Arbitrage Opportunities

Arbitrage is the market-risk-free bet that two securities will converge in price. It's market-risk-free because it involves the selling of one while buying the other and hence fluctuations in the market price either up or down won't affect the outcome if the two securities do close their price gap.

A popular form of arbitrage is when companies buy each other. The arbitrage, in this case, involves selling short the shares of the acquirer and buying shares of the target company, under the assumption that the acquirer is paying a premium for the target company.

Several web services post the expected returns available on pending acquisitions. Recently, two such opportunities caught my eye.


The first one is AT&T's (T) bid to buy Centennial Communications (CYCL). AT&T offered $8.50 cash per share of CYCL, but CYCL is still trading for around $7.60. By betting that the transaction will close, an investor can make a lot of money for little downside risk. The risk involved is, of course, that the buyout won't close.

In the case of T & CYCL merger, odds are really good that the transaction will close, because:
  1. Shareholders of both companies have authorized the deal.
  2. A closing date is set (third quarter 2009).
  3. The transaction is not subject to financing.
(Of course, in all merger arbitrages, one should only invest after the deal has been confirmed. Trading on rumored acquisitions is never a sound investing strategy.)

The risk remaining is the authorization by the Federal Communications Commission (FCC).

As far as I could see from both company's disclosures, there isn't anything more than regulatory formalities into the FCC investigation.

If all goes according to plan, there's about a 12% real return on the table for the next month or two, yielding an annualized 147% gain.


PepsiCo (PEP) recently announced its intention to buy the remaining fraction it didn't already own of both of its largest bottling companies, PepsiAmericas Inc. (PAS) and Pepsi Bottling Group Inc. (PBG). Both offer a little more than a 2% spread between the acquisition price and their current market prices. Since both transactions are planned for late 2009 or early 2010, the returns should be modest but still decent, at around 5% annualized.

Both transactions have been authorized by all three companies and all that's pending is regulatory and shareholder approval (I note that PEP owns 33 and 43% of PBG and PAS respectively so the odds of a shareholder approval are tilted in PEP's favor).

Interestingly though, there's a twist to juice up the returns here. It involves options and thus market risk -- hence, this is not an arbitrage opportunity as much as a "trade" based on the acquisition's pricing and timing.

March 2010 $35 put options for PBG are trading at $2.00. This means that the market is pricing in close to a 36% chance that the transaction won't close by March 2010 -- that is, that the stock will be below $35 by March 2010.

Since PBG shares are trading for $35.50 now, the only way a put seller can lose money is if the transaction is canceled before March 2010 and the stock drops below $33 ($35 minus the $2 premium). Even if the transaction does not close by March but as long as it is still planned, there's no reason why PBG should trade for less than $35, making the selling of these puts an interesting way to leverage your returns.

The risk, of course, is having to fork $3500 for each $200 received for the put options sold. But at the same time your $3500 would be exchanged for 100 shares of PBG, which, by itself, is not a terrible business to own: it has guaranteed business with Pepsi, sports a 2% dividend at current levels and would probably be Pepsi's acquisition target again in the future.

Don't forget that selling puts can hinder your returns as much as it can juice them up, since it's a form of leverage. But nonetheless, in this case, it seems like a safer bet than usual. Proceed at your own risk.

Disclosures: Short T, long CYCL, long PEP. No other interest in the above mentioned securities at the time of writing.

No comments:

Post a Comment