Best Idea in the Universe: RB Swallows Up Infant Formula Maker
Current Favorite: Mead Johnson Nutrition Co. (MJN)
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 Mead Johnson Nutrition was expected to produce returns more than 3 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: It’s a girl deal!
On February 10, 2017, infant formula maker Mead Johnson Nutrition (MJN) announced that it had agreed to be acquired by the world’s leading consumer health and hygiene company, Reckitt Benckiser (RB), in an all-cash deal worth $90 per share. The acquisition price represents a 29% premium to MJN’s closing price on February 1, 2017, the day before market speculation of a potential transaction.
As you can see in the chart of MJN’s stock price below, the stock moved up following the rumor, rose again following the deal announcement, and has since traded in a tight range around $87.
Mead Johnson Nutrition: Share price from 2/1/17 to 3/10/17
- Investment Research: Infant formula producer + condom maker = low antitrust risk
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 MJN. The takeout price is $90 and the consideration is entirely in cash. Shareholders of MJN will vote on the takeover, as will shareholders of RB (that’s unusual – the buyer’s shareholders normally vote only if the acquisition involves issuing stock to the target’s shareholders). MJN will continue to pay its $0.4125 dividend until the deal closes, with closing expected in the third quarter of 2017.
Interestingly, the press release that was issued by RB has more detail, including RB’s plans for financing and that the deal is subject to Chinese regulatory approval. Bank of America Merrill Lynch, Deutsche Bank and HSBC will lend RB $20 billion and £1 billion to complete the deal. The merger agreement also notes that availability of financing is not a condition to RB’s obligations to complete the acquisition.
So if financing isn’t a condition, what is?
Conditions of the Deal: Developmental Milestones
Section 9.1 of the merger agreement doesn’t provide much guidance beyond what we already knew from the press release. It does make a reference to non-U.S. governmental approvals, but unfortunately those are spelled out in an unpublished Annex to the merger agreement. Thanks for telling us what you’re not telling us … maybe we can make an educated guess. Understanding which approvals will be needed is critical to forecasting how long the deal could take.
U.S. Antitrust Approval
Section 8.01(c) of the merger agreement obliges RB and MJN to file with U.S. antitrust authorities by February 24, 2017. MJN’s business is narrowly focused on pediatric nutrition, and RB is absent from that space. U.S. antitrust clearance in this case is a question of when, not if.
International Antitrust Approvals
Section 8.01(c) of the merger agreement also requires RB and MJN to file with non-U.S. antitrust authorities by March 10, 2017, though it doesn’t share where they need to file. With a little bit of research, we can cross-reference regulatory authorities’ minimum revenue thresholds and estimates of MJN and RB’s combined revenues within the various jurisdictions. Based on that, it’s likely that they will need to seek antitrust approvals from China (as disclosed in RB’s press release), Mexico, Brazil, and the EU (or subsidiary countries).
MJN – Section 4.02 of the merger agreement conditions completion of the merger on approval by a majority of MJN’s stockholders. Section 6.02 of the merger agreement stipulates that MJN must file a preliminary proxy with the SEC by March 10 and hold a vote for stockholders within 40 days of the proxy approval.
RB – Section 5.02a of the merger agreement confirms that the deal is also conditioned on approval by a majority of RB’s shareholders. Section 7.02 goes on to say RB will file its shareholder circular with the United Kingdom Listing Authority (UKLA) by March 24 and hold a vote of its shareholders within 28 days of the UKLA’s approval.
Estimating the Timeline: Done By the Third Trimester?
MJN and RB say that they expect to complete the merger in the third quarter of 2017. They filed for approval in Poland on March 3. No confirmations are available, yet, regarding the status of any other antitrust or shareholder reviews. MJN’s preliminary proxy was filed on March 13, and it confirms that all international regulatory applications were filed by March 10.
Given the lack of overlap between MJN and RB, there’s not much substance on which an antitrust regulator could base an objection. So we’re once again faced with two very basic questions to estimate the timeline:
- How long will MJN and RB need to arrange meetings of their shareholders to vote on the merger?
- How long will the various antitrust agencies take to complete their reviews and clear the deal?
As has been discussed before, the opacity of foreign approval processes makes it difficult to pinpoint the expected closing date accurately. The roster of antitrust approvals and our expectations for each are:
|Brazil||If needed, probable clearance by mid-June; regulatory guidelines provide for an initial review period of up to eight months (similarly low-risk acquisition of Technip by FMC took three months from filing to clearance)|
|United States||Transparent process, probable clearance by March 26|
|China||Probable clearance by end of August (similarly low-risk acquisition of Intersil by Renesas took four months from filing to clearance)|
|Mexico||If needed, probable clearance by mid-May; regulatory guidelines provide for an initial review period of up to 60 days|
|Netherlands||If needed, probable clearance by April 9|
|Poland||Filed March 3, probable clearance by April 2|
Of all the antitrust approvals, China is likely to be the last one to clear before the deal can be completed. The most recent example we have of a transaction running the Chinese Ministry of Commerce (MOFCOM) gauntlet is Intersil / Renesas, which was filed with MOFCOM on September 30 and cleared on January 25, 135 days after the deal had been announced (also about 117 days after the filing was actually made). MJN and Intersil are in very different industries, but if they experience the same review timeline, the acquisition of MJN by RB would be approved by MOFCOM around the end of June. For purposes of conservative analysis, we’re using the end of August.
It’s customary, though not necessary, that both companies’ shareholder meetings will be held on the same day. MJN filed its preliminary proxy on March 13. If MJN files its definitive proxy 30 days later on April 13, we would expect stockholders to be able to vote by mid-May. If RB files its shareholder circular by March 24, and receives approval by April 24 (note this fascinatingly transparent description of circular turnaround times from the UKLA), RB shareholders will probably be able to vote by the end of May. If the companies try to schedule both meetings on the same day, we would expect to be done with the shareholder approval conditions to this deal by the end of May.
Bringing these two tracks together, if shareholders vote in favor of the deal by the end of May and all antitrust approval processes are done by the end of August, then the transaction will close in the third quarter as guided in the initial press release.
Applying the Research: Finding the Right Trade
MJN’s expected stock price if the merger is completed is $90. MJN stockholders will also receive two, possibly three, $0.4125 dividends per share before the deal is completed. It’s worth noting that RB will save its shareholders almost $76 million if it can complete the transaction before the September 9 dividend.
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 August 2017 $82.5 call and selling an August 2017 $85 call. This position will achieve its maximum profit if MJN is trading at or above $85 when the options expire. In the unlikely event the deal has already been completed by August’s options expiration, the position will also achieve its maximum profit. 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 MJN at or above $85.
We looked at trading in the January 2018 $87.5 / $90 call spreads, as well. That would be a bet on the successful completion of the deal. However, the cost to add the January spreads is so high (best case is risking $220 to earn $30) that we believe the deeper in-the-money strike prices and earlier expiration of the August trade makes for a much more attractive risk/reward.
3. Trading: The Math Behind the MJN 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 MJN trade, the maximum acceptable cost that ArbitrOption could pay for an August-2017 $82.5 / $85 bullish call spread would be $2.24. 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 189 days (the period between the February 10 announcement and August 18, 2017 option expiration) would have to produce a 5.18% return. The maximum post-commission cost for this call spread that would still produce a 10% annualized return is $2.38.
- 10% / (365 / 189) = 5.18%
- $2.50 option spread / (1 + 5.18%) = $2.38 maximum cost that would permit a 10% annualized return
At $87.73, with a success value of $90 and a failure value of $67.90 (the pre-rumor value of MJN stock, adjusted for comparable companies’ recent market movements), the risk / reward ratio in the stock is 19.83 / 2.27, or 8.74x (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 $2.24.
- $2.24 risk / $0.26 reward = 8.62x
- 8.62x < 8.74x
Since February 10, 2017, ArbitrOption has bought August-expiration $82.5 /$85 call spreads that risk 5% of the portfolio. The call spreads were bought at prices that will produce a 11.6% return on investment if MJN is worth $85 or more when the options expire. Assuming the options expire in-the-money on August 18, 2017, the annualized return will be 22.4%. In the unlikely event that the deal closes before the options expire, the options’ expirations will be accelerated and their deliverables will be adjusted to cash.
4. Portfolio Management: Tracking Approvals
Because this transaction was announced relatively recently, we’re in the early stages of the deal proceedings. We’re looking forward to the definitive proxy statement and any updates it provides about the status of the regulatory approvals. Ultimately, we expect the timing of this deal to be determined by the Chinese review. To us, this is a question of when, not if – a situation that favors the August 82.5 / 85 call spreads that are below the expected takeout value.
As we see progress in approvals, ArbitrOption will increase the portfolio’s exposure to MJN 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 MJN for $87.72 on February 10 would earn $2.28 if MJN is acquired at $90, or a return-on-investment of 2.60%. If the investor also receives two $0.4125 dividends, the return improves to 3.54%. On an annualized basis to August 18, the return would be 6.84%. 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 11.6%. The annualized return of the option spread would be 22.4%, over 3 TIMES that of the stockholder.