Idea Generation: Merger at Cruising Altitude
On October 23, 2016, the world's leading manufacturer of aircraft cabin interior products, B/E Aerospace (NASDAQ:BEAV), announced that it had agreed to be acquired by avionics technology firm Rockwell Collins (NYSE:COL) in a cash-plus-stock deal valued around $62 per share, a 22.5% premium to the previous closing price.
As you can see in the chart of BEAV's stock price below, the stock moved up following the announcement and has since traded in a tight range around $59.50.
Source: bigcharts.marketwatch.com, retrieved 12/10/16
Investment Research: Estimating Ticket Price and Departure Time
Before we can identify the right trade on a deal, we need to forecast terminal values and a completion date. That starts with a review of the deal terms in the press release issued by BEAV (emphasis added):
Under the terms of the agreement, B/E Aerospace shareholders will receive $34.10 per share in cash and a number of Rockwell Collins shares of common stock equal to $27.90, with such number of shares of Rockwell Collins common stock determined based on the volume weighted average closing price of Rockwell Collins common stock for the 20 trading days ending on the day prior to closing (provided that this volume weighted average price is no less than $77.41 and no greater than $89.97 per share). If the volume weighted average price of Rockwell Collins common stock during this period is above $89.97, the stock portion of the consideration will be fixed at 0.3101 shares of Rockwell Collins common stock for each share of B/E Aerospace, and if it is below $77.41 per share, the stock portion of the consideration will be fixed at 0.3604 shares of Rockwell Collins common stock for each share of B/E Aerospace. Upon completion of the transaction, which is expected in the spring of 2017, current B/E Aerospace shareowners will own approximately 20 percent of the combined company.
To summarize, if COL is below $77.41, BEAV shareholders get $34.10 in cash plus 0.36 shares of COL for each BEAV share they own. If COL is between $77.41 and $88.97, BEAV shareholders get the same amount of cash, plus a quantity of shares that are worth $27.90. And if COL is above $88.97, BEAV shareholders will get the same amount of cash, $34.10, plus a smaller number of shares, 0.31. That shifting quantity of COL shares acts as a collar around the deal value, keeping it pretty close to $62 per share. COL closed at $94.37 on December 9 th; for every $1 that COL is above $89.97, BEAV shareholders will get cash and COL shares that are worth an extra $0.31 above $62.
The transaction is not conditioned on financing, but COL expects to finance about $3.5 billion with debt, some portion of which has already been committed. To alleviate ratings agencies' concerns about COL's coverage ratio, the company has committed to reduce its share buyback program and pay off at least $1.5 billion of its new debt by September 30, 2019.
Conditions of the Deal: The Ticket's Fine Print
This transaction is interesting because it represents an expansion by COL into a market that is related-to-but-different-from where it has participated, historically. BEAV manufactures products and provides services to support aircraft seating products, food and beverage prep, cabin, lavatory and galley modular systems, oxygen delivery systems, and other similar components. COL, in contrast, manufactures and supports avionics - the electronic equipment in an aircraft - as well as communications, mechanical systems, training and simulation, flight control, and other technical systems.
Since the number of COL shares to be issued is greater than 20% of COL's current outstanding share count, the merger will have to be approved by both BEAV and COL shareholders. Both companies have extensive international operations, such that antitrust approvals will be needed not just from the United States, but also from the European Commission, Chinese Ministry of Commerce, South Korean Fair Trade Commission, Taiwanese Fair Trade Commission, and Turkish Competition Authority. Because COL and BEAV don't compete head-to-head, and because the buyers that purchase their products have substantial negotiating power, we don't see much to be concerned about from an antitrust perspective. This is hardly another Honeywell/GE deal.
One last note regarding regulatory approvals - COL derives a substantial portion of its business from defense contracts. Sections 3.21, 3.22, and 4.21 of the merger agreement represent that BEAV and COL are currently in compliance with the International Traffic in Arms Regulations (ITAR) and National Defense Authorization Act (NDAA). It is interesting that those bodies of law are only mentioned from the perspective of currently being in compliance - the transaction is not conditioned on an approval from the U.S. Department of Defense.
Within the world of merger arbitrage, there's always the possibility that an agreement could be terminated because the acquirer gets acquired. On November 30th, Bloomberg reported that hedge fund Starboard Value has taken a stake in COL and is pushing to terminate the merger agreement and instead seek a buyer for COL. Because the merger is conditioned on approval by a voting majority, there is a possibility that COL shareholders could block the transaction if they see a better opportunity elsewhere.
Possible, but pretty unlikely…
First, we haven't seen a 13-D filing from Starboard, which means that their stake in COL is less than 5% of the outstanding shares. Bloomberg's report indicates that three other "top 25" shareholders are also opposed to the BEAV deal, and the 25th-largest shareholder of BEAV controls less than 1% of the outstanding shares, so the combined portion of shares controlled by holders who don't like the BEAV merger is probably less than 8% of the total of COL shares outstanding. That's not enough to get in the way of this transaction.
Second, COL is buying a complementary business and expanding its relationships with aircraft manufacturers at an acceptable price. BEAV grew its income 8% last year and has provided guidance that it expects to grow another 6% this year. COL, in contrast, grew at a slower rate, just 4%. The press release identifies $160 million in synergies, but COL probably breaks even with just half of that. This is not a merger that screams " bad idea", " arrogance", or " empire-building."
Third, the background section of the preliminary S-4 shows that COL already considered a broad range of strategic options, in a formal process spanning early 2015 through the announcement of this deal in October 2016. Suppose that Starboard and its colleagues can and do advocate for COL to terminate the BEAV acquisition (at a cost of $300 million) and restart the strategic exploration; Starboard & Co. could face the possibility that COL fails to find any interested buyers (again). It's one thing if the merger happened without sufficient exploration of strategic alternatives - but entirely another if the Board of Directors already looked and didn't find anything.
Our take: This is a transaction with substantial fundamental logic, limited regulatory risk, and tightly defined consideration. Over the past three years, COL shares have traded as low as $72 and as high as $99. The terms of the transaction, including the collar, mean that even if COL should somehow tumble back to $72 a share, BEAV shareholders would still get cash + stock worth $60 a share. To us, this looks like a great example of Benjamin Graham's margin of safety.
Estimating the Timeline: A Reasonable Layover
BEAV and COL say that they expect to complete the merger in the spring of 2017, and they disclosed on November 22nd that they filed for U.S. antitrust approval on November 7th. No information is available, yet, regarding the status of the non-U.S. antitrust approvals. We expect to see the definitive S-4 toward the end of January (about 60 days after the preliminary S-4 of November 22), and the shareholder vote should happen in late February or early March.
Given the lack of overlap, and the strong negotiating power of BEAV and COL's customers, there's not much substance on which an antitrust regulator could base an objection. For example, the U.S. antitrust review expired on or before December 7th without a request for additional information (more on this below). So we're faced with two very basic questions to estimate the timeline:
- How long will BEAV and COL need to prepare and file their various requests for approval from international antitrust agencies?
- How long will those agencies need to complete their reviews and clear the deal?
Once again, the opacity of foreign approval processes makes it difficult to pinpoint the expected closing date accurately. The roster of non-U.S. approvals and our expectations for each are:
Transparent process, probable clearance 30 days after application is filed
Probable clearance 120 days after notification is filed, possibly less
Probable clearance 30 days after application is filed
Probable clearance 30 days after application is filed
Probable clearance by the middle of May 2017
Of all the non-U.S. approvals (Europe, China, South Korea, Taiwan, and Turkey), China is likely to be the gating item, the last one to clear before the deal could be completed. The most recent example we have of a transaction running the Chinese Ministry of Commerce (MOFCOM) gauntlet is St. Jude / Abbot, which was reported to win approval on October 18 th, 173 days after the deal had been announced (also about two weeks after the deal's Phase II had reportedly started, and an unknown number of days after the filing was actually made). If the acquisition of BEAV by COL operates on the same timeline, it will be approved by MOFCOM in mid-April. For purposes of conservative analysis, we're using the middle of May.
If shareholders vote in favor of the deal in February or March and all regulatory approval processes are done by the end of May, then the transaction will close in the spring, as guided in the initial press release.
Applying the Research: Finding the Right Trade
BEAV's expected stock price if the merger is completed is at least $62, the sum of the $34.10 cash consideration and the probable value of the stock shareholders will receive - so long as COL's shares remain above $77.41. The value of the consideration climbs above $62 as COL shares rise above $89.97.
Now we have an expected completion date and an expected terminal value. Based on current option prices, we believe the best investment is a bullish call spread, buying an April 2017 $55 call and selling an April 2017 $60 call. This position will achieve its maximum profit if BEAV is trading at or above $60 when the options expire. In the unlikely event the deal has already been completed by April's options expiration, the position will achieve its maximum profit if COL is above $71.67. It's worth noting that this trade is different from our usual approach - instead of betting on a completed deal reaching its terminal value, this is an investment that wins if the pending deal is sufficient to keep BEAV at or above $60.
Trading: The Math Behind the BEAV Bullish Call Spread
At $59.30, with a success value of $62 and an estimated failure value of $49.14 (the value of BEAV stock, adjusted for comparable companies' recent market movements), the risk / reward ratio in the stock is 10.16 / 2.70, or 3.76x (note that a lower multiple is superior because it represents less risk relative to greater return). The maximum price that could be paid for a BEAV April 55/60 call spread and still achieve a superior risk / reward ratio is $3.95.
$3.95 risk / $1.05 reward = 3.76x
At that price, the option spread would generate a return of 26.6%. Given that there are 180 days between April option expiration and October 23rd when the deal was announced, the annualized return can be calculated as:
26.6% / (180 / 365) = 53.9% annualized return
In the unlikely event that the deal closes before the April options expire, they will achieve their maximum profit so long as COL remains above $71.86.
Current Status: Tracking Approvals
Because this transaction was announced relatively recently, we're in the early stages of the underlying processes that must be completed before it can close. One small note of success which may explain the recent move in BEAV is that the companies cleared the waiting period for Hart-Scott-Rodino, a preliminary merger notification process for the Federal Trade Commission and Department of Justice (COL confirmed that by email on December 8th).
We're looking forward to the shareholder vote, and any news at all regarding the filing or clearance of foreign antitrust approvals. Ultimately, we expect the timing of this deal to revolve around the Chinese review. To us, this is a question of when, not if - a circumstance that warrants the April 55/60 call spreads that are in-the-money relative to the expected takeout value.
Exit: Upon April Option Expiration
Barring changes in the expected outcome, we think the best play here is to exit the position when the options expire.
The merger of BEAV and COL has a strong fundamental basis, straightforward conditions and approval processes, and a tightly defined consideration for BEAV shareholders. As the transaction progresses toward successful completion, we expect BEAV to appreciate toward $62, more if COL continues to trade above $89.97 (and, of course, less if COL falls below $77.41). The option spread offers an approach that could generate substantial returns while providing defined risk if the deal doesn't work out.
Disclosure: I am/we are long BEAV. 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.
Additional disclosure: This information is provided for educational purposes only, and is intended to be an example of how ArbitrOption applies its investment strategy. It does not constitute investment advice. As with all investments, there are associated risks and you could lose money investing. Prior to making any investment, a prospective investor should consult with her or his own investment, accounting, legal, and tax advisers to evaluate independently the risks, consequences, and suitability of that investment to their personal financial circumstances.