Merger Arbitrage Analysis And Spread Performance - August 4, 2019

by: Malcolm Spink, CFA

Pacific Biosciences rises following comment from Illumina.

Red Robin Gourmet Burgers declines on lack of deal progress.

Cash merger arbitrage spreads marginally narrow as broader market declines sharply.

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. We also give a brief analysis and insight into our current approach to merger arbitrage investing.

Pacific Biosciences of California (PACB)

Pacific Biosciences of California staged a comeback during the week. At first glance, it would appear bargain hunters stepping in as no news was immediately apparent. However, on closer inspection Illumina reiterated their expectation of Q4 closing in the latest filing following the announcement of their own earnings. This helped the stock close up $0.19 or 3.63% for the week at $5.43. The spread remains wide at 47.33%. Illumina (ILMN) have previously offered $8 a share. Although the closing date may be difficult to judge, Illumina have stated that they expect an FTC decision before the CMA of the UK that also added a tiny bit more clarity to the expected proceedings.

Also in the news was a report of Syquant Capital Sas, which had increased its position in PACB by 216,101 shares during the previous quarter. We have temporarily halted our active arbitrage strategy but continue to maintain our position whilst awaiting further news.

Spark Therapeutics (ONCE)

Spark Therapeutics was the second largest gainer this week up 3.52% at $101.53. The big announcement made during the week was the extension of the tender offer until September 3. Clearly, the market does not realistically expected the deal to have cleared the necessary regulatory hurdles by that time. However, it does reaffirm Roche's (OTCQX:RHHBY) intent to stick with the deal. This rebound brings to an end a series of weekly declines. Without further news available, we maintain our small position.

Array BioPharma (ARRY)

TO round up the major winners this week we will add a quick note about ARRY. The offer from Pfizer (PFE) of $48 per share closed during the week way ahead of schedule. This produced a handsome profit for our position initiated only two week prior. This once again shows the importance of deal closing schedules and maximizing the potential annualized return by recycling capital more frequently. Congratulations to all who also jumped aboard whilst the opportunity existed.

Red Robin Gourmet Burgers (RRGB)

Red Robin was this week's worst performer and despite a rebound on Friday still finished the week down 5.15% at $32.87. This leaves the spread at 21.69% against an offer price of $40 from Vintage Capital. This deal is still non-binding although the parties involved have admitted to having constructive conversation. However, a poison pill does remain in effect. Vintage capital already own a sizable stake in RRGB. We suspect traders maybe doubting the true motive of Vintage Capitals proposal. It is a possibility that they intend to flush out a rival bidder to whom they can sell their stake. As things stand this deal is much more speculative than most and we feel the wide spread is justified. However, we have already taken a small positon and await further developments.

Mellanox (MLNX)

The recovery of Mellanox stalled during the week as the stock tumbled 2.03% and gave up most of the positive returns recently achieved. This leaves the spread at 12.23% against an offer price of $125 from NVIDIA (NVDA). The reigniting of the US-China trade dispute continues to negatively affect this deal. As stated before, we expected this volatility to continue until things are resolved between the two trading partners but we have no yet instigated an active arbitrage strategy. We currently maintain our position.

Merger Arbitrage & Market Data

The broader market declined sharply during the week. As forecasted interest rates were lowered but this appears to have troubled the markets despite a firm labor market. The S&P 500 ETF (NYSEARCA:SPY) finished down 3.11% for the week.

The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) was almost indifferent to the broader market. By Friday, the MNA ETF was down just 0.09%, breaking a four week winning streak. (You can read our analysis of the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).

Merger Arbitrage Returns August 2, 2019

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 11 advances and 6 declines this week with 3 non-movers. The top 20 largest cash merger arbitrage spreads as defined by improved by 0.25% and the standard deviation of returns was 1.84%. This is above the levels experienced over the 3-month medium term average and longer term average. The performance of the portfolio was attributed in large part to the increases in PACB, ONCE and ARRY.

The top 20 discount spreads still offer an average of 6.62% despite the aforementioned increases in the above stocks. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. Even with the advances made during the week have left the portfolio (available from the Merger Arbitrage Limited website) still relies on the top four stock providing over 70% of the average expected return.

Merger Arbitrage Strategy

The previous week saw a great deal of economic news make the headlines. Interest rates were lowered as expected. At these low levels we do not see these decisions having a direct effect. However, we shall revisit this point in the future as and when required. The effect on the broader market however is substantial and this in turn effects merger arbitrage spreads (an indirect effect) especially those with a low Deal Closing Probability (DCP). The economic data gave conflicting signals as the labor market remained robust which in turn reinforces faith in high consumer spending. This is despite a slowing of the global economy and hence the need to lower rates.

All this in a week when the President caught markets off guard by announcing the latest tariffs on Chinese imports. Naturally, deals requiring Chinese regulatory approval were affected. If this course of action is part of the president's reelection plan then one would expect the president to have an end game in which he can claim a victory. However, we are yet to learn of Chinese retaliation to this action. In the meantime, the volatility in the markets should help us identify opportunities in the merger arbitrage space.

We are currently researching the possibility of using active arbitrage with MLNX in the same way we have performed well with PACB. (Despite the recent decline, the strategy remains valid). With fewer new deals making it into the investable space and existing returns being dominated by a handful of spreads, it seems wise to expand our horizons and strategy implementation.

We maintain a mildly positive outlook for the profitability of merger arbitrage but we will be paying close attention to the political scene and corporate announcements made during the coming week.

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, ACIA, MLNX, RRGB. 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.