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Absolute Return Podcast #38: Pre-Arbitrage and the Art of Deal Speculation

By November 4, 2019 No Comments


November 4, 2019-Fitbit to be Acquired by Google for $2.1 Billion. How Did Merger Speculators End Up Doing?

French Luxury Giant LVMH Makes Play for Tiffany & Co. Does this Unsolicited Proposal Have a Shot?

Canfor Strikes Friendly Deal at Same Price as Previous Unsolicited Offer. Why Did the Board Settle?

Federal Reserve Cuts Rates as Bank of Canada Holds Steady. Why the Divergence in Monetary Policy?

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Transcripts

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome investors and podcast listeners to episode 38 of The Absolute Return Podcast. I am your host Julian Klymochko.

Michael Kesslering: And I Michael Kesslering.

Julian Klymochko: Today is Friday, November 1st, 2019. Got an interesting episode this week we are highlighting a number of speculative deal situations including

    • Fitbit, which media announced earlier this week that they were in talks to be acquired by Google. That, of course, went definitive today. We are going to talk about how that situation ended up and how merger speculators ended up doing on that pre-arbitrage situation.
    • Going to chat about French luxury giant LVMH made a play for Tiffany and Co. Does this unsolicited proposal have a shot of success?
    • Canfor struck a friendly deal at the same price as their previous unsolicited public offer. Why did the board settle and not push for a bump in the price?
    • Lastly, we are going to touch on a bit of macro’s stuff they had a rate cut in the US from the Fed and Bank of Canada held steady on rates.

Google acquired Fitbit

Julian Klymochko: We had a big deal this week in the technology space, with Fitbit agreeing to be acquired by Google in a friendly deal for two point one billion dollars. The consideration is seven dollars and thirty-five cash per share. Now this represents a premium of nearly seventy-one percent over the unaffected price and I am referring to the unaffected price here, because earlier this week there was a Reuter’s story speculating, breaking a story that Google and Fitbit were in discussions on a deal on that day. On Monday, Fitbit shares rallied thirty percent on that story and so real successful trade for what we call pre-arb speculators, where they get into the stock on some of these rumours prior to a definitive deal being announced. Some background on Fitbit, obviously, they are the smart watchmaker, a real innovator in the space that is until Apple came along and pretty much decimated their business and you can tell from the historical performance of their stock price, they hadn’t really done all that well. The IPO in 2015 at twenty bucks per share now they’re getting taken out at a sixty-three percent lower price than that at the seven dollars and thirty-five cents per share, even though that seven thirty-five is a massive premium to where they are trading in a four dollars and change just one week ago.

In the last well-documented struggles in the smart watch sector as Apple came to dominate, past three quarterly reports of Fitbit saw their share price drop on average, fourteen percent. So certainly not meeting up to investors’ expectation in terms of financial performance. So somewhat of a mercy kill from Google here, although they are trying to further expand into the device and hardware business. It is similar to Google’s historical track record of acquisitions they are very acquisitive company and this two point one billion dollar deal will be one of their biggest. It is certainly their biggest since they bought Nest in 2014 for three point two billion dollars and Nest does smart electronics for the homes such as thermostats, etc. Their biggest deal, in fact, was for Motorola in 2011 for twelve point five billion. Some strategic rationale behind the deal James Park, the co-founder and CEO of Fitbit, said Google was an ideal partner and with Google’s resources and global platform, Fitbit will be able to accelerate innovation in the wearables category, scale faster and make health even more accessible to everyone. That is really what you are starting to see, the emergence of wearables applied to health. You are seeing Apple make a huge push into that space with health monitoring and different ways of improving fitness and whatnot but it is interesting to look at the deal here.

It is trading currently at a discount to the seven dollar and thirty-five percent price reflecting both, ninety percent odds, implied odds of success of this deal closing. There is some deal risk, obviously a ton of regulatory scrutiny behind Google’s parent Alphabet with a lot of political pressure, investigations, not just in the US, but also the Euro zone. People, state and federal authorities they are really concerned about anti-competitive practices related to consumer data and how they operate in the digital advertising market. So Google is not really involved much in these smart watch sector. They do manufacture various devices, but really not much market share in smart watch or fitness tracker so there really isn’t much market share concern. However, most of the regulatory scrutiny will just be on Google and Alphabet in general and what they do with consumer data. Consumer health data specifically because I mean, that is some of the most sensitive data out there, not just that, but location information as well, which is another major concern.  Nonetheless, really successful trade for pre-arb or deal speculator’s here with them getting in after it surged thirty percent on Monday but the ones that did get in got another twenty percent bump today on the successful announcement of this deal. What are your thoughts on this interesting transaction here?

Michael Kesslering: Yes. So going back to the antitrust concerns, I think some of the some of the worry with government officials and regulators is although this really, as you mentioned Google does not have much market share in the wearables market, but they are really looking at deals within this space through the lens of some of their past mistakes. Looking back to Facebook now and their acquisition of Instagram. Now, if that deal was announced today, that likely would get blocked by regulators but with you know, in hindsight that looks like a really anti-competitive deal that went through with Facebook. I think, you know, anything to do with any of these large tech companies are really going to be scrutinized by the regulators. Just an example of how that makes it difficult from a merger arbitrageur, is a look at the spreads based on different closed dates. So if you assume a December 2020 close is the only guidance that they gave was that it was going to close in 2020, which is a very wide range. Typically, a company will say either H1 or H2 or Q1, Q2, Q3, Q4.

Julian Klymochko: Right. Not a lot of visibility into how long the regulatory process will take to get this deal past the finish line.

Michael Kesslering: Absolutely. If you assume that December 2020 closed date, that is about a two point seven percent spread as of closed today. If it is quicker, let us say April 2020, that moves out to a six point five percent spread so that really changes the dynamics of the risk-reward scenario based on when you when your estimate of closing is.

Julian Klymochko: Right and so a six point five percent annualized.

Michael Kesslering: Yes, absolutely. Also, you know, one thing that you mentioned as well was with regards to the antitrust is there is a very large break fee in this deal. Now, that is two hundred and fifty million dollars payable by Google. So it’s actually a verse based break fee if they cannot secure antitrust approval, which works out to about twelve percent of the deal value, which is massive and really does not have much precedent, does it?

Julian Klymochko: It is certainly much, much higher than you typically see and as the target company, you have to have comfort in that, whereas the deal breaks for regulatory issues such as a block by the FTC, an anti-trust regulatory body, then at least Fitbit gets compensated well. It is abnormal, but there are some precedents. We have talked about it on the podcast in the past, the AT&T and T-Mobile deal where that merger was in fact blocked and AT&T had to compensate T-Mobile very, very handsomely and basically, sets T-Mobile on the path of success. I believe that break fee was roughly four billion or so.

In addition, I remember the Google Motorola deal spread in 2011, which was surprisingly volatile and I say surprising because Motorola was an old cell phone manufacturer with some intellectual property and Google really had no exposure to that space. So no real market share concerns. However, the deal suffered from a number of regulatory delays and ultimately got approved. However, that deal had a massive break fee, I believe, in the billions of dollars and the twelve point five billion dollar deal and it was nearly thirty percent of the deal price. Now, here on this Fitbit deal, it is roughly twelve percent of the deal value. So very, very high, but certainly not unprecedented. But it’s one thing to notice because it is representative of increased deal risk recognition by both sides of the transaction here. So that’s interesting for investors to know that there is a little bit of risk behind this one, and with that risk, you might see this spread to kind of jumping all over the place. It will not be super steady. It might be a little bit volatile. So if you are an arbitrageur, long the spread, then, you know, get your seat belt on and prepare for a ride.

LVMH made a play for Tiffany and Co

Julian Klymochko: Another interesting and speculative pre-arbitrage situation emerged in the market this week with jewellery company Tiffany and Co. receiving an unsolicited takeover proposal from French luxury company LVMH. That is Moet, Hennessy, and Louis Vuitton. So what happened here was LVMH they proposed acquiring Tiffany at one hundred and twenty bucks in cash per share. Now this represented a premium of about twenty-two percent and a fourteen point five billion dollar deal value so big deal for sure. Then you look at the other side, the acquire is pretty massive. They have a market value of two hundred and fourteen billion and it was built over the past four decades by its CEO Arnault, who also happens to be Europe’s richest person. It is an interesting story which Mike you can get into. He has actually built LVMH from a near bankrupt French textile company to the world’s largest luxury group. Their brands include brands like Dior, Louis Vuitton, and Sephora interesting strategic rationale behind this. They are really just looking to continue that consolidation strategy in the luxury space that has worked so well for them and made their CEO one of the richest in the world. I think he has been at the top of the rich list at some point kind of trades between Bill Gates, Jeff Bezos and the CEO of LVMH here.

The other thing to talk about is the price action here. So pre-bid Tiff stock Tiffany Ticker T-I-F, was just below a hundred bucks. Then you got this hundred twenty dollar cash proposal. It is actually trading at a premium that rocketed as high as one hundred forty per share an ounce, trading around one-twenty-six now. What is happening here? Basically, pre-arb speculators are betting on a higher bid. An analyst from Credit Suisse and Cowan saying Tiffany could be worth as much as one hundred forty to a hundred sixty per share. So certainly some bullishness from the sell side, expecting a higher bid there and media there saying that Tiffany is expected to reject this proposal and hold out for more cash. The board, I believe it is going to say that the bid undervalues the company but I mean this is the same song and dance we tend to see on unsolicited proposals. The way it works is their first price is never their best price and the target companies know this. So it is the same song and dance where there’s a starting bid, there’s a counteroffer and then, you know, hopefully you settle somewhere in the middle. If the target is amenable to transacting and selling the company, which most public companies are, at some point you face pretty significant deal pressure. Not just that, but if you look at the trading in the shares, you’re seeing massive volume on this deal speculation as more event driven traders come into this stock and their goal is to get out of it quickly at a nice premium. So they would certainly like to see a share sale at one-forty, one-fifty, a friendly deal to LVMH and so that is really what the play is here. What are your thoughts on it?

Michael Kesslering: Yes. So as you had mentioned, Arnault, he is yeah, the world’s the third richest person at ninety seven billion. He has built himself a substantial wealth over these years and I have followed LVMH over the last number of years. It is a very interesting company. They are really focused I would not necessarily say just on shareholder value, but really just building these brands over the very, very long term and when I say that, I mean generational and that’s how this this industry typically works. In terms of the strategic rationale for this from LVMH, his side is that this would really just be an expansion of their jewellery division, which is their smallest division and it includes brands such as Bulgari, Hublot, Tag. I believe they are the brand that Division CEO is a former Tag executive as well.

The rationale with that is just really tried to diversify right now, although this is a very large conglomerate, includes many other brands that you had mentioned. It is really driven by Louis Vuitton in their fashion at fashion and designer segment where that segment drives about a quarter of their revenue and I believe almost fifty percent of their profits so they are really tied to Louis Vuitton despite their large nature. As well, this would also be another example of LVMH, although they are a global conglomerate this would be a further expansion into the U.S. as Tiffany’s their most popular market is the U.S. So would be a furtherance of that sort of strategy. Now, moving more towards the potential bidding war and you know what could happen there, Tiffany’s is really viewed as a trophy asset, as it’s really one of the only global luxury brands that is not under family control, which is very important.

Julian Klymochko: Right and shareholders there is nothing like music to the ears of an arb as a bidding war can be. Certainly stock getting bid up on this but nonetheless, it is still quite a bit below the price it hit just last summer one hundred forty bucks a share in summer 2018. So people are thinking, look, it is not even at an all-time high. They’ve kind of been down in the dumps since then, not met expectations in terms of quarterly financial performance, but certainly some are taking a longer term view of it. And the other interesting thing in terms of dynamics and it’s something that I feel doesn’t get spoken  of very often, is when there is this deal speculation and you see this big turnover in the stock, whether it’s a massive amount of volume as shares go from long term shareholders to more event driven traders, speculators, merge arbitrageurs, etcetera. And many complain that, oh, you know, these people are just quick buck artists. They are just in it for, you know, to get a quick premium and sell and they don’t have the long term interests of the company like a longer term shareholder. But you have to look at how did those event driven traders get the stock in their hands? The way they do get the stock is buy long-term shareholders choosing to monetize that, take off the risk and exit that long-term position, effectively agreeing with the thought that, look, this is fair value. I want to exit. I no longer believe that, you know, it’s undervalued and wanting to kind of crystallize that value and I don’t think it’s a fair criticism because the fact that those speculators are fast money traders, get their hands on stock, are representative. That’s a long term investors wanted to exit and are de-risking and are allowing these pre-arb deals, speculators to take the risk in that situation.

Michael Kesslering: Certainly. In terms of a bidding war like who the players could be other than, LVMH is you have Kering, which is LVMH’s largest competitor. They are the owner of the Gucci brand, which although LVMH is very reliant on the Louis Vuitton brand, that is very much magnified with Kering where Gucci, I forget the exact numbers, but they are very reliant on that brand to drive their profits. Ultimately, looking at them, it’s speculated that they are not very keen on increasing their debt levels and getting into a bidding war. Another competitor the second largest competitor of LVMH, which is Richemont and the owner of Cartier. There another possible acquire but they are still acquiring and they are still digesting an acquisition from last year and once again, not very interested in adding to their debt load, which is a very common theme across this space, is very conservative balance sheets, as these are thought. Many of the management teams in these businesses treat them more as a family business as opposed to a corporation where leverage is something that is accepted.

Julian Klymochko: Right. The other thing that I wanted to discuss is, you know, what are we talking about here. We are talking about a potential bidding war for a luxury goods maker near its all-time high. This is something that does not happen at the bottom of the market. So certainly, this is a bull market indicator that we recently saw a bid at a huge premium, a friendly deal for Sotheby’s. You know another sort of rich person type stock that does well off the enormously wealthy.

 Michael Kesslering: An auction for an auctioneer.

Julian Klymochko: And certainly, you know, Tiffany’s is no different where, you know, they’re obviously related to the cycle of the wealthy getting wealthier. How did they do that? Well, they do that through the stock market, doing well generally. Obviously, economic pro-cyclical type stock for sure. And so you really, really got to step back and say, you know, what is this telling me? It is certainly confirming that we are, I hate to say what inning of the bull market is I am certainly not going to make that call, but certainly not near the lows that is for sure.

Another speculative pre-arb situation turned friendly deal, different dynamics on this one, though. What happened was forestry company Canfor agreed to a friendly nine hundred million dollars acquisition by B.C. billionaire Jim Pattison at sixteen bucks cash per share. Now, this represented that same price that he previously publicly announced this past summer. What is different about this situation is typically when someone comes out and announces an unsolicited proposal for a company the board’s job is to go out and improve upon that. At least that is what is expected but the problem here is that Mr. Pattison already controlled Canfor by owning fifty-one percent of it. So completely took away any potential competitive dynamic of potential bidding war where someone else would come in if the company was in fact, in play. The other dynamic here is that the forestry industry is just in a real slump. It is suffering from low pulp and lumber prices. It has been like that for a while but I mean benchmark lumber prices have tumbled nearly forty percent over the past sixteen months. So some shareholders not too stoked on the price, even though it was a fairly massive premium its unaffected price was eight dollars and eighty cents so a sixteen dollar bid is eighty something percent premium, far larger than you’d normally see.

Nonetheless, there is a five percent shareholder out there saying that it plans on voting against the offer despite this massive premium, saying that the premium to the prior closing price is based on a very depressed share price. So they think that they’re getting taken out at a cyclical low but you look at that historical trading and just in June 2018, the stock was at thirty-four bucks a share. So it certainly has been crushed and that seems like he is coming in with a lowball bid just based off a really depressed share price of a sector that has been doing very poorly. The other thing that I wanted to note is that, of course, to get a valuation here from an investment bank to justify the board signing off on this deal, and Greenhill came in with a valuation $14.24 to $19.38, which is conveniently right around the sixteen bucks per share as we know, you know our attitude about fairness opinions and valuations on stocks after both of us working as the investment banking analysts crunching these numbers. It’s kind of implied that for the bank to make five million bucks here, they pretty much build a model to justify that price. What are your thoughts on this Canfor deal here?

Michael Kesslering: I do not have too many comments, although as you’d mentioned well, you know, with Letko, so they own point, four point eight percent. They have announced their intention not to bid with management and the board on the deal. The deal still does need a majority of the minority shareholders. So that will be an interesting dynamic to watch. What will happen now is the passing group and the rest of the board will be going to some of these other larger minority shareholders and trying to get an indication of which way they’re going to bid. And if it seems like enough of them aren’t going to be bidding with the deal, then they would likely have a small bump and that would likely be enough to take it over the finish line.

Julian Klymochko: Right. We recently saw that on that Transat deal where Air Canada struck a friendly deal to acquire them. They had some shareholder pushback, Air Canada forced to bump by a material amount far more than expected. Interesting, here is Canfor when the proposal was made, traded to a near sixteen but a decent discount. On the announcement of this friendly deal, it ticked up a bit so a couple of percent still at a discount to sixteen. So not really pricing in a bump. Certainly no competitive dynamics here. It’s really hard to envision any sort of interloper, especially when Mr. Pattison controls fifty-one percent. So it’s interesting one to follow. I think ultimately this point you just have five percent against out of fifty percent minority, not a huge pushback but we’ll see how this one develops. Ultimately, we think this one will get done.

Macro News-Rate Cut

Julian Klymochko: A lot of M&A speculation, some friendly deals happening. We have a bit of macro news on the rate side. What happened was the Federal Reserve came out with a rate cut this week as expected by the market. So they cut by twenty-five basis points or zero point two-five percent that’s for the third time this year. This took their benchmark interest rate to the target range of one point five to one point seven-five percent. But the interesting thing is that Fed Chair Jay Powell indicated that this easing cycle is likely over thinking three rate cuts and that is it. A quote from Jay Powell, he indicated, “we believe monetary policy is in a good place; we see the current stance of policy as likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook”. And just looking at the macro data you add, U.S. jobs numbers came in beating expectations unemployment still three point six percent, which is near all-time low. Obviously, unemployment rate is one of the Fed’s mandates. The other thing is price stability, inflation and that’s also checking the box. We always joke that the Fed’s third mandate is S&P five hundred targeting and certainly the market loving it with S&P five hundred hitting new all-time highs.

President Trump loving that, tweeting about new all-time highs in the stock market. The other thing that we’ve seen on the macro front and why the Fed may be done here with respect to rate cuts, perhaps a resolution of Brexit, which was a major concern, it’s looking like a Brexit deal is going to happen. And the other thing is some relieving the pressure on the trade front side. You have the US and China and this potential phase one deal that they’re expected to enter into potentially this month. So a lot going on there. Meanwhile, up in Canada, Bank of Canada holding rates steady at one point seventy five percent was interesting enough. They now have the highest official interest rate in the world’s advanced economies. It’s above the Fed’s rate for the first time in three years. In contrast to the Fed, who kind of indicated that they may be done cutting rates the Bank of Canada certainly did introduce it, what market participants believed to be an easing bias, meaning that they believe that the Bank of Canada may be preparing the market for a potential insurance cut.

It’s branded an insurance cut just to get the rate down, maybe one or two cuts, not a full on easing cycle, but one or two rate cuts to get the inverted yield curve to not be inverted anymore and just placate the market such that it’s happy and really follow pretty much every other central bank in the world in cutting rates. Basically, the Bank of Canada is worried that the U.S. China trade uncertainties persist, which could end up damaging the Canadian economy. But they also need to balance this on what they perceived to be over levered balance sheets of Canadian consumers and a potentially overheated housing market, which they don’t want to stoke that fire and get home prices rising unsustainably again. So it’s kind of in the middle of the road here. The market’s actually starting to increase the odds of a potential Bank of Canada rate decision rate cut later this year. Traders’ now still seeing about thirty percent chance of a quarter point cut from the Bank of Canada in December, which is their next rate setting decision date. And this is up from thirteen percent the day before they came out with this rate decision this week. But certainly S&P five hundred, NASDAQ, Dow Jones all hitting new highs, loving that Federal Reserve rate cut. What are your thoughts?

Michael Kesslering: Yes. So in terms of, you know, I guess going back to why the B.O.C, hasn’t been cutting while the Fed has is part of that has to do with really the Fx rate is that the central bank in Canada is very cautious with regards to any changes that they think would affect the Fx rate just because of Canada’s reliance on exports, particularly to the U.S.. And so when you haven’t seen the CAD run against the USD, there really hasn’t been any reason to cut. But now with the Fed funds rate going below the B.O.C. overnight rate, there is more potential for that. But you really haven’t seen it in the in the spot rates yet.

Julian Klymochko: Right. And the way those dynamics work is if Canada’s a higher yielding currency with higher rates than investors will want to buy that currency, bid it up and you see that effect on the currency rates. And as the Canadian dollars appreciating, then exporters will suffer. And then, you know, you’ll see that come through the negative economic figures.

Michael Kesslering: Absolutely. But you are correct in, you know, your interpretation of Poloz’s language in terms of the decision is it really does seem like they have left the door open for a rate cut in the not too distant future. But I think one of the main things to watch will be the Fx rate. You also mention that they really are worried about the effects on consumer debt levels both with regards to debt levels on the personal side as well as mortgages. So that’s something that the B.O.C. is monitoring and really wanting to ensure that the impact doesn’t have any unintended impacts.

Julian Klymochko: Yeah, you bring up an interesting point. I mean, FX, because the Bank of Canada doesn’t admit it, but I believe given their historical actions, that they keep a very close eye on the Fx and they are certainly not scared to whip out that shotgun and blast that loonie out of the sky as it starts to rally. And I think you saw that this week because the loonie was approaching highs for the year vs. the U.S. dollar. It was the best performing currency, best performing developed market currency of the year, I believe. And I think they’re getting nervous on that. That’s why they came out with this sort of dovish hold language and potentially introducing the chance of a rate cut later this year or early next year just to get that currency down and put speculators on notice that they’re really not having any of that currency appreciation because they want the economy to remain competitive. And hence, you saw that in the price action believe the loonie was down nearly eighty basis points on the day in which Poloz made this announcement.

Nonetheless, Canada on hold for now, U.S. cutting and potentially done with rate cuts for this cycle. But certainly markets liking it. TSX not quite at a new all-time high, but U.S. markets are loving it as they hit all-time highs.

And that’s all we got for you on Episode 38 of the Absolute Return podcast. If you like it, you can always check out more at absolutereturnpodcast.com until next week. We will chat with you soon. Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.