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Merger Arbitrage Analysis And Spread Performance - August 18, 2019

by: Malcolm Spink, CFA

Pacific Biosciences of California continues to recover lost ground.

Red Robin Gourmet Burgers declines on lack of deal progress.

Cash merger arbitrage spreads remain stable in an volatile week.

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 had one of its more volatile weeks last week. The stock started brightly but on Tuesday took a nosedive. PACB then recovered throughout the rest of the week to close up 1.41% at $5.76. There was no new deal news announced. However, PACB did announce via the blog section on their website a new preprint that evaluates the "utility of PacBio HiFi reads for assembly of a human genome". The article in question is entitled “Improved assembly and variant detection of a haploid human genome using single-molecule, high-fidelity long reads”. For a more comprehensive analysis of this topic, readers are directed to the Genetic Engineering & Biotechnology News website. The study is a follow-up to a recent publication in Nature Biotechnology that introduced a technique to generate sequencing reads with both long read length and high accuracy.

The distinction between long and short reads forms the crux of the CMA investigation announced some weeks earlier. This is a new report and it is difficult to judge how the regulatory authorities will interpret these technological advancements in the marketplace. This highlights one of the major issues in merger arbitrage research. The trader has to very quickly become familiar with a wide range of topics in order to gauge the attractiveness of the deal. In addition to this, such an announcement should have a positive effect on the floor price of the target stock. That is, should the deal fail, the ensuing drop may not be quite as severe as it would have been otherwise. This is sufficient to give us some renewed confidence in this deal.

Hence, we maintain our previous advice with this stock. The PACB merger has benefited us well. We have no regrets not adding to our position at lower levels because of the risk involved. Should the stock move higher in the coming weeks we will reinitiate our active arbitrage strategy. In the meantime, the simple spread has narrowed to 38.89% against an $8.00 offer price from Illumina (ILMN).

Cypress Semiconductor (CY)

Cypress semiconductor continued its march upwards during the week. The stock closed 1.23% higher with the spread now standing at 4.83% against an offer price of $23.85 from Infineon (OTCQX:IFNNY). There was little news announced during the week other than an amendment to the Definitive Proxy Statement. We maintain our position here and will await further clarification in the global trade arena.

Red Robin Gourmet Burgers (RRGB)

Red Robin had a horrendous week before it release of Q2 figures next Friday. The stock closed down for the week by 6.34% at $31.61 against an offer of $40 per share from Vintage Capital. This was despite a strong recovery on Friday when the stock rebounded 4.32%. From out T20 universe this was the only decliner of note from amongst six that were in the red this past week. There was no new deal news announced which we found strange. Assuming nothing has been leaked regarding the proposed deal we think this could be related to the changes made to the Board of Directors as announced last week. We are disappointed with the performance of this spread thus far but we maintain our position until further news is made available.

Merger Arbitrage & Market Data

The broader market continued with another volatile week following negative economic data from both China and Germany. This has caused many to fear the economic slowdown could lead to a full-blown recession. However, positive productivity data from the U.S. and robust retail sales data has helped calm those fears. This can be seen by the recovery in the broader market on Friday. The S&P 500 ETF (NYSEARCA:SPY) finished down 0.96% for the week.

The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) was almost unchanged. By Friday, the MNA ETF was up by 0.03%. (You can read our analysis of the MNA ETF in the "Strategy" section at the MergerArbitrageLimited website).

Merger Arbitrage Returns August 18, 2019

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 14 advances and 6 declines this week with 0 non-movers. The top 20 largest cash merger arbitrage spreads as defined by declined by 0.08% and the standard deviation of returns was 1.55%. This is above the long-term average but slightly below the figures recorded in recent times. The elevated StDev of returns was caused by the outsized decline in RRGB.

The top 20 discount spreads now offer an average of 6.80% due to the aforementioned decline made during the week. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. The potential portfolio (available from the Merger Arbitrage Limited website) return is becoming dominated by the six largest spreads. This is signified by the narrowing of the PACB spread whilst other spreads have widened.

Merger Arbitrage Strategy

We have previously suggested

deals with a low Deal Closing Probability (DCP) would be subject to greater volatility following movements in the broader market.

We believe in times of market volatility it is important to reiterate this fact. Chinese retaliation in the on-going trade war has begun but once again we now enter the "cooling" period as both sides look for an amicable solution. However, this time, weaker Chinese economic data may force their hand especially as the U.S. economy continues to move forward powered by the ever-reliable consumer.

This is an increasingly difficult time for merger arbitrage. Deals with small spreads may not be sufficient for some investors despite their proximity to closing. Large movements in the broader markets can cause unacceptable losses in the interim holding period whilst waiting for these deals to close. As mentioned above deals with large DCP's are already subject to greater market movement sensitivity. Deals with a connection to China or require Chinese regulatory approval are in an even higher risk category.

Over the past weeks we have become less bullish on the near term profitability of cash based merger arbitrage. That is not to say we do not think these pending deals will close. Only that the price movement in the short term may cause losses which may not be commensurate with the potential gains. Once again there were no significant new deals that fit our criteria for monitoring. Thus making locating new profitable opportunities more difficult to locate. We caution new market participants to thoroughly do their research before entering a position. Although we maintain a mildly positive outlook for the profitability of merger arbitrage, we are cautious about the effects the global economy is currently having on the broader markets.

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.

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Disclosure: I am/we are long PACB, CY, 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.