- Apollo should finalise the acquisition of Tech Data within around one month.
- The market is pricing in an 86% probability of the deal closing.
- 3.6% potential upside for shareholders.
M&A Spreads Have Narrowed but Remain Attractive
If you’ve been following the flurry of merger arbitrage notes I have put out since March 22, then you may be curious to see how our scorecard is shaping up.
Whilst there has been a narrowing of spreads since the period of dislocation in mid-March, spreads still remain moderately attractive, particularly for complex or risky deals.
Prior to the onset of the coronavirus pandemic, Tech Data Corp. (NASDAQ:TECD) traded at a narrow 1% spread to Apollo Investment’s (AINV) offer price of $145. Apollo originally bid $4.77 billion ($130 per share) but was out-bid by Berkshire Hathaway (BRK.A, BRK.B), before sweetening the offer to $5.14 billion ($145 per share) on November 13, 2019.
As the virus began to spread, financial markets plunged and the gross spread on TECD blew out during mid- to a peak on March 18. The gross spread has since narrowed to 3.6%, which some observers may regard as unexciting. However, it is important to consider that with the passage of time, there is a "pull to par" effect with announced merger deals. There is likely only one month left until closure, and the financing has been firmly committed by a consortium of financial institutions. Moreover, Tech Data is performing well as a business.
What Does Tech Data Do?
Tech Data Corporation is an IT distribution and solutions business. The company distributes products from technology vendors and sells through a range of channels. Its customers comprise resellers, direct marketers, retailers and managed service providers. The bulk of its revenue is derived from Europe (52%), followed by the United States (40%). Margins are slim in the IT distribution world, but the business is highly cash-generative, producing $545 million in free cash flow in the financial year ending January 2020.
Risk-Reward is Favourable
The original bid by Apollo was $130 per share. Berkshire Hathaway then put out an offer for $140 before Apollo bumped its original offer to $145 to secure the deal. There is no clearly no guarantee that Berkshire Hathaway would step in and acquire the company should Apollo manage to pull out of the deal, but the fact that Berkshire is an interested party provides some degree of comfort that the overall level of downside should be contained. As an aside, it took Berkshire all of one day to submit its offer after meeting with management of Tech Data. Clearly, there was high degree of confidence in the quality of management and the future potential prospects of the business.
Berkshire may not the only interested party. In January, CVC acquired ConvergeOne, a distributor of networking and collaboration products for $1.8 billion, underscoring the attractions of seasoned distribution businesses with strong end-markets.
The following equations lay out the calculation of upside, downside and probability of success in the merger situation. To calculate the downside price, I am using the unaffected share price prior to the original bid, which was $104. COVID-19 will have an impact on the business during 2020 and consensus earnings estimated have retracted by around 30%. However, the terminal value of the business is less impacted, and high-quality businesses with lower gearing are being well bid in the current market environment, particularly given the decline in base rates.
Upside = acquisition price – current share price + dividends
= 145.00 – 139.21
Downside = current share price – unaffected share price
= 139.21 – 104.00
From these figures, we can derive the market-implied probability of success:
Probability of Success = Downside / (Upside + Downside)
= 35.21 / (5.79 + 35.21)
There are many reasons why a deal can fall apart, so let us analyse such possibilities for Tech Data / Apollo:
Shareholders vote against the deal
Shareholders have already voted in favour of the deal, so there is zero risk of non-approval.
Apollo pulls out
The two largest players in the IT distribution sector are Tech Data and Ingram Micro. Ingram was acquired by HNA Group in December 2016 for an equity value of $6 billion. Apollo then tried to buy Ingram in 2018, as HNA was seeking to de-lever, but the two parties could not agree on a price. Fast forward another two years and Apollo is buying Tech Data for a 15% discount to the price paid for Ingram for a more profitable business, albeit with a lower revenue base.
Op income (2018)
Apollo would also face a termination fee of $316 million if it withdraws from the deal and is found to be in breach of its obligations as set out in the merger agreement.
Whilst "pandemic" is not explicitly carved out of the Material Adverse Clause section of the purchase agreement, there is a reference to "national emergency or other similar events". Ideally, one would wish to see explicit reference to a pandemic or epidemic. If the coronavirus is construed as a national emergency, Apollo would have to prove in a court of law that the virus has had a disproportionate impact on Tech Data’s operating performance relative to peers if it sought to renege on the deal. This would be challenging to prove, and there is no force majeure clause in the agreement that provides for an exit due to "unforeseeable circumstances".
Regulators block deal
Again, this is highly unlikely, particularly given the acquirer is a financial sponsor.
Financing falls through
A consortium of financial institutions has committed to providing debt financing of up to $5 billion. Moreover, the consummation of the merger is not subject to a financing condition. There is limited stress across the US banking sector and no reports of any major financial institution facing stress or solvency issues. As such, it is highly unlikely that the financing will be pulled.
Tech Data carries a relatively narrow spread, but it is far wider than the discount the shares offered before the onset of the coronavirus pandemic. Ultimately, I believe the probability of the deal closing is higher than the implied probability assigned by the market.
This article was written by
Analyst’s Disclosure: I am/we are long TECD. 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.
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