Merger Arbitrage Analysis And Spread Performance - September 1, 2019

by: Malcolm Spink, CFA

El Paso Electric rises as customers set a new peak demand for electricity.

Red Robin Gourmet Burgers falls on broker downgrade.

Cash merger arbitrage spreads widen as broader market rises.

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.

El Paso Electric (EE)

El Paso Electric (NYSE:EE) was amongst the largest gainers this week and rose 0.98% to $66.70 against an offer price of $68.25 from Infrastructure Investments Fund. For the second time in a few week's customers set a new peak demand for electricity. Good news such as this helps underpin the floor price in the event of a deal break. We spoke previous about this spread. The additional regulatory issues concerning a utility stock lead to an extended closing timeline, in this case the middle of next year. With early closing, the annualized spread is an investment possibility, however we shall continue to review and bide our time.

WABCO Holdings (WBC)

WABCO was another gainer of note this week. This competes a rare trio of less volatile stocks filling the top three places. WBC gained 0.82% to $133.51 against an offer price of $136.50 from ZF Friedrichshafen. What made this rise important for us is that we top a position early on in the week at $132.50. We took a small position in anticipation of the DOJ review. A suspect early closing in this deal may provide a profitable opportunity. The stock may also have benefited from a slowdown in the drop of Chinese auto sales.

Red Robin Gourmet Burgers (RRGB)

Red Robin Gourmet Burgers (NASDAQ:RRGB) continued its rollercoaster ride this week. The stock finished down $1.41 or 4.04% at $33.49 against an offer of $40 per share from Vintage Capital. This leaves a spread of $6.51. On Tuesday, Bank of America Merrill Lynch lowered their rating to underperform from neutral. This sent the stock down over 2% although there was no mention of the proposed takeover was made. Investors are clearly concerned about the future of the company if it remains in the public domain. One would assume this negativity surrounding the business outlook might spur RRGB management into active dialogue with Vintage Capital. Investors may of course be remembering the shareholder rights plan (poison pill) adopted on June 5.

Spark Therapeutics (ONCE)

Spark Therapeutics had a terrible week hitting new lows since the takeover announcement. The stock closed down another 3.35% at $97.41 this is against an offer price of $114.50 from Roche (OTCQX:RHHBY). Other than announcing a change of venue for the AGM, there was no other news. Once again, we will be waiting for a decision from the regulatory authorities regarding this deal. We maintain our position.

Pacific Biosciences of California (PACB)

Pacific Biosciences of California (NASDAQ:PACB) is never far from the action. The stock was the third worst performer this week. It finished down 1.07% at $5.55 against an $8.00 offer price from Illumina (ILMN). There was no new deal news announced although there was "General statement of acquisition of beneficial ownership" filing. The current volatility of this stock would be playing well into our previous active arbitrage strategy. However, we have enforced strictly discipline in this instance. We maintain our long position.

Merger Arbitrage & Market Data

The broader market rebounded this week following last week's sell-off. Optimism returned as investors considered the possibility of further tariff hikes might be avoided. Domestic U.S. economic news showed consumer spending rose by 4.7% in the second quarter. The U.S. consumer accounts for more than two thirds of the overall economy. The S&P 500 ETF (NYSEARCA:SPY) finished up 2.66% for the week.

The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) also had an impressive week. By Friday, the MNA ETF was up 0.44%. (You can read our analysis of the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).

Merger Arbitrage Returns August 30, 2019

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 13 advances and 7 declines this week with 0 non-movers. The top 20 largest cash merger arbitrage spreads as defined by declined by 0.16% and the standard deviation of returns was 1.34%. 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 RRGB and PACB but partly offset by a larger number of smaller gainers.

The top 20 discount spreads now offer an average of 6.96% 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 simple spread to more than 44%.

Merger Arbitrage Strategy

Last week we spoke at length about how an escalation in the trade war will effect merger arbitrage. We suggested that volatility in deal spreads will continue and that it is likely the situation will get worse before things improve. However, the U.S. remains in a strong position with the economy underpinned by the robustness of the U.S. consumer.

With so much at stake and so many crucial decisions to be made we aim to maximize and profit from market volatility whilst it continues. We have previously demonstrated with PACB how an active arbitrage strategy can increase profits and reduce risk. Going forward we anticipate identifying and including more volatile stocks in this category. Those with Chinese connections or requiring Chinese approval are obvious candidates. It is important however not to become too heavily weighted in any one market segment or risk factor.

Once again, this week saw no significant new deals that fit our criteria for monitoring. We are becoming increasingly less optimistic on the near term profitability of straightforward cash based merger arbitrage. The continuing trade war and the wider implications of BREXIT seem to be having an effect of the level of larger public company cash acquisitions. This is causing us to be more cautious and we will seek further clarification in this arena before revising this view.

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, WBC, ONCE, 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.