Best Idea in the Universe: Time Warner
Current Favorite: Time Warner (TWX)
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 Time Warner was expected to produce returns 230% 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: Betting on Regularly Scheduled Programming
Time Warner (TWX) agreed on 10/22/16 to be acquired by AT&T (T) for approximately $107.50 per share, comprised of $53.75 in cash and a varying quantity of T shares (more on this later). As the chart below shows, the stock initially traded at a substantial spread to the takeout price, but rallied following the U.S. election and has reduced the gap over time.
Source: Marketwatch, downloaded 9/17/17
- Investment Research: De-Mystifying a Complex Lineup
While this deal was announced nearly a year ago, it continues to be an evolving beast, and a mover of portfolio returns from month to month. It has faced volatility, but our conviction has been and continues to be that it will eventually close – and presents a profitable opportunity for our investors.
This volatility and complexity means that even at this late stage in the deal we can follow our regular process of forecasting terminal values and a completion date. As it turns out, both factors are particularly hairy. Let’s start with the terminal value possibilities:
The cash-and-stock deal sets out a range of possible takeout prices. If the merger is completed successfully, TWX shareholders will receive $53.75 cash per share plus a varying number of T shares. The ratio at which TWX shares will be exchanged for T shares varies depending on T’s volume-weighted average price during the 15 business-day period that ends three business days before the deal is completed, creating a deal-price “collar” of 1.3 to 1.437 T shares per share of TWX.
|If Volume-Weighted Average Price of T is …||Then the Exchange Ratio is …||And the deal value per TWX share is …|
|$36.00||1.437||$51.73 in stock + $53.75 cash = $105.48|
|$37.411||1.437||$53.76 in stock + $53.75 cash = $107.51|
|$39.38||53.75 / 39.38 = 1.365||$53.75 in stock + $53.75 cash = $107.50|
|$41.349||1.3||$53.75 in stock + $53.75 cash = $107.50|
|$42.00||1.3||$54.60 in stock + $53.75 cash = $108.35|
A chart of T’s trading history since the deal announcement is below, with yellow lines denoting the range of the collar.
Source: Marketwatch, downloaded 9/17/17
Bringing these charts together, below one can see TWX and T in a single image. Looking at the stock trends this way reveals that TWX has traded up even as the per-share value of the deal has declined; that indicates the market’s greater confidence over time that the merger will be completed.
Source: Marketwatch, downloaded 9/17/17
The two companies initially indicated that the merger would close by the end of 2017, a period of more than a year from the deal announcement. Forecasting the closing date rests on a series of regulatory assumptions.
Conditions of the Deal: Winning Anti-Trust Confidence from All Corners
The deal’s financing outlook couldn’t be stronger. The merger agreement commits that T “had and will continue to have sufficient funds necessary for the payment of the merger consideration.” In other words, the deal is explicitly not conditioned on availability of financing.
Shareholder and Regulatory Approvals
The S-4 preliminary proxy statement, the first step for setting a shareholder vote, was filed 11/18/16. An amendment to the S-4 was filed on 12/23/16, setting the record date for shareholders at 1/3/17 (one must be a shareholder by that date in order to vote). A second amendment was filed 1/5/17, setting the shareholder vote for 2/15/17. Shareholders voted in favor of the transaction.
The regulatory reviews are a more uncertain process. T is the largest telecom company in the world, and it is merging with TWX, which ranks as the second-largest cable television company in the U.S. Merging these two behemoths understandably triggers a range of antitrust concerns across a number of international jurisdictions. Here’s where the assorted list stands:
Cleared via a No Action Letter in April, 2017 (exact date not disclosed).
Cleared 9/4/17 with behavioral remedies.
We don’t have any information directly from Chinese authorities, but the Chilean approval on 9/4/17 indicated that only the Brazilian and U.S. approvals are still pending.
Federal Communications Commission
In the second amendment to the S-4 that was filed on 1/5/17, the companies said that TWX “will not need to transfer any of its FCC licenses to AT&T in order to continue to conduct its business operations after the closing of the transaction.” TWX opted to sell its only TV station in Atlanta, GA to Meredith Corp. so that the merger with T could avoid a FCC review. The Meredith application was filed on 2/23/17 and approved on 4/14/17.
U.S. Antitrust: Still Pending
The application for U.S. antitrust approval was filed 11/4/16 (reported in the S-4 on 11/18/16). The U.S. Senate Subcommittee on Antitrust, Competition Policy & Consumer Rights held hearings regarding the competitive impact of the transaction on 12/7/16. There’s no approval required from the Senate, but a hearing like this can create pressure on antitrust regulators to show that they’re fully investigating the implications of the merger. The U.S. Department of Justice issued a request for additional information on 12/5/16, and a 2nd request was disclosed 12/23/16 in the amended S-4 filing.
The LA Times reported on 9/7/17 that, “A green light from the government is expected this month, according to people close to the process who were not authorized to discuss it. The U.S. Department of Justice is in the final stages of its merger review, these people said.”
Brazil: Still Pending
The Brazilian application was filed on 3/7/17. On 8/22/17, Brazil’s CADE decided it had sufficient concerns about the anticompetitive effects of the deal to refer the transaction on to the General Superintendent for further review. The docket at CADE reveals that there were two meetings between the companies and CADE subsequent to this decision – one on 8/25 and another on 8/30.
The anticompetitive concerns presented by Brazil’s communications agencies (Ancine and Anatel) are legitimate, but not unique to Brazil. It’s somewhat puzzling that this transaction has been able to gain approval in Canada, Turkey, South Africa, etc., but Brazilian authorities are concerned that integrating Time Warner with AT&T will lead to less diversity of programming content.
Authorities are also concerned that integrating Time Warner and AT&T’s Sky TV operation could create an incentive for AT&T to share sensitive information belonging to Time Warner’s competitors. AT&T could potentially also gain access to the terms its distribution competitors negotiated with Time Warner. CADE’s Opinion Document also notes the difficulty of constructing a behavioral remedy for these problems, though the companies were able to find a suitable resolution for the authorities in Chile. It appears that CADE is attempting to negotiate a structural solution to its concerns, meaning a divestiture of either programming or distribution assets of sufficient size to mitigate the concerns.
Reuters recently wrote that AT&T is considering a divestiture of its Latin American assets to reduce the transaction’s debt load and address antitrust concerns.
Estimating the Timeline: An End in Sight
Considering all of these points, we continue to forecast a closing date in the fourth quarter of this year. If the LA Times and Reuters reporting is accurate, completion of the merger by the end of October seems plausible. In the initial press release, the companies guided to a close before the end of 2017. The companies reiterated their expectation that the deal would close before year-end ’17 in the 8/22/17 press release that announced the Mexican approval.
Applying the Research: Finding the Right Trade
The successful merger of TWX into T is an enormously complex undertaking that is subject to globe-spanning conditions. To complicate matters, the final deal price is a moving target. Pinpointing a completion date and terminal value are, in our view, very, very hard.
However, the structure of the consideration, and the probability of successful eventual completion, allow us a different approach for investing in this merger. While we don’t know when the deal will be completed, nor the precise value of TWX shares at the time of merger completion, we are able to use options to invest in bullish put spreads that will attain their maximum profit if TWX remains at or above $95.
- Trading: The Math Behind the TWX 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 TWX trade, the minimum acceptable credit that ArbitrOption could receive from an October 2017 $92.50 / $95 bullish put spread would be $0.05. That price is found by taking the lesser of a) the minimum credit that would allow a 10% annualized return, or b) the credit that matches the delta-adjusted risk/reward ratio of the stock.
To generate a 10% annualized return, an event that lasts 32 days (the period between this September 18th analysis and the October 20th option expiration) would have to produce a 0.88% return. The minimum post-commission credit for this put spread that would still produce a 10% annualized return is $0.03.
10% / ( 365 / 32 ) = 0.88%
$2.50 option spread / (1 + 0.88%) = $2.47 maximum risk; minimum 0.03 credit to achieve 10% annualized return
Our typical risk/reward analysis that contrasts the stock’s risk with the risk of an in-the-money option spread isn’t strictly “apples-to-apples” in this case. The $92.5 / $95 option spread is betting that the stock will stay above $95, while an investor buying the stock is betting that they’ll receive an estimated success value of $107.50 (or thereabouts). It is instructive, however, to have a sense for the price at which a $105 / $107.50 option spread would be taking on the same risk as the stock, and contrast that price with the market for our $92.5 / $95 in-the-money spread.
At $101.87, with an estimated success value of $107.50 and a failure value of $67.79 based on the pre-deal TWX adjusted for change in value in a basket of peers, the risk/reward ratio in the stock is 34.08/5.63, or 6.05x. The minimum credit for a $105 / $107.50 put spread that would still achieve a superior risk/reward ratio is $0.35 (we note that a lower multiple is superior because it represents less risk relative to greater return). Again, that’s the minimum for a spread with an upper strike of $107.50. A $92.5 / $95 option spread presents much less risk because currently available information leads the market to believe the stock is worth $101.87.
$2.15 risk / $0.35 reward = 6.14x
If one can trade a much safer option spread, such as the $92.5 / $95 put spread, while still capturing some of the minimally acceptable return from a much riskier option spread, then one is adding potential gains at manageable risk. The key question is, how much safer is betting on the stock staying above $95, relative to a bet it will be above $107.50?
The answer is found by contrasting the options’ delta, a derivative that estimates how much an option’s price will move in reaction to a $1 move in the underlying stock. The TWX October $107 put has a delta of -0.78. The $95 put has a delta of -0.11. -0.11 / -0.78 = 14.1%, implying that the 92.5 / 95 put spread has 14% of the risk of the $105 / $107.50 spread. If we can take on 14% of the risk, while capturing more than 14% of the minimally acceptable return, we’re well-compensated for the risk we’re taking.
$0.35 minimum credit x 14.1% risk adjustment = $0.05 minimum post-commission credit for the $92.5 / $95 put spread
Since June 5th, ArbitrOption has bought October ’17 expiration $92.5 / $95 put spreads that risk 9.6% of the portfolio. The $92.5 / $95 put spreads were bought at prices that will produce an 18.34% return on investment if TWX is worth $95 or more when the options expire. The annualized return will be 48.86%.
- Portfolio Management: Monitoring Multiple Approval Processes (and Throwing Darts at a Board)
Given the open-ended nature of the outstanding U.S. and Brazilian antitrust processes, it is very difficult to forecast the deal completion date with certainty. Neither the Brazilian nor the U.S. antitrust regulators have a required deadline by which they must bring their investigations to a close. If the companies chose to certify substantial compliance with the Department of Justice’s request for additional information, they could impose a 30-day deadline. Certifying substantial compliance is generally seen as an aggressive, uncooperative action and is best used as a last resort. And with Brazil still pending, it’s not enough to get the deal done anyway.
Recent reporting from the LA Times indicates that Department of Justice sources expect a decision to be made by the end of September. Reuters reports that the companies are looking into a divestiture of AT&T’s Latin American operations. The companies themselves haven’t said anything since August 22nd, when they reiterated that the deal is expected to close by the end of 2017. If the reporting is accurate, then the earliest the deal would probably close is the end of September.
Based on the steps that would need to occur after the U.S. antitrust approval, and the time needed for Brazilian authorities to bless a divestiture, we believe a reasonable estimate is that the transaction will be completed around the end of October.
ArbitrOption is actively watching for new developments, but we have taken our maximum position and will not increase the portfolio’s exposure to TWX before October options expire.
- Exit: Upon Deal Closing, or Options Expiring
Barring changes in the expected outcome, ArbitrOption will exit its position as options expire.
An investor who bought TWX for $99.70 on June 5th would earn $7.80 if the transaction is completed at $107.50, or a return-on-investment of 7.82%. In contrast, an investor in the option spread described above takes on lower risk but earns a return-on-investment of 18.34%, over 230% that of the stockholder.