Best Idea in the Universe: Mid-Air Merger
Current Favorite: B/E Aerospace Inc. (BEAV)
ArbitrOption’s investable universe includes risk arbitrage and special situation opportunities with three basic characteristics:
- a pending corporate event must be disclosed by the company’s management or Board of Directors (no “rumortrage”)
- the pending corporate event must have a calculable terminal value and timeline
- the company must have exchange-listed options with suitable expiration dates and strike prices
At the time of our initial trade, our option spread on B/E Aerospace was expected to produce returns more than 14 TIMES better than ArbitrOption’s equity-trading peers.
ArbitrOption’s investment process can be broken down to five stages:
- Idea Generation
- Investment Research
- Portfolio Management
1. Idea Generation: Merger at Cruising Altitude
On October 23, 2016, the world’s leading manufacturer of aircraft cabin interior products, B/E Aerospace (BEAV), announced that it had agreed to be acquired by avionics technology firm Rockwell Collins (COL) in a cash-plus-stock deal valued around $62 per share, a 22.5% premium to the previous closing price.
As you can see in the chart of BEAV’s stock price below, the stock moved up following the announcement and has since traded in a tight range around $59.50.
B/E Aerospace: Share price from 10/21/16 to 12/9/16
2. Investment Research: Estimating Ticket Price and Departure Time
Before we can identify the right trade on a deal, we need to forecast terminal values and a completion date. That starts with a review of the deal terms in the press release issued by BEAV (emphasis added):
Under the terms of the agreement, B/E Aerospace shareholders will receive $34.10 per share in cash and a number of Rockwell Collins shares of common stock equal to $27.90, with such number of shares of Rockwell Collins common stock determined based on the volume weighted average closing price of Rockwell Collins common stock for the 20 trading days ending on the day prior to closing (provided that this volume weighted average price is no less than $77.41 and no greater than $89.97 per share). If the volume weighted average price of Rockwell Collins common stock during this period is above $89.97, the stock portion of the consideration will be fixed at 0.3101 shares of Rockwell Collins common stock for each share of B/E Aerospace, and if it is below $77.41 per share, the stock portion of the consideration will be fixed at 0.3604 shares of Rockwell Collins common stock for each share of B/E Aerospace. Upon completion of the transaction, which is expected in the spring of 2017, current B/E Aerospace shareowners will own approximately 20 percent of the combined company.
To summarize, if COL is below $77.41, BEAV shareholders get $34.10 in cash plus 0.36 shares of COL for each BEAV share they own. If COL is between $77.41 and $88.97, BEAV shareholders get the same amount of cash, plus a quantity of shares that are worth $27.90. And if COL is above $88.97, BEAV shareholders will get the same amount of cash, $34.10, plus a smaller number of shares, 0.31. That shifting quantity of COL shares acts as a collar around the deal value, keeping it pretty close to $62 per share. COL closed at $94.37 on December 9th; for every $1 that COL is above $89.97, BEAV shareholders will get cash and COL shares that are worth an extra $0.31 above $62.
The transaction is not conditioned on financing, but COL expects to finance about $3.5 billion with debt, some portion of which has already been committed. To alleviate ratings agencies’ concerns about COL’s coverage ratio, the company has committed to reduce its share buyback program and pay off at least $1.5 billion of its new debt by September 30, 2019.
Conditions of the Deal: The Ticket’s Fine Print
This transaction is interesting because it represents an expansion by COL into a market that is related-to-but-different-from where it has participated, historically. BEAV manufactures products and provides services to support aircraft seating products, food and beverage prep, cabin, lavatory and galley modular systems, oxygen delivery systems, and other similar components. COL, in contrast, manufactures and supports avionics – the electronic equipment in an aircraft – as well as communications, mechanical systems, training and simulation, flight control, and other technical systems.
Since the number of COL shares to be issued is greater than 20% of COL’s current outstanding share count, the merger will have to be approved by both BEAV and COL shareholders. Both companies have extensive international operations, such that antitrust approvals will be needed not just from the United States, but also from the European Commission, Chinese Ministry of Commerce, South Korean Fair Trade Commission, Taiwanese Fair Trade Commission, and Turkish Competition Authority. Because COL and BEAV don’t compete head-to-head, and because the buyers that purchase their products have substantial negotiating power, we don’t see much to be concerned about from an antitrust perspective. This is hardly another Honeywell/GE deal.
One last note regarding regulatory approvals – COL derives a substantial portion of its business from defense contracts. Sections 3.21, 3.22, and 4.21 of the merger agreement represent that BEAV and COL are currently in compliance with the International Traffic in Arms Regulations (ITAR) and National Defense Authorization Act (NDAA). It is interesting that those bodies of law are only mentioned from the perspective of currently being in compliance – the transaction is not conditioned on an approval from the U.S. Department of Defense.
Within the world of merger arbitrage, there’s always the possibility that an agreement could be terminated because the acquirer gets acquired. On November 30th, Bloomberg reported that hedge fund Starboard Value has taken a stake in COL and is pushing to terminate the merger agreement and instead seek a buyer for COL. Because the merger is conditioned on approval by a voting majority, there is a possibility that COL shareholders could block the transaction if they see a better opportunity elsewhere.
Sure, that’s possible, but it’s pretty unlikely…
First, we haven’t seen a 13-D filing from Starboard, which means that their stake in COL is less than 5% of the outstanding shares. Bloomberg’s report indicates that three other “top 25” shareholders are also opposed to the BEAV deal, and the 25th-largest shareholder of BEAV controls less than 1% of the outstanding shares, so the combined portion of shares controlled by holders who don’t like the BEAV merger is probably less than 8% of the total of COL shares outstanding. That’s not enough to get in the way of this transaction.
Second, COL is buying a complementary business and expanding its relationships with aircraft manufacturers at an acceptable price. BEAV grew its income 8% last year and has provided guidance that it expects to grow another 6% this year. COL, in contrast, grew at a slower rate, just 4%. The press release identifies $160 million in synergies, but COL probably breaks even with just half of that. This is not a merger that screams “bad idea”, “arrogance”, or “empire-building.”
Third, the background section of the preliminary S-4 shows that COL already considered a broad range of strategic options, in a formal process spanning early 2015 through the announcement of this deal in October 2016. Suppose that Starboard and its colleagues can and do advocate for COL to terminate the BEAV acquisition (at a cost of $300 million) and restart the strategic exploration; Starboard & Co. could face the possibility that COL fails to find any interested buyers (again). It’s one thing if the merger happened without sufficient exploration of strategic alternatives – but entirely another if the Board of Directors already looked and didn’t find anything.
Our take: This is a transaction with substantial fundamental logic, limited regulatory risk, and tightly defined consideration. Over the past three years, COL shares have traded as low as $72 and as high as $99. The terms of the transaction, including the collar, mean that even if COL should somehow tumble back to $72 a share, BEAV shareholders would still get cash + stock worth $60 a share. To us, this looks like a great example of Benjamin Graham’s margin of safety.
Estimating the Timeline: A Reasonable Layover
BEAV and COL say that they expect to complete the merger in the spring of 2017, and they disclosed on November 22nd that they filed for U.S. antitrust approval on November 7th. No information is available, yet, regarding the status of the non-U.S. antitrust approvals. We expect to see the definitive S-4 toward the end of January (about 60 days after the preliminary S-4 of November 22), and the shareholder vote should happen in late February or early March.
Given the lack of overlap, and the strong negotiating power of BEAV and COL’s customers, there’s not much substance on which an antitrust regulator could base an objection. For example, the U.S. antitrust review expired on or before December 7th without a request for additional information (more on this below). So we’re faced with two very basic questions to estimate the timeline:
- How long will BEAV and COL need to prepare and file their various requests for approval from international antitrust agencies?
- How long will those agencies need to complete their reviews and clear the deal?
Once again, the opacity of foreign approval processes makes it difficult to pinpoint the expected closing date accurately. The roster of non-U.S. approvals and our expectations for each are:
|Europe||Transparent process, probable clearance 30 days after application is filed|
|South Korea||Probable clearance 120 days after notification is filed, possibly less|
|Taiwan||Probable clearance 30 days after application is filed|
|Turkey||Probable clearance 30 days after application is filed|
|China||Probable clearance by the middle of May 2017|
Of all the non-U.S. approvals (Europe, China, South Korea, Taiwan, and Turkey), China is likely to be the gating item, the last one to clear before the deal could be completed. The most recent example we have of a transaction running the Chinese Ministry of Commerce (MOFCOM) gauntlet is St. Jude / Abbot, which was reported to win approval on October 18th, 173 days after the deal had been announced (also about two weeks after the deal’s Phase II had reportedly started, and an unknown number of days after the filing was actually made). If the acquisition of BEAV by COL operates on the same timeline, it will be approved by MOFCOM in mid-April. For purposes of conservative analysis, we’re using the middle of May.
If shareholders vote in favor of the deal in February or March and all regulatory approval processes are done by the end of May, then the transaction will close in the spring, as guided in the initial press release.
Applying the Research: Finding the Right Trade
BEAV’s expected stock price if the merger is completed is at least $62, the sum of the $34.10 cash consideration and the probable value of the stock shareholders will receive – so long as COL’s shares remain above $77.41. The value of the consideration climbs above $62 as COL shares rise above $89.97.
Now we have an expected completion date and an expected terminal value. Based on current option prices, ArbitrOption believes the best investment is a bullish call spread, buying an April 2017 $55 call and selling an April 2017 $60 call. This position will achieve its maximum profit if BEAV is trading at or above $60 when the options expire. In the unlikely event the deal has already been completed by April’s options expiration, the position will achieve its maximum profit if COL is above $71.67. It’s worth noting that this trade is different from our usual approach – instead of betting on a completed deal reaching its terminal value, this is an investment that wins if the pending deal is sufficient to keep BEAV at or above $60.
3. Trading: The Math Behind the BEAV Bullish Call Spread
In each trade, ArbitrOption aims for annualized return greater than 10% and a risk/reward ratio that is superior to that of the stock. In the BEAV trade, the maximum acceptable cost that ArbitrOption could pay for an April 2017 $55 / $60 bullish call spread would be $3.95. That price is found by taking the lesser of a) the maximum cost that would allow a 10% annualized return, or b) the cost that matches the current risk/reward ratio of the stock.
To generate a 10% annualized return, an event that lasts 180 days (the period between the October 23rd announcement and April ‘17 option expiration) would have to produce a 4.93% return. The maximum post-commission cost for this call spread that would still produce a 10% annualized return is $4.77.
- 10% / (365 / 180) = 4.93%
- $5.00 option spread / (1 + 4.93%) = $4.77 maximum cost that would permit a 10% annualized return
At $59.30, with a success value of $62 and a failure value of $49.14 (the value of BEAV stock, adjusted for comparable companies’ recent market movements), the risk / reward ratio in the stock is 10.16 / 2.70, or 3.76x (note that a lower multiple is superior because it represents less risk relative to greater return). The maximum price that could be paid and still achieve a superior risk / reward ratio is $3.95.
- $3.95 risk / $1.05 reward = 3.76x
Since October 24th, ArbitrOption has bought April 2017 expiration $55/$60 call spreads that risk 4% of the portfolio. The call spreads were bought at prices that will produce a 40% return on investment if BEAV is worth $60 or more when the options expire. Assuming the options expire in-the-money on April 21, the annualized return will be 80.8%. In the unlikely event that the deal closes before the options expire, they will achieve their maximum profit so long as COL remains above $71.86.
4. Portfolio Management: Tracking Approvals
Because this transaction was announced relatively recently, we’re in the early stages of the underlying processes that must be completed before it can close. One small note of success which may explain the recent move in BEAV is that the companies cleared the waiting period for Hart-Scott-Rodino, a preliminary merger notification process for the Federal Trade Commission and Department of Justice (COL confirmed that to ArbitrOption by email on December 8th).
We’re looking forward to the shareholder vote, and any news at all regarding the filing or clearance of foreign antitrust approvals. Ultimately, we expect the timing of this deal to revolve around the Chinese review. To us, this is a question of when, not if – a circumstance that warrants the April 55/60 call spreads that are below the expected takeout value.
As we see progress in the approvals needed to complete the deal, ArbitrOption will increase the portfolio’s exposure to BEAV if circumstances allow us to add to the position at attractive prices relative to the risk.
5. Exit:Upon Deal Closing, or Options Expiring
Barring changes in the expected outcome, ArbitrOption will exit its position when the options expire.
An investor who bought BEAV for $58.89 on October 24th would earn $1.11 if BEAV is trading at $60, or a return-on-investment of 1.88%. On an annualized basis to April 21st the return would be 3.82%. In contrast, an investor in the option spread described above takes on a defined risk (no exposure to downside estimation error) and earns a return-on-investment of 26.58%. The annualized return of the option spread would be 53.9%, over 14 TIMES that of the stockholder