:
ATK has two primary business lines, Aerospace/Defense and Recreational Sports Equipment. Over the past two years, the value generated by the recreational business has grown from about 14% of EBIT to 55% by Q1 2014. The growth in that business has been driven primarily by two factors, i) the acquisitions of the Savage Sports Corporation and Bushnell Group in 2013, and ii) the dramatic spike in demand for guns and ammunition following the threat of strict gun control actions in the wake of the shootings in Newtown.
The size and volatility of this business is likely the main reason ATK has decided to spin it off into a new company called Vista Outdoor. Recent performance has been negative, driven by cooling demand for guns and ammunition since the spike. In the last reported quarter, the organic revenue growth, without adjusting for the acquisition of Bushnell, was -8%. As a result, ATK recently announced a write down of the goodwill from these acquisitions.
There is real concern over what the value of Vista Outdoor will be. The figure below shows the equity price of ATK, split between aero/defense and recreational sporting, based on the percentage of EBIT contribution to the business.
The key judgment in evaluating this transaction is to understand what the market value of Vista is in ATK's total market value. Using a DCF model with information from the proxy, Vista is worth $52.82 per share, assuming ATK's current share count. ATK's closing stock price on Dec 19 was $110.76. This implies that the value of the remaining ATK aerospace/defense business is about $58 per share. In the merger with Orbital, ORB holders receive .449 shares of ATK for each share of ORB, so this implies a market value of current ORB shares, post-merger, of $26. That represents a deal spread of $1.11 or 4.44%, and we expect the deal to close by Jan 31, 2015.
One of the big risks to an arbitrageur is the underlying value of Vista. However, if you are just long ORB and Vista's value turns out to be below our DCF value of $52.82, then the spread to the new ATK equity offering is even larger. The issue in capturing this spread is that without a direct publicly-traded competitor to Vista, there is really no way to completely hedge out the Vista market value risk. In addition, without competitive multiples and other comparisons, the projection of the stock market value at the time of issue has a wide variance.
This analysis assumes that the market is accurately pricing the remaining ATK aerospace/defense business as well as the combination with Orbital's business. Our work led us to the conclusion that this transaction is far more valuable than the market is giving credit.
In our DCF model we combine the post-spin ATK and ORB using information from the proxy. We assume synergies of $70MM, but do not include any new advantages from additional scale and product offerings. We estimate the fundamental value of the new ATK Orbital to be $78.18 per share to current ATK shareholders. At the current price of $57.94 per share, we believe the market is severely undervaluing this business. Based on our valuation, shares of ORB warrant a price of $35.24. That is a $10.33 spread to the closing price on Dec 19 or about 41% return.
Orbital's stock, on a stand-alone basis, is priced below where it was when the deal was announced. Based on the current fundamentals, our model values Orbital at $24.75 per share as a stand-alone business. With a closing price of $24.91 per share on December 19, there is very little deal premium priced into ORB stock at this point, which significantly limits potential downside if the deal were to break.
The primary risk here is clearly that there is a future problem with the investigation around the accident. We believe that fear has been significantly overstated by the market. The benefit of having a rocket explode near the earth is that there is plenty of data to analyze and determine the cause. Orbital management has already done so and continues to state that there will be no significant financial impact to ORB from the incident. Further, despite a thorough review of non-public information related to the accident ATK decided to go ahead with the merger with no modification to the terms. In our view, this is an important endorsement of ORB's conclusions.
This investment idea is typical of hedge fund investing, but may not be suitable for all types of investors. If this is not something that you are monitoring professionally, here are some additional thoughts on sizing, risk, and actively managed ideas within the context of a broader secure financial strategy.
The merger of ATK and ORB, including the spinoff of Vista, is a very rich opportunity. The probable value of a share of Orbital today is about $35.24 versus the market value of $24.91 assuming that the deal closes this is a 41% return that exists because of:
- The un-hedgable nature of the merger
- The discount the market is applying due to a lack of a good market price indicator for Vista
- Possible stock market concern about the turndown in the organic revenue growth in the ATK sporting group
- The huge discount in the prices of ATK and ORB resulting from the Orbital launch failure on October 28th
As the price of this transaction converges on the fundamental value of these businesses, either before or after the transaction, one can effectively pay $24.91 to buy $35.24 of economic value by purchasing one share of ORB today. We believe the downside risk is well priced in at this point, as ORB's stand-alone value has not recovered from the launch failure. The catalysts to unlock this value are expected in the not too distant future with the closing of the merger and the conclusion of the investigation into the launch failure.
Disclosure: The author is long ORB.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.