Disclosure: I am/we are long BHI, ODP, OWW, BF.A, ALTR.
Summary
- 5 merger stocks returning between 5% and 34%.
- Annualized returns up to 75%.
- Risk/reward favorable in all five spreads.
What do Baker Hughes (NYSE:BHI), Brown-Forman (NYSE:BF.B), Office Depot (NASDAQ:ODP), Altera (NASDAQ:ALTR), and Orbitz (NYSE:OWW) have in common? They all offer oversized returns, and except for Brown-Forman they all are in the midst of being acquired.
The spreads are wide and they could get wider. But in the end as long as the mergers close, the trades will be profitable.
Of the five, two are cash deals, two are a mix of cash and stock and one isn't actually a merger but a dual share class.
The Big Five
Altera
Intel (NASDAQ:INTC) sealed a deal to buy Altera on June 1. Intel paid $54 in cash for Altera, a price some analysts thought was pretty high. Altera traded in the 51s the first month or so, but has come down to $49 due to potential antitrust risk and/or China slowdown concerns. Last year Altera reported more than 30% of its revenues came from China. The spread is only a few cents off its widest level since deal announcement. Finding 10% spreads on high quality deals isn't easy. Professionals who trade merger arbitrage stocks are taking advantage of this opportunity. 14 of the funds that employ the merger arbitrage strategy that I track have at least 1% of their portfolios in Altera.
Baker Hughes
Nine months ago the number two and three players in the oil service industry agreed to merge with Halliburton (NYSE:HAL) buying Baker Hughes for a 41% premium to BHI's stock price before HAL's initial offer. The current spread is attractive but is off its high. The transaction was agreed upon early on in oil's decline. That decline continues today with WTI Crude Oil trading at $42.50 down from $107.20 14 months ago. Oil's plunge has helped keep the deal spread wide as sentiment for anything oil has turned ultra bearish.
In addition, there have been reports that the merger could be delayed because of the complexities of the required divestitures. The companies continue to work with the DOJ. When I wrote about the merger less than two month ago I included the following quote from Halliburton's Chief Integration Officer, Mark McCollum:
Regardless of market conditions we continue to target annual pre-tax cost synergies of nearly $2 billion. As we evaluate this transaction and move toward completion, we are confident that we can achieve our synergy objective.
As with Altera, BHI is a favorite of hedge funds that concentrate on merger stocks.
Brown-Forman
There is no merger deal but there is a spread. Brown-Forman is one of the securities that have a dual-class share structure. The class B shares have the liquidity, while the class A shares have the voting rights and are controlled by the Brown family. According to company bylaws, the A and B shares are entitled to the same economics in terms of earnings, dividends and consideration in the event of a change of control. Yet the two classes trade with an almost 8% spread. The details of why this spread exists can be found in two excellent articles on Seeking Alpha, here and here. In short, the probable reason for the class A move was the inclusion of the A shares in the Russell indexes in late June, with the indexes forced to buy shares of the relatively illiquid class A shares.
Brown-Forman A vs. B
| BF.A | 39K daily volume | $117.30 | |
| BF.B | 513K daily volume | $108.50 | 7.6% discount |
The company has an ongoing buyback in which they can buy back either share class. It would make sense to buy the cheaper B shares and it is likely that that's what they have been doing and will continue to do. The spread has tightened a bit from its high of 14% two months ago but still has plenty of room to collapse to parity where it was just four-plus months ago.
BF.B data by YCharts
Office Depot
Let me pose a question. Is there a world and an internet or is the internet just part of the world? Staples (NASDAQ:SPLS) is attempting to buy rival Office Depot and the market is very worried that the Federal Trade Commission may vote to block it. But there's no internet AND the world. It is one. And Amazon as well as hundreds of other online retailers compete with Staples and Office Depot. Every year the online retailers grow share.
So why can an investor buy ODP today and short SPLS and earn almost 34% as long as the deal closes?
- 18 years ago Staples tried to buy Office Depot, but the FTC blocked the deal and won in court. Some investors still remember.
- Terminated Sysco deal: In late June, a federal judge granted the FTC's request for an injunction on antitrust grounds. Days later Sysco cancelled the transaction. Some market participants compared Sysco/US foods with Staples/ODP.
I don't buy either argument. Number one is buying number two. There will be divestitures. But the spread is huge, has widened out and presents a favorable risk/reward. The stock is back to where it was trading before the merger announcement. Starboard Value's recently reported 13-F shows ODP as its 2nd largest position. Good company for longs to be in.
Orbitz
Orbitz/Expedia (NASDAQ:EXPE) is similar to Staples/Office Depot. The combination would boast a huge percent of the online travel space. But how do we define the travel space? Isn't offline travel still travel? And all the offline travel players offer online as well. And two little companies, Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOGL) (NASDAQ:GOOG) are entering the space.
The spread had been more than a dollar until the New York Post reported two weeks ago that the deal would be cleared by the DOJ. Now the return has slipped to around 5%, but annualized it is about 22% since the closing (if approved) is anticipated to be in the October time frame.
Conclusion
It isn't called risk-arbitrage for nothing. If there was no risk there wouldn't be much potential reward. The above five stocks represent a favorable risk/reward in my opinion. Three of the five spreads have closed somewhat while the other two are at or close to their widest. But it wasn't long ago that Lorillard (NYSE:LO), and DirecTV (NASDAQ:DTV) were offering double-digit spreads to anyone interested.
Additional disclosure: I rounded the percentage returns.
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