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.
Pacific Biosciences of California (PACB)
Pacific Biosciences of California (NASDAQ:PACB) continued its impressive comeback during the week. The stock was the week's best performer and finished up an additional 4.60% at $5.68. PACB released a solid set of figures during the week. This is significant despite being in the middle of a takeover as it reinforces the floor price. This is the price to which the stock will revert to should the deal fail. Alternatively, this is the price the stock would have been trading at had no takeover approach ever materialized. For simplicity, we will not discuss the effect of exiting arbs and the supply imbalance following the abandonment of a deal.
However, more importantly was the reiteration by PACB during the announcement of their earnings that both,
"The Company and Illumina (ILMN) expect the Merger to be completed in the fourth quarter of 2019"
This statement comes despite the merger currently being under review by both the FTC and the CMA. We are of course pleased with the recovery in this stock. We maintain our position and will do so until further increases of additional news is released.
Red Robin Gourmet Burgers (RRGB)
Red Robin made a strong recovery from last week's disappointing performance. The stock was this week's best performer. The stock was the only other significant performer for the week and finished up 2.68% at $33.75. This still leaves a spread of 18.52% against an offer of $40 per share from Vintage Capital. Having announced the appointment of three new directors to the board the company ended the announcement with,
"We are confident their experience and expertise will be valuable assets to Red Robin as we execute on our strategic priorities and continue the Board's efforts to create value for our shareholders."
In addition to this, there was a number of Form 3 & 4 filings made during the week. This indicates changes and initiations of holding in the stock. We maintain our position in this stock and await further deal announcements.
Acacia Communications (ACIA)
Acacia Communications (NASDAQ:ACIA) was by far the worst performer this week decreasing in price by 4.64%. At $63.56, the spread is now 12.73% against an offer price of $70 from Cisco (CSCO). Despite a positive earnings beat during the week, the stock declined sharply. The company also announced the date of the special meeting to vote on the proposed takeover as Friday, September 6, 2019. On the negative side, however was a filing of a complaint claiming misleading information in the proxy statement. Although more seriously was the line given in the proxy statement,
"the receipt of certain applicable foreign antitrust approvals, including in Austria, China and Germany"
In light of the reigniting of the US-China trade dispute, we suspect regulatory approval may take longer than first realized. Subsequently the stock has reacted accordingly. As previously stated, we took a position in this stock. Although this may appear to have been a little premature, we are still happy to maintain our position for the time being.
Mellanox again took a tumble during the week. The stock was the second worst performer and finished down 3.47% at $107.58. The spread is now 16.19%. It appears that the $125 offer from NVIDIA (NVDA), like ACIA, has also been caught up in the throes of the latest US-China trade dispute. We maintain our position here and will await further clarification in the global trade arena.
Merger Arbitrage & Market Data
TThe broader market continued with another volatile week following the retaliatory actions from China in the ongoing trade dispute. Markets did however take comfort from the suggestion that the currency devaluation would not be an ongoing feature. In addition, earnings season will start to wind down following broadly bullish results and a resilient domestic labor market. The S&P 500 ETF (NYSEARCA:SPY) finished down 0.35% for the week.
The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) was almost unchanged. By Friday, the MNA ETF was unchanged. (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 10 advances and 8 declines this week with 2 non-movers. The top 20 largest cash merger arbitrage spreads as defined by MergerArbitrageLimited.com declined by 0.10% and the standard deviation of returns was 1.81%. This is above the 3-month and long-term averages. The heightened StDev of returns was caused by the disparity in returns from PACB and ACIA.
The top 20 discount spreads now offer an average of 6.76% 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 becoming less reliant on a handful of spreads as observed recently. This is signified by the narrowing of the PACB spread whilst other spreads have widened.
Merger Arbitrage Strategy
We suggested last week that deals with a low Deal Closing Probability (DCP) would be subject to greater volatility following movements in the broader market. We also stated market movement would be inevitable once Chinese retaliation is implemented. This has been the case during the last week as deals with the largest spreads fluctuated wildly. Especially those with Chinese connections or requiring Chinese regulatory approval.
We expect the situation to settle down for the time being as the recent posturing is digested by both sides. However, as a result of the economic and trade dispute merger arbitrage has become caught up on the crossfire. Over the medium term, these issues should play themselves out. Despite shorter-term fluctuations, money can still be made in merger arbitrage assuming the deals close of course. We broadly expect this to be the case and do not, at this stage, believe US-China relations will deteriorate so far as to block all merger and acquisition proposals en mass.
Without any significant new deals coming into play, profitable opportunities (for the risk concerned) are becoming harder to locate. At this point, we caution new market participants to thoroughly do their research before entering a position. Although we maintain a positive outlook for the profitability of merger arbitrage, we are cautious about the overall profitability being affected by a single economic driver.
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, RRGB, ACIA. 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.