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.
Cypress Semiconductor (CY) is proving to be a dark horse within the portfolio. Last week it was the best performer and finished up 0.81% at $22.24. The stock went ex-dividend during the week paying $0.11. The spread is now 8.23%. That's a $1.61 discount to the $23.85 offer price from Infineon (OTCQX:IFNNY). There was little news during the week other than a flurry of filings clarifying the status of employee stock options and a statement in change of beneficial ownership. However, the previous week saw Infineon raise 1.5bn Euros to help fund the cost of the acquisition. Although this is another semiconductor, we have taken a position in this spread. We are looking for early closing for this investment to be worthwhile. Currently, the official expected closing date is early in the New Year.
Cray Inc. (CRAY) was the only other gainer of note during the past week. The stock rose $0.20 to $34.82 up 0.58%. The spread is now 0.52% against an offer price of $35.00 from Hewlett Packard (HPE). According to the original press statement:
"the transaction is expected to close by the first quarter of HPE’s fiscal year 2020, subject to regulatory approvals and other customary closing conditions."
As a guide, Hewlett Packard announced Q1 earnings for 2019 on February 21, 2019 for the three months ending January 2019. With such a small spread, it appears the company is well on track to achieve this. We have no position.
Pacific Biosciences of California
Pacific Biosciences of California (PACB) continued its downward trend during the week. On Tuesday, the company informed the CMA of the UK that it would not be offering any undertakings that would prevent or delay the referral of the deal to a phase 2 investigation. The stock continued its decline until hitting a low of $5.81 on Thursday. Following the notification on that day that the deal was to be referred, the stock rallied. It closed at $6.05 but still down 2.89% for the week, making it the largest decliner from the Top20 cash spreads.
We believe this deal finally has some clarity. It may make sense for Illumina (ILMN) and PACB not to have responded immediately. This gives more time to formulate and present a clearer argument later on in the investigation. Initially, we expect little stock price movement as news flow is expected to be slow. Further out, we expect volatility to increase and assist our active arbitrage strategy. Our previous analysis of not adding to our position until further clarity has served us well. We shall now look to add to the position on weakness and continue the strategy as before.
Spark Therapeutics (ONCE) was the second largest decliner this week, losing 2.56% to $102.38. There was no mainstream news for this decline, but it does follow last week's recovery. We suspect traders have taken this opportunity to exit this deal and go elsewhere. A simultaneous investigation by the FTC and the CMA (again) have caused investors to look again at the potential downside of the deal. The stock was trading at around $50 a share before any deal talk began. However, we maintain our small position until further news is available.
WageWorks, Barnes & Noble & Sotheby's
Three deals that have not previously made our list are WageWorks (WAGE), Barnes & Noble (BKS) and Sotheby's (BID). They have all been trading over the initial offer price in anticipation of a higher bid. This was confirmed for WAGE with a new higher offer of $51.35. This has proved an expensive gamble for some as the stock previously rose above $53. The stock was down 2.03% for the week. We have previously warned against such speculation. This is a strategy for seasoned market players. However, as demonstrated, some of these professionals have lost some of their investment in this situation. We took a small short position previously and we considered ourselves fortunate to be able to exit at a small profit. This highlights the perils involved in these situations. However, now that the deal is no longer hostile we may look to initiate a position if the stock retreats to the $51.60 level.
The market is also currently expecting higher offers for BKS and BID. However, these stocks finished down 1.62% and 1.34%, respectively, for the week. We have no plans to initiate position in these stocks.
Merger Arbitrage & Market Data
The broader market retreated slightly from the highs last week. However, positive news from the G20 is set to boost the markets in the coming week. It appears progress is being made regarding the ongoing U.S.-China trade war as further talks are scheduled to take place. A shift in central bank policy to help maintain the economic expansion will provide support for equities for the short to medium term. The S&P 500 ETF (NYSEARCA:SPY) finished down 0.34%.
The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) also suffered. By Friday, the MNA ETF was down 0.85%. (You can read our analysis of the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).
Merger Arbitrage Portfolio Analysis
U.S. based cash merger arbitrage positions saw 9 advances and 10 declines this week with 1 non-mover. The top 20 largest cash merger arbitrage spreads as defined by MergerArbitrageLimited.com declined by 0.28% and the standard deviation of returns was 0.93%. This is below the level experienced during the last few weeks but in line with the 3-month and long-term averages. The performance of the portfolio was attributed to the large declines in PACB and ONCE.
The top 20 discount spreads now offer an average of 5.29% due to the aforementioned declines made during the week. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. The portfolio (available from the Merger Arbitrage Limited website) is once again becoming reliant on a handful of spreads for the high average return. This is signified by the widening of the PACB spread to more than 32%.
Merger Arbitrage Strategy
Investors still have a number of attractive options from which to choose, deals which have sufficiently wide spreads but do not have the complications that come with investing in PACB or ONCE. Although no investable new deals (in our opinion) were announced during the week, some have appeared recently that could be attractive. Now that the deal is a friendly one, we are looking to take a position in WageWorks if the stock pulls back. We currently like the look of Cypress Semiconductor which offers an 8.23% spread. Early closing of the Cypress Semiconductor deal could produce a very healthy return. We discuss deal-closing schedules in a separate article.
It is important to remember stocks with a lower deal closing probability may offer larger returns, but that is for a good reason. The average spread is wider than recently but PACB and ONCE increase the risks in our portfolio. It is also important to remember the movement of these stocks are more susceptible to broader market movements. Successful trade talks are by no means a foregone conclusion. We have marginally decreased our long exposure from previous weeks. Difficulties remain with individual spreads, but we maintain our positive outlook for the profitability of merger arbitrage.
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 PACB, ONCE, CY. 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.