Merger Arbitrage Analysis And Spread Performance - May 19, 2019

by: Malcolm Spink, CFA

Wageworks spikes on Friday as announcement appears imminent.

Mellanox declines further as fears of Chinese retaliation effect deal closing probability.

Merger arbitrage cash spreads widen significantly following market turbulence.

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

A rare bright spark this week was WageWorks (WAGE) up 1.87%. The stock has been extremely volatile during the week. A strong performance on Friday took the price above $50 against the $50.50 offer price from HealthEquity HQY. There was no news official news during the week so we expect that an announcement is imminent. This deal is yet to be agreed by both sides so no official deal terms have been released. A movement such as this may raise a few eyebrows if a higher offer is subsequently announced. In the meantime it appears the accuracy of previous financial reports is not deterring investors. We had been long this stock during the week and have already taken some profits. Our short $50 call position referred to in last week's article also worked out well. Stock was purchased against exercising of the call but profitability was only marginally effected.

Redhat (RHT) also managed to land in positive territory for the week. The stock finished up 0.40% and was the second best performer of the week. The DoJ blessing last week of the acquisition by IBM without remedies or conditions seems to have continued its momentum. Traders now seem aware that no additional Chinese clearance is required. This leaves a relatively straight forward run to deal completion. We continue to foresee (and have always done so) a closing date much sooner than that initially forecasted. This gives an annualized return closer to 9%. For this reason we maintain our long position and may possibly increase it on weakness if the opportunity arises. Alternatively, should the stock continue to rise at this rate we may take profits to redeploy finds elsewhere as opportunities arise.

The biggest loser this week was Mellanox (MLNX) down 4.25%. This spread has serious exposure to the whims of the Chinese regulators. As noted last week, "the escalation in the US-China trade war has caused arbitrageurs to run for cover and dump their positions". This has continued throughout the week inflicting larger losses on the arbs. MLNX now has the largest simple spread in the portfolio at 10.73% up from 6.02% last week. This is a $12.11 discount to the $125 offer price from NVIDIA (NVDA). With no immediate resolution in sight, we see this spread remaining in limbo for some time. Depending on the spread level once the selloff subsides, the stock may provide an attractive opportunity should trade relations show any signs of thawing. Traders are advised to tread cautiously with this spread and not to take unnecessary exposure to the whims of U.S. economic policy.

Pacific Biosciences of California (PACB) has been relatively quiet for some time but exploded into life once again last week. The stock dropped $0.18 to finish down for the week by 2.43%. Currently trading at $7.23, the stock is now $0.77 below the $8.00 offer price from Illumina. Traders will be well aware of our strategy by now. We actively trade this stock and are continuously entering and exiting our positions, sometimes multiple times in a single day. We had previously stated we had exited most of our position and were looking to buy back on weakness. Our wishes have been fulfilled. Once again there was little news so we are happy to scalp the volatility of the market in a merger arbitrage framework.

For the sake of completeness we also mention other notable decliners during the week. This is to inform the trader of alternative opportunities that have arisen as deal spreads have declined. Spark Therapeutics (ONCE) declined 1.96%, Buckeye Partners (BPL) was down 1.84%, Luxoft Holding (LXFT) was down 1.37% and Bluegreen Vacations Corporation (BXG) was down 1.25%.

Merger Arbitrage & Market Data

The broader market saw large losses during the early part of the week but were somewhat pared by the close on Friday. The escalation of the US-China trade war continues to weigh on global markets. The S&P 500 ETF (NYSEARCA:SPY) finished down 0.44% for the week.

Surprisingly, the MNA ETF had held up quite well but eventually succumbed to selling pressure by the end of the week. By Friday the MNA TETF was down by 0.72%. We continue to question the validity of the short leg of stock for stock deals which is represented by a broader sector ETF product. (You can read more about the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).Merger Arbitrage Returns May 19, 2019

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 4 winners and 15 losers this week with 0 non movers. The top 20 largest cash merger arbitrage spreads as defined by declined by 0.94% and the standard deviation of returns was 1.30%, much higher than the 3 month and long term averages. The negative performance of the portfolio was attributed to the numerous large declines of spreads mainly in line with the broader market but also some stock specific reasons.

The portfolio of cash spreads widened during the week. The top 20 discount spreads now offer an average of 3.86%. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. The return figure is more broadly based than ever as spreads have declined across the board.

Merger Arbitrage Strategy

Positive portfolio performance going forward has a greater diversity than in previous months. Investors have a number of option to choose from for a healthy return. There have also been some new deal announcements. The portfolio is no longer as reliant on a small number of spreads such as PACB as noted in a previous article.

We have extensively 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 during the last two weeks has presented these opportunities. We have substantially increased our long positions during the week to take advantage of this weakness.

The spreads on our top 20 list (available from the Merger Arbitrage Limited website) have risen up to surpass the level of return available for simply holding cash, circa 2.40% pa. This should entice more bargain hunters into the merger arbitrage space. For a deal to close early, as we expect RHT and LXFT to do, an attractive return is possible. We discuss deal closing schedules in a previous article. We maintain our positive outlook for the profitability of merger arbitrage despite this week's pullback. The additional volatility provides a number of opportunities not seen in this strategy space for some time.

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, PACB, MLNX, ONCE. 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.