Merger Arbitrage Analysis And Spread Performance - May 12, 2019

by: Malcolm Spink, CFA

Redhat receives greenlight from Department of Justice.

Wageworks states financial reporting and disclosure controls & procedures were ineffective.

Merger arbitrage spreads widen following market downturn.

This article explains the reasons behind the movement in a selection of the largest U.S. cash merger arbitrage spreads from the past week as calculated by Merger Arbitrage Limited. We analyze the attractiveness and profitability of each spread going forward and indicate the trading position or action we have taken or intend to take based upon the analysis given.

Deal Specifics

Redhat (RHT) rocketed up on Monday and finished the week up 1.20% or $2.19. On Monday The Department of Justice concluded its review of the Red Hat acquisition by IBM without remedies or conditions. This latest regulatory hurdle clears one of the bigger challenges faced in the US. IBM continues to see a H2 closing. An end of year closure gives an annualized return of 2.82%. However, we foresee a closing date much sooner giving an annualized return closer to 10%. For this reason we maintain our long position and may possibly increase it on weakness if the opportunity arises.

WageWorks (WAGE) also suffered this week down 1.45%. The stock had previously traded within $0.25 of the $50.50 offer price from HealthEquity HQY. As well as being caught up in the broader market turmoil, WAGE also filed a NT 10-Q. This detailed that WAGE "is unable to file its quarterly report on Form 10-Q for the quarter ended March 31, 2019". This led to the following statement "certain financial statements for periods in 2016 and 2017 should be restated and should no longer be relied upon". Accordingly, the stock sold off and the spread widened. The stock continued to be volatile during the rest of the week. Traders are still trying to determine what a restatement of results may mean for the future of the deal. The deal is not scheduled to close until end of October. We have traded this stock cautiously both long and short. Currently, we are short the $50 call expiring this coming week. We strongly caution traders on being involved in this stock as we expect more volatility and news in the near future.

The biggest loser this week was Mellanox (MLNX) down 2.10%. This spread has serious exposure to the whims of the Chinese regulators. Thus the escalation in the US-China trade war has caused arbitrageurs to run for cover and dump their positions. MLNX now has the second largest simple spread in the portfolio at 6.02%. This is a $7.10 discount to the $125 offer price from NVIDIA (NVDA). With no immediate resolution in sight, we see this spreads remaining in limbo for some time. It is unlikely that this stock will be used as any form of bargaining chip but the trader must be aware the Chinese are unlikely to be in any rush to green light this deal. Depending on the spread level once the selloff subsides, the stock may provide an attractive opportunity should trade relations show any signs of thawing. Obviously we regret not exiting the position when we suggested and will remain long for the time being.

Bluegreen Vacations Corporation (BXG) declined 1.43% thus week. The stock had rebounded in recent weeks but is now back to $15.15 with a spread of 5.61%. Results were announced during where EPS was in line and revenue was higher than expected. With the differences of opinion on the likelihood of a successful deal outcome, we suspect this spread could be a candidate for our active arbitrage strategy. There is still a great deal of room for this spread to move. The offer price from BBX Capital Corporation (BBX) is at $16. Should we trade this stock in the near future, readers will be kept informed via our twitter feed.

Merger Arbitrage & Market Data

The broader market saw large losses for the week pared by the close on Friday. The escalation of the US-China trade war overshadowing the positive domestic economic news from the previous week. The S&P 500 ETF (NYSEARCA:SPY) finished down 2.02% for the week.

Surprisingly, the MNA ETF produced another positive return to finish the week up by 0.25%. This once again shows the shortcoming of investing in this particular product. The short leg of stock for stock deals is represented by a broader sector ETF product. Should this particular "hedge" be sold off during the week the MNA is likely to show a profit. This is regardless of how the merger spreads have played out. (You can read more about the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).Merger Arbitrage Returns April 21, 2019 Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 6 winners and 10 losers this week with 1 non mover. The top 20 largest cash merger arbitrage spreads as defined by declined by 0.28% and the standard deviation of returns was 0.98%, higher than 3 month average. The negative performance of the portfolio was largely attributed to the large declines of spreads for a mixture or specific and broader reasons.

The portfolio of cash spreads widened during the week. The top 20 discount spreads now offer an average of 2.84%. The T20 portfolio has 18 deals and 2 vacant spots filled by cash. The return figure has become less reliant on the returns available from PACB and BXG indicating greater diversity.

Merger Arbitrage Strategy

As mentioned, the T20 list now has a 2 part cash component. Positive portfolio performance going forward has a greater diversity than in previous months with some new deal additions. The portfolio is no longer as reliant on a small number of spreads with the capacity to move profitably as noted in a previous article.

We have warned for some time of the failure to resolve the US-China trade talks. We have continuously suggested traders keep some power dry for such an event as we saw during the week. The decline in the market this week has presented some opportunities.

The spreads on our top 20 list (available from the Merger Arbitrage Limited website) have broadly begun to rise up to (and surpass) the level of return available for simply holding cash, circa 2.40% pa. For a deal to close early, as we expect RHT to do, an attractive return is possible. We discuss deal closing schedules and how understanding this facet of merger arbitrage can help to maximize profitability in a previous article. We maintain our positive outlook for the profitability of merger arbitrage despite this week's pullback.

Merger arbitrage trading is not without risks. This strategy, although accessible to individuals as well as professionals should be thoroughly understood BEFORE investment capital is put at risk. To assist the reader, "evergreen" content such as "how-to" & introductory guides, a reading list and much more including a list of the largest cash merger arbitrage spreads currently available can be found at the Merger Arbitrage Limited website associated with the author of this article.

Disclosure: I am/we are long RHT, WAGE, MLNX. 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.