Best Idea in the Universe: Orbital ATK, Inc.
Current Favorite: Orbital ATK (OA)
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 Orbital ATK was expected to produce returns over FIVE 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
- Idea Generation: Prepping for Launch
Orbital ATK (OA), a global leader in aerospace and defense technologies, agreed on 9/18/17 to be acquired by Northrop Grumman (NOC) for $134.50 per share in cash. As the chart below shows, the stock immediately jumped on the deal’s announcement and has been consistently close to, but below, the agreed acquisition price.
Orbital ATK: Share price from 9/18/17 to 1/18/18
- Investment Research: Building a Framework for our Expectations
The announcement of the transaction provides a blueprint that investors can use to gauge the potential risks. It tells us that:
- OA and NOC expect the deal to close in the first half of 2018
- OA shareholders will have a chance to vote on the acquisition
- NOC has fully committed financing to pay for all $134.50 per share in cash, plus transaction expenses,
- Customary regulatory approval processes will apply
The merger agreement provides some additional details on those regulatory approvals; Section 5.03 of the agreement specifies that OA and NOC must put forth reasonable best efforts to seek approval from US and European antitrust authorities. A quick review of OA’s Annual Report shows that its sales are limited to US and US allies, making it likely that the European commission mentioned in the merger agreement is the only non-US antitrust approval required.
Conditions of the Deal: Houston, Are We Clear For Take Off?
The deal’s financing terms are very strong. The merger agreement commits that NOC “will have on the Closing Date sufficient funds available (through credit arrangements or otherwise) to pay the aggregate Merger Consideration and all related fees and expenses required to be paid”. Section 5.07(d) of the merger agreement also confirms that obtaining the financing is not a condition to the closing of the transaction. The only weak point in the financing description is that the merger agreement prohibits OA from suing NOC’s financing sources in order to compel them to provide the previously committed funding. For what it’s worth, that’s a pretty standard item.
The preliminary proxy statement, the first step for setting a shareholder vote, was filed 10/2/17. An amended preliminary proxy was filed on 10/23 and then, shortly thereafter, OA filed a definitive proxy statement that set the date of the shareholder vote for 11/29/17. Shareholders voted in favor of the transaction on that date.
US Antitrust Approval
The regulatory reviews are a not quite as straightforward as the shareholder approval. Both OA and NOC are significant players the markets for spacecraft, launch vehicles, and electronic warfare systems, competing against firms such as Lockheed Martin, Airbus, Boeing, Raytheon, Harris, and BAE Systems. These products are extremely complicated and well-regulated, so it comes as little surprise that the US Federal Trade Commission and the European Competition Commission would want to thoroughly vet the implications of combining two major defense contractors.
We learned from the preliminary proxy that the application for US antitrust approval was filed on 10/4/17. Then, on 11/20/17, OA revealed that NOC had withdrawn the application for antitrust approval and refiled it on 11/6/17. This is a common tactic used by companies to try and give the reviewing authorities more time to evaluate a deal while possibly avoiding the time and expense of a formal request for additional information. Unfortunately, the tactic was not successful; the FTC issued a second request on 12/6/17.
At present, OA and NOC are most likely in the midst of responding to the FTC’s information request. If the FTC determines that the transaction could result in anticompetitive behavior by NOC, it might ask OA and NOC to divest some business units or execute long term agreements with customers. The merger agreement provides that NOC is not required to divest businesses whose revenue in 2016 exceeded $450 million. Unfortunately, OA does not detail its revenues to a degree that would allow us to identify the revenues of individual business units that compete with NOC.
Here’s what limited information we know about OA’s 2016 revenue:
|Group||% of Revenue||$$$ million|
|Flight Systems Group||33%||1496|
|Defense Systems Group||40%||1823|
|Space Systems Group||27%||1238|
Our best option is to assume that OA and NOC considered the potential divestitures that might be required by antitrust authorities when they agreed to set the cap at $450 million cap.
EU Antitrust Approval
The EU application was filed on 1/18/18; it has a provisional deadline of 2/22/18. This filing follows weeks of pre-notification discussions (as reported in the definitive proxy back on 10/25/17).
International sales were only 17% of OA’s business in 2016. It’s very difficult to perceive a circumstance in which the US antitrust authorities approves this transaction, but the European review is a sticking point. We expect that the EU will not have any objections to the acquisition and will approve it in February.
Estimating the Timeline: How Many Suppliers of Spacecraft Do We Need, Really?
The relevant case history of previous space or defense deals is limited. The best analog is 2012’s acquisition of GeoEye (GEOY) by DigitalGlobe (DGI). The companies were both present in the market for commercial and military satellite imagery and analysis. The deal received a second request, much like OA / NOC, and was ultimately cleared by US antitrust authorities 4 months later.
GEOY and DGI filed their US antitrust application on 8/22/12 and received a request for additional information from the Department of Justice 30 days later. On 12/3/12 the companies disclosed that, although they were working cooperatively with the Department of Justice, the expected completion had been delayed to early 2013 (they were previously guiding for a Q4 ’12 close). Without any fanfare, the Department of Justice closed its investigation on 1/9/13.
We’re hesitant about drawing too much insight from that example because the application of US antitrust regulations under the current Administration seems to have little in common with how rules have been applied in the past. The acquisition of OA by NOC would be lucky to have a regulatory review process similar to that of GEOY / DGI. If we use the timetable from GEOY / DGI as a best possible outcome, then we would expect OA / NOC to clear its antitrust approval process around the end of March.
If, for purposes of conservative estimation, we want to project the timetable of OA / NOC based on a highly contentious transaction, then we should look to the FTC’s review of Becton, Dickinson’s (BDX) acquisition of C.R. Bard (BCR). This merger of two medical products companies received its antitrust approval 226 days after the application was filed, and required a heavily negotiated asset divestiture as well. If we use the timetable from BCR / BDX as a worst possible outcome, then we would expect OA / NOC to clear its antitrust approval process around the end of June.
The issue with the BCR / BDX acquisition stemmed from the fact that Becton, Dickinson and C.R. Bard were head to head competitors and market leaders in two distinct product markets. Orbital ATK and Northrop Grumman may have some similar capabilities, but their combination is highly unlikely to give Northrop the ability to increase prices or degrade service. Further, OA and NOC compete against a substantial number of similarly capable market participants who have constrained prices in the past and are likely to do so in the future.
From the deal’s announcement, OA and NOC have consistently guided to a deal closing in the first half of 2018. It’s probably for the best that their request for additional information was issued by the FTC, as the Department of Justice has been sloppy and getting sloppier in recent history. Given the two examples above, the general trend in the timeframe for FTC antitrust reviews, and the comparative competitive landscape of OA / NOC vs. BCR / BDX, it seems prudent to expect that the US antitrust process will be resolved in mid-May, and will not yet have been completed by the end of March.
Applying the Research: Finding the Right Trade
OA’s expected stock price if the acquisition is completed by the middle of May is $134.50, the acquisition price. The expected value if the acquisition fails is $120.76, OA’s share price prior to the deal announcement, adjusted for recent changes in comparable companies’ stock prices.
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 a May 2018 $130 call and selling a May 2018 $135 call. Note that the acquisition price is $134.50. Hence, this position will achieve its maximum profit if OA is trading at or above $134.50 when the options expire. If the deal is completed before the options’ expiration, the options’ deliverables will be adjusted to cash and the options will expire early.
- Trading: The Math Behind the OA Bullish Put Spread
In each trade, ArbitrOption aims for an annualized return greater than 10% and a risk/reward ratio that is superior to that of the stock. In the OA trade, the maximum acceptable cost that ArbitrOption could receive from a May 2018 $130 / $135 bullish call spread would be $3.96. 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 delta-adjusted risk/reward ratio of the stock.
To generate a 10% annualized return, an event that lasts 242 days (the period between the September 15th deal announcement and the May 15th expected deal completion) would have to produce a 6.63% return. The maximum post-commission cost for this call spread that would still produce a 10% annualized return is $4.22 (see calculation note at end).
At $132.84, with a success value of $134.50 and a failure value of $120.76, the risk/reward ratio in the stock is 12.08/1.66, or 7.27x. The maximum cost that could be paid and still generate a superior risk/reward ratio is $3.95 (we note that a lower multiple is superior because it represents less risk relative to greater return) (see calculation note at end).
Since September 15th, ArbitrOption has bought May ‘18 expiration $130 / $135 call spreads that risk 4.03% of the portfolio. The $130 / $135 call spreads were bought at prices that will produce a 9.49% return on investment if OA is worth $134.50 or more when the options expire. Assuming the transaction is completed on May 15th, the annualized return will be 14.31%.
- Portfolio Management: Monitoring our Flight Path
Given the outstanding process, the transaction could close as early as March or as late as June. We believe that closing by the middle of May is most likely.
ArbitrOption is actively watching for new developments (such as approval from the European Union), and will increase the portfolio’s exposure to OA if circumstances allow us to add to the position at attractive prices relative to the risk.
- Exit: Upon Deal Closing, or Options Expiring
Barring changes in the expected outcome, ArbitrOption will exit its position as options expire or when the transaction closes, whichever comes first.
An investor who bought OA for $132.25 on September 18th would earn $2.25 if the transaction is completed at $134.50, or a return-on-investment of 1.7%. In contrast, an investor in the option spread described above takes on similar risks but earns a return-on-investment of 9.49%, over FIVE TIMES that of the stockholder.
Appendix: Underlying Math
Annualized Return Underlying Math
10% / ( 365 / 242 ) = 6.63%
$4.50 call spread / (1 + 6.63%) = $4.22 maximum risk to achieve 10% annualized return
Risk / Reward Underlying Math
$3.95 risk / $0.55 reward = 7.18x