Merger Arbitrage Analysis And Spread Performance - March 1, 2020

Summary

• Red Robin Gourmet Burgers suffers a major setback as results disappoint.
• Mellanox gets caught up in negative sentiment as arbitrage spread widens.
• Average all-cash merger arbitrage spreads widen significantly in volatile trading 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.

Red Robin Gourmet Burgers (RRGB)

Red Robin suffered the worst decline in its history last week as a set of less than impressive results were announced. Despite management's attempt to present the numbers in a positive light, the figures were well short of analysts' expectations. This led to two consecutive days where the stock was crushed by more than 10% each time. By Friday, RRGB had closed down for the week by $9.19 at $27.50 against an offer price of $40 from Vintage Capital, a fall of 25.05%, leaving the simple spread at 45.45%. This closing level was almost $2 above the low of the week. A rebound fueled by the announcement that Vintage Capital had nominated 4 directors for election to the board. The date of which is yet to be announced. In response to the nominations, RRGB management reaffirmed their commitment to the strategic plan and long-term success of the company and implemented a share buyback program, all whilst continuing dialogue with Vintage.

Data by YCharts

Going forward, we continue with our active arbitrage strategy and exploit this unprecedented level of volatility. We clearly stated how we had reduced our position as the stock rose, thus protecting us from significant losses during this recent fall. Although we bought back a large amount of stock at higher levels, we were still able to benefit from the lower levels on Wednesday and subsequently started selling again by Friday for a profit. We shall continue with our strategy for the immediate future.

Mellanox (MLNX)

MLNX was also a poor performer this week, reversing some previous significant gains. The stock had moved higher following Nvidia's (NVDA) strong results but has retreated on news of the refiling with the SAMR following the expiration of the 180-day review period. As the discussions with Chinese regulators are still "progressing," it may be speculated that the disease outbreak may cause some kind of delay. With the spread having been so tight, it would appear prudent that some traders would take profits instead of hoping for a higher bid from Nvidia in light of recent company performance. The stock gained an additional $3.20 to $119.42 against an offer price of $125 from Nvidia. This gives a simple spread of 4.67%. We no longer have a position in this stock, although we shall monitor this spread closely for possible re-entry.

Craft Brew Alliance (BREW)

Despite overwhelming shareholder support of the deal with AB-InBev (BUD), as demonstrated by 98% of stockholders (including a majority of the outstanding shares held by investors other than A-B or its affiliates) voting in favor of the deal at the recent extraordinary meeting held during the week, Craft Brew Alliance still managed to post a significant decline. By Friday's close the stock was down $0.28 at $15.91 against an offer of $16.50 from AB-InBev, a fall of 1.73%. However, without any update to the request from the DOJ for additional information in relation to the merger and an expected completion update simply given as "the transaction is expected to close in 2020," traders in such a volatile market seemed happy to exit their positions.

Merger Arbitrage and Market Data

The broader market took a beating this week as traders opened up to the possibility of a significant effect to the global economy caused by the coronavirus outbreak. The markets should learn this week whether or not the Fed will respond to President Trump's criticism and inject additional liquidity into the domestic economy. The continued spread of the virus has caused the first 10% correction in the broader market since 2018. By the close on Friday, the S&P 500 ETF (SPY) finished down 11.16%.

The IQ ARB Merger Arbitrage ETF (MNA), however, started the week in a robust manner in part due to the unique hedging strategy that the ETF employs. It was still in positive territory at one point during Wednesday's session. (You can read our analysis of advantages and disadvantages of investing with the MNA ETF in the "Merger Arbitrage Strategy" section at the Merger Arbitrage Limited website). However, the ETF finally succumbed to a drop on Friday brought on by the broader market sell-off. By the end of the week, the MNA was showing a loss of 0.60%.

Merger Arbitrage Portfolio Analysis

U.S. based cash merger arbitrage positions saw 17 declines against 2 advances this week with 1 non-mover. There were no cash positions last week as the index of cash merger arbitrage spreads maintains its full complement of deal constituents. The top 20 largest cash merger arbitrage spreads as defined by MergerArbitrageLimited.com fell by 1.83% and the dispersion of returns was a 5.51%. This is way above the levels experienced by both the 3-month medium-term and long-term averages. The negative performance of the portfolio was in most part attributed to the significant decline in RRGB as discussed above.

The index of cash merger arbitrage spreads now offers an average of 5.39%. This is significantly above last week's figure of 2.91% and showing a marked reversal to what was a gentle narrowing of the spread. For the coming week, the T20 portfolio has 20 deals and 0 vacant spots filled by cash.

Our recent cautious approach to the profitability of cash only merger arbitrage appears to have been prudent. Spreads have ballooned as the market has declined. However, it should be noted that two-thirds of this week's decline was solely attributable to RRGB. On the one hand, this shows the risk diversifying effects of including a merger arbitrage strategy in a broad portfolio of assets. It also highlights how risk management strategies can improve performance by avoiding an attractive risk/return situations. We have explained in increasing detail how our active arbitrage strategy is designed to benefit from the volatility of a merger arbitrage spread and how as the spread narrows, our positions become significantly reduced. At this point, we suggest traders consider how various global scenarios brought on by the spread of the coronavirus may effect the performance of individual spreads. Questions to be asked may include

• will regulatory approvals be delayed?
• will a global slowdown force acquirers to reconsider consummating the deal?
• how does the lowering of the floor price effect the risk/reward profile of the spread?

We shall explore these issues in greater detail over the coming weeks.

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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Analyst’s Disclosure: I am/we are long 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.