Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article.
Bad News And More Bad News
The DOJ has informed the companies that it does not believe that the remedies offered to date are sufficient to address the DOJ's concerns.
While the press release mentions that the DOJ "acknowledged that they would assess further proposals" and is not initiating litigation at this time to block the transaction, the statement is an indication that DOJ's concerns are significant and there is no certainty that Halliburton will be able to find a workable solution.
Early on in the process, Halliburton proposed to the DOJ a substantial divestiture package, with assets generating up to $7.5 billion in revenue. The company's pitch to the regulators was that the businesses being sold would facilitate a platform for a new major competitor (or competitors) to enter the markets, mitigating the departure of Baker Hughes. The divestiture package was recently enhanced, apparently to address the DOJ's specific concerns.
It is obvious, however, that the proposed divestiture package does not come anywhere close to Baker Hughes' scale and scope of service and product offering. U.S. regulators are worried that the merger would lead to reduced competition, higher prices and reduced innovation in the industry.
The deal has already faced antitrust objections in Australia. While discussions with regulators are still ongoing, Australian officials have delayed final approval three times and most recently stated concern that the merger would create conditions that allow for "coordinated behavior."
The status of review by European antitrust authorities also raises alarms. According to a Reuters article last week, the "state of play" meeting between Halliburton and European Union antitrust regulators is scheduled for late this week. Such meetings usually take place at the end of the third week of the preliminary review by the EU Commission for Competition where the enforcer conveys its concerns related to the proposed M&A deal. If the merging companies are not prepared to offer sufficient concessions in the course of the preliminary scrutiny (which is scheduled to proceed through January 12), they may face a lengthy investigation which could last five months or more, with an uncertain outcome.
The European Commission has been reviewing the proposed deal since November 27 when Halliburton re-filed a request for approval after an earlier application was dismissed due to insufficient data. The Reuters article indicated, citing "a person familiar with the matter," that Halliburton "would likely be told about competition worries over its bid for Baker Hughes." Worrying about competition is the Commission's job, so there is nothing in the Reuters article that suggests that Europe's regulators are blocking the merger. However, given the context of the proposed transaction, it is clear that there can be no guarantee that an approval can be won based on the current divestiture plan.
The proposed merger has so far received regulatory approvals in Canada, Colombia, Ecuador, Kazakhstan, South Africa, and Turkey. However, the deal is still under review in several critically important jurisdictions, including the U.S., European Union, Australia, Brazil and China.
Can Regulators' Concerns Be Addressed?
The fact that the proposed merger has led to many concerns among regulatory authorities is not surprising. Indeed, taking a 10,000-foot view of the situation, it is surprising that the two companies decided to pursue such a risky undertaking in the first place.
The marketplace - particularly internationally - is dominated by three integrated "Oil Service Majors," Schlumberger (NYSE:SLB), Halliburton and Baker Hughes. While Weatherford International (NYSE:WFT) pursues a similar business model, it remains a much smaller competitor and is challenged by high financial leverage. All the four companies pride themselves on premium technology and the ability to provide a near-full range of products and services to customers worldwide.
Service integration, bundling and cross-selling are critical elements that distinguish the four companies' integrated business model.
Clearly, a consolidation of Halliburton and Baker Hughes would effectively lead to a near-duopoly, particularly in international markets, of two giant providers who would be able to use their size, balance sheets and dominance in certain high-tech product niches to defend their margins.
While the deal promised advantages to all integrated oil service providers, customers and regulators might have taken a different view. In addition, given that both the U.S. and European Union are significant net importers of crude oil, the regulators' concern over reduced competition likely goes beyond their respective domestic industries.
A Risky Risk Arbitrage
As one can see from the graph below, the BHI/HAL deal spread "exploded" in the past two weeks, indicating the market's view that the likelihood of the deal falling apart is very high.
(Source: Google Finance)
I should note that from the outset the BHI/HAL pair did not fall within the "risk arbitrage" category. The term "arbitrage" means "certain outcome." However, given the extremely high risk of the deal not being able to gain necessary approvals, the pair was never an "arbitrage." Based on my conversations with arbitrageurs, from the very beginning this special situation was not investable for many merger arbitrage portfolios due to its uncertain outcome.
Generally speaking, a market-neutral arbitrage trade position would consist of going short 112 HAL shares for every 100 BHI shares on the long side.
In my previous note, I provided a discussion of the arbitrage spread. Using September 29, 2015 closing prices of $34.66 per share for Halliburton and $50.47 per share for Baker Hughes, the merger arbitrage spread was ~$7.32 per share, assuming one BHI and one HAL dividend payment captured before the deal's close.
For professional merger arbitrageurs, the cost of borrowing HAL shares and the cost of capital tied up in the long/short position can be relatively low. By establishing a neutral merger arbitrage position - going long 1 BHI share and going short 1.12 HAL shares - the arbitrageur uses total capital of $89.29 per pair. Let's assume that the cost of funds for the arbitrageur is 3% per annum on total capital deployed. The arbitrageur would also have to pay dividends on his short position in HAL. If the transaction closed in 4 months, the arbitrageur would have posted a net gain on the trade of ~$6.42, or ~7.2% above the cost of funds in just four months.
In the merger arbitrage world, such a high return indicates a very high risk of the deal not closing.
In the past two weeks, the implied BHI/HAL deal spread widened dramatically, to $14.35 per BHI share, based on the closing prices on December 16 of $35.83 for HAL and $44.79 for BHI. The market is increasingly discounting the risk of the deal not being approved.
It is also quite notable that the market is not penalizing Halliburton's stock, despite the continued slide in commodity prices and the giant $3.5 billion cancellation fee that Halliburton would have to pay to Baker Hughes in the event the deal falls apart.
I wrote in my earlier note that the market may in fact reward the news about the deal being called off with a run-up in Halliburton's stock. So far, that thesis has proven to have some validity.
What Are The Implications For The Stocks?
Clearly, both Halliburton and Baker Hughes are critically motivated to see the deal succeed. For Halliburton, the deal's failure would likely equate to the $3.5 billion break-up fee coming due, hundreds of millions of dollars of merger-related costs without payback, and, very possibly, a leadership change. For Baker Hughes, the $3.5 billion fee would not offset the loss of the lavish premium being paid in the transaction. Therefore, it would be premature to conclude that the merger is not happening. However, if the deal ultimately goes through, its cost for Halliburton shareholders is likely to be gargantuan.
Given that the two companies are likely to fight to the very end, it would not be surprising to see another round of concessions followed by another round of regulatory reviews. The process may keep grinding forward for several more months, hence the extension of the deadline in the merger agreement to April.
The unusually wide deal spread is a reflection of the market's collective view on the probability of the merger ultimately closing.
As I wrote in the previous note, the deal spread at the end of September suggested that the behind-the-scenes negotiations with the DOJ were more difficult than might be visible to a common observer.
With the spread doubling, the market appears to assign a ~50/50 probability to the deal actually going through.
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.