Volatility in global equity markets has continued to accelerate. Dueling trade tariffs between the U.S. and China have increased tensions between the two countries. Merger arbitrage spreads have widened in reaction to these factors, and deal specifics have changed in many of the top positions held in event funds. Widening spreads on a mark-to-market basis, not necessarily broken deals, have been the culprit recently. Below are examples of three large deals making major headlines recently.
NXP Semiconductors agreed to be acquired by Qualcomm:
NXP Semiconductors agreed to be acquired by Qualcomm under improved terms ($127.50 vs. $110 previously) and is currently awaiting the final regulatory approval from Chinese MOFCOM. As the recent tensions with China have elevated, shares of NXP traded lower resulting in a wider deal spread.
The deal has been impacted by recent tensions between US and China as the companies need Chinese antitrust approval, and that approval is being withheld in retaliation vs the United States for (1) trade tariffs imposed by the US, (2) the rejection that certain Chinese tech deals have received in the US, and (3) punitive US measures against Chinese companies like ZTE and Huawei. We do not think there is a material antitrust issue (takeover has already been approved by all other global regulators). Even though antitrust is not problematic, China can use it as a reason to block the deal and may do so unless there is some thawing of US-China relations. Our view is that it is in China’s best interest to clear this deal and wring out concessions to the benefit of its own tech industry. Benefits that it may not get if it blocked the deal outright. But with the market price of the stock suggesting that the deal will not close, it brings us to:
If there is No Deal – where does the stock trade?
Though it is hard to say, the stock trades at around $104/shr, below the level at which we thought it would trade without a deal. We do not think there is any takeover premium in that price, but just an absence of buyers as arbitrage funds cut risk and sell their positions.
At $104, NXP trades at approximately 12x 2019 EPS and 9.5x EBITDA, both of which are discounts to its closest comps – such as TXN, ADI, MCHP. I also note that those multiples give no credit for the approximately $5 a share termination fee that NXP would receive if the deal breaks.
So where does that leave us today with NXP? Qualcomm and NXP have offered attractive concessions that would seem to be deemed favorable for Chinese technology companies and should motivate MOFCOM to approve the transaction at some point. NXP has strong growth prospects in automotive and Internet of Things (IoT) applications, and the downside on NXP shares is limited from here. Though, it has been a tough couple of weeks with this investment, it is still a core position in many funds, and our base case is that the merger completes but we certainly acknowledge that the risk of a break is up substantially higher from just a few weeks ago. Finally, we think that in the event of a blocked deal, once the arbitrage selling is complete, the downside from here is somewhat limited by fundamentals.
Time Warner agreed to be acquired by AT&T:
As a refresher, Time Warner agreed to be acquired by AT&T in October 2016 for $107.50 – half in cash and half in shares of AT&T common stock. Time Warner is a media company that owns premier assets including HBO, Turner Cable networks and the Warner Brothers movie studio. We see limited downside in TWX shares in the absence of a deal, and there was a well-worn path to deal approval using the blueprint of the similar vertical merger between Comcast and NBC Universal in 2011. It was surprising that the DOJ filed suit to block the acquisition in November 2017 given that the deal is a vertical merger. Historically, vertical transactions are seen as pro-competitive: no competitor is removed from the market; and, customers benefit from lower prices and more innovative products. The government claims that AT&T and Time Warner could threaten to withhold content from cable distributors to extract higher fees, but AT&T have already committed to behavioral remedies – including no-blackout, baseball-style arbitration – that would eliminate that threat.
The trial commenced on March 19 and we have been actively examining the court proceedings. Witness testimony is expected to complete this week, with closing arguments on Monday. The key takeaway from the trial is that the government’s economic models that suggest prices will increase for consumers have been at least partly discredited. Also, the government-hired economists lowered the potential harm from the deal going through. A key point in the trial came during testimony from telecom company Charter Communications when Judge Leon asked the witness whether AT&T’s proposed style of arbitration could be restructured in a way that was more agreeable for competitors. The witness from Charter acknowledged he DID believe a restructured arbitration agreement could resolve their concerns. This could provide Judge Leon with a path to approve the deal, subject to a new style of arbitration that would reduce AT&T’s incentives and ability to raise the cost of Time Warner content.
The timeline forward from here after closing arguments and final briefs, Judge Leon has indicated it is likely to take him about 5 weeks to write his decision. That means the decision would come before the June 21st outside date of the merger agreement, as requested by the parties.
From our perspective, the current valuation of Time Warner’s shares at $95 is attractive even in the absence of a deal. Time Warner has executed at a very high level since the acquisition by AT&T was announced, posting strong operating results in each quarter. This has lifted Time Warner’s “stand alone” value were the DOJ successful in blocking the merger in court. Tax reform has helped bolster our view that TWX shares are an attractive investment as TWX’s EPS is expected to increase 25% resulting from a lower effective tax rate and bonus depreciation. A recent regulatory filing from the Disney/Fox transaction showed that there were multiple active suitors bidding in the process – including Verizon, which had previously been mum on its content acquisition strategy. We think this highlights the attractiveness of high-value content assets and believe Time Warner’s premier entertainment assets and content could potentially attract a new suitor, both within the traditional media industry and outside of it. Time Warner remains a core holding around for many event managers. We see the downside equaling $7.50 EPS 2018 @ 12x (2x P/E discount to DIS) would get ~$90 per share.
AKRX Inc. agreed to be acquired by Fresenius SE & Co.:
Akorn Inc. agreed to be acquired by Fresenius SE & Co. Akorn develops and manufactures specialty generic pharmaceuticals. Under terms of the agreement Akorn shareholders would receive $34.00 cash per share, valuing the transaction at approximately $4.9 billion.
On Monday 4/23/18, Fresenius has attempted to terminate its acquisition of Akorn on the basis that Akorn has failed to fulfill several closing conditions, including a material breach of FDA data integrity requirements. Akorn has responded by filing suit in Delaware Court seeking Specific Performance to enforce the merger agreement.
The complaint has been filed confidentially and will be soon be made publicly available. It should give us more insight into Akorn’s investigation into the alleged data breach as well as a better understanding of the timeline. Additionally, Akorn management has confirmed to us that they have been voluntarily updating the FDA on their internal investigation and currently the FDA is not pursuing its own investigation.
At this time we don’t know exactly what Fresenius has found, but it should be noted that based on the merger agreement, the failure of a reps and warranties condition is qualified by a material adverse change (MAC). This is an extremely high threshold, which has never been found by a Delaware judge.
Given the strong merger agreement and support of legal precedent, we will continue to assess as we learn more about Fresenius’s findings. While at this point we still believe that the most likely outcome is a price cut and settlement, we are cognizant of the potential for significant downside in the event that there are material issues with the pipeline.
The street projects an approximately $11 per share stand-alone value with current market dynamics, but this projection has little basis in reality. If the deal with Fresenius closes, we’d expect it to be under a re-negotiated price in the mid-to-upper $20 range. Conversely, if the deal falls apart, it would likely mean that there is a material negative impact from the FDA data integrity that could compromise AKRX’s future business.
These deals have created much volatility in the event space and have had an adverse effect on short term performance in funds in the space. Much is not definitive but will need to be monitored, though we are being better compensated for the risk; the reward now has many hidden variables driven by the political tensions that seem to be multiplying globally. Discipline, intense research and continued diligence will be imperative in factoring out the winners and losers, and more importantly how to size and trade around positions. Our conservative approach remains a key aspect of our approach in the space. More to come…
Column by Gabelli Funds, written by Michael Gabelli
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GAMCO MERGER ARBITRAGE
GAMCO Merger Arbitrage UCITS Fund, launched in October 2011, is an open-end fund incorporated in Luxembourg and compliant with UCITS regulation. The team, dedicated strategy, and record dates back to 1985. The objective of the GAMCO Merger Arbitrage Fund is to achieve long-term capital growth by investing primarily in announced equity merger and acquisition transactions while maintaining a diversified portfolio. The Fund utilizes a highly specialized investment approach designed principally to profit from the successful completion of proposed mergers, takeovers, tender offers, leveraged buyouts and other types of corporate reorganizations. Analyzes and continuously monitors each pending transaction for potential risk, including: regulatory, terms, financing, and shareholder approval.
Merger investments are a highly liquid, non-market correlated, proven and consistent alternative to traditional fixed income and equity securities. Merger returns are dependent on deal spreads. Deal spreads are a function of time, deal risk premium, and interest rates. Returns are thus correlated to interest rate changes over the medium term and not the broader equity market. The prospect of rising rates would imply higher returns on mergers as spreads widen to compensate arbitrageurs. As bond markets decline (interest rates rise), merger returns should improve as capital allocation decisions adjust to the changes in the costs of capital.
Broad Market volatility can lead to widening of spreads in merger positions, coupled with our well-researched merger portfolios, offer the potential for enhanced IRRs through dynamic position sizing. Daily price volatility fluctuations coupled with less proprietary capital (the Volcker rule) in the U.S. have contributed to improving merger spreads and thus, overall returns. Thus our fund is well positioned as a cash substitute or fixed income alternative.
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