February 18, 2020—Judge Approves T-Mobile’s Merger with Sprint. After Two Years in Limbo, Will this Deal Finally Close?
U.S. Federal Trade Commission Cracks Down on M&A by the Largest Tech Companies. Will this Slow Deal Activity?
Simon Announces Acquisition of Taubman in a Mega-Mall Merger. Why are they Betting Big on Shopping Malls?
A Discussion on the Next Frontier in Investment Management: Alpha + Beta.
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 to Episode 54 of The Absolute Return Podcast, I am your host, Julian Klymochko.
Michael Kesslering: And I am Michael Kesslering.
Julian Klymochko: Today is February 14, 2020. So happy Valentine’s Day to all the investors, traders and speculators out there. Have a few interesting topics to chat about this week.
- Number one, T-Mobile, Sprint. Is this deal finally going to get done after nearly two years in limbo? A judge approved the merger, which sent the stocks of both companies skyrocketing.
- The U.S. FTC cracks down on M&A by the largest tech companies. Is this going to slow deal activity?
- Simon announces the acquisition of Taubman in a megamall merger. Why are they betting big on shopping malls?
- Lastly, we are going to chat about the next frontier in investment management, which is alpha plus beta.
T-Mobile & Sprint
Julian Klymochko: After nearly two years of uncertainty, a U.S. district judge finally approved the $59 billion merger of the third and fourth largest U.S. wireless carriers, T-Mobile and Sprint. This occurs after years of regulatory hostility in the Obama administration, which blocked when these companies previously tried to merge.
They have been trying to get together for at least half a dozen years, if not more. I remember back in 2013, we had a position in T-Mobile just based off the merger speculation because at the time Sprint was actually larger than T-Mobile. But over the years, Sprint declined markedly and T-Mobile just kicked butt in that market. Now T-Mobile is significantly larger and it looks like they are actually going to get this done and this deal over the finish line. A little bit of additional background here on this specific deal.
The DOJ and FCC had already approved the merger and this involved a side deal with Dish Network in which Dish would buy some assets from the pro forma entity to create another fourth wireless competitor. Because this deal with T-Mobile and Sprint combining the third and the fourth creates effectively a strong third player that will compete against AT&T and Verizon. So the antitrust regulators got onside with this deal, citing lowered anti-competitive effects. Just do due to Dish Network’s involvement and the build out of a new fourth competitor in that space. However, after the DOJ and FCC approved the deal, multiple states came in and sued to block the deal, arguing that it is anti-competitive and will raise prices for customers. And this was basically unprecedented in terms of the state attorneys general coming in and trying to get the deal blocked after federal anti-trust regulators already approved it. So a lot of major implications for this, and ultimately the judge shutting down the State AG’s gambit to have this deal blocked. And what the judge said, he has been unpersuaded by the state’s arguments that T-Mobile would act anti-competitively following the merger, predicting that the combined company would be, quote, “chomping to take on its new market peers and rivals and head on competition.” And that’s really framing how T-Mobile has attacked this market over the past 10 years under the leadership of CEO John Leger.
He has basically just crushed his competitors and gotten T-Mobile from a weak fourth place competitor. Now this pro forma entity will be gunning for number one. The other major aspect coming into play on this deal was Sprint, which is the current fourth-place player in the market. They are actually unlikely to survive as an independent competitive player. They have been on the decline for many, many years. Not just that, but losing customers and massively leveraged balance sheet. If this deal fell apart, they need a bailout of ten to twelve billion dollars, which could be hard to come by. Nonetheless, on this news, shareholders loving this, T-Mobile gaining 14 percent. Sprint surging over 80 percent and clearly, the market got this one wrong. I talked to many professional deal guys and many thought that this was highly likely to get blocked and that the states would be successful in this merger challenge. I heard estimates of 20 to 30 percent chance of success that it would actually go the way of the companies. My thoughts I always had a coin flip, kind of 50 percent odds on it, but definitely happy to see it go through. It really removes a lot of uncertainty in terms of having State AG’s come out of nowhere to try to block deals after receiving federal approval. So it’s certainly better for merger arbitrage arbitrageurs, certainly, but I believe the biggest winner here besides those involved in T-Mobile and Sprint is perhaps Softbank. Japan’s Softbank, which serves as much as 13 percent. Given that, they are huge shareholders of Sprint.
Michael Kesslering: Absolutely, and I mean, this is not quite a done deal yet, as I think something to discuss now would be what the potential is for a revision of the terms for consideration offered to sprint. Now, it has been reported that Deutsche Telekom, which is the majority owner of T-Mobile at about 60 percent, wants the consideration cut as you had mention Sprint’s business has been deteriorating.
Julian Klymochko: Especially over the deal cycle. This deal cycle has been nearly two years, it was announced in April 2018.
Michael Kesslering: Absolutely. Just leaving a lot of room for deterioration in their underlying business model. Now, really, it pits them against Softbank, which, as you had mentioned, is Sprint’s controlling shareholder. Now, it will indicate that Deutsche Telekom does have some leverage. As you had mentioned, Sprint would require an estimate of a $10 billion capital injection. And it’s pretty unlikely that Softbank is too keen to provide that type of financing, and arranging for that type of financing with external parties may come at a pretty high cost in terms of dilution and very high interest rates, if they pursued debt. But under the original terms, Sprint shareholders would own about 30 percent of their pro forma entity, and Deutsche Telekom just really wants to bring that down. In terms of the actual merger docs itself, the drop-dead date was in November 2019. So T-Mobile is technically free to walk away. They can use that somewhat as leverage, but in reality, analysts are saying that it’s a very low probability that T-Mobile would be interested in walking away at this point in time, both from the amount of resources that they have allocated to this merger defence. But as well as the strategic nature of the deal in wanting the Sprint spectrum assets, which are very important for them looking at 5G. And so if there is a cut Julian. What kind of cut do you first see in this deal if they are able to get a little bit of a consideration price cut?
Julian Klymochko: Yeah, it is a really good question and certainly the market is pricing in a bit of a price cut here. I wanted to back it up a little bit. You mentioned in that definitive merger agreement, the so-called outside date, they blew through this because this deal cycle has been much, much longer than expected. They initially guided to, I believe, a mid-2019 closing. So we’re way past the outside date, leaving T-Mobile with the advantageous position of being able to threaten to walk away, able to pressure Sprint and Softbank into getting more advantageous terms. But clearly, T-Mobile wants and needs this deal. You can see by the price action, their shares rallying 14 percent. There is just exceptional amount of synergies available here. I believe that estimates are somewhat around $5 billion annual cost and capital synergies with present value in the 20 to 30 billion dollar range. So just massive, massive….just favourable deal for both companies here. Just getting together and harvesting those synergies. Not only that, but putting them in a much better competitive position to capitalize on this new 5G technology, which is really where the industry is going now. As for a price cut, T-Mobile did publicly talk about cutting that back. So the market certainly is expecting one here, the merger spread seems to be pricing in a 10 to 15 percent discount, a 10 to 15 percent cut to the current merger terms that will be advantageous to T-Mobile. And so we’ll monitor that, see what happens there, but I think it’s highly likely that the deal closes at revised terms, revised terms downward, more favourable for T-Mobile. And Sprint is going to have to take a bit of a hit here, but it’s certainly better than walking away from the deal and being left to potentially declare bankruptcy because they might be insolvent.
Michael Kesslering: And one other thing that I did want to bring up was after the judgment. The attorney generals of California and New York both left open the possibility that they would appeal. Lastly, what do you think the probability of them doing so would be in this situation?
Julian Klymochko: I think it is pretty unlikely. And if they are to challenge it, then that is very unlikely to be successful. I mean, they already have egg on their face, given that they got ruled against. An really an unprecedented gambit that, in my opinion, was really out of left field. The federal regulators criticized them pretty significantly just due to this unprecedented move. And it had potential major implications on all M&A if a deal gets federal blessing and then you have all these different State AG’s coming after it. You know, things could go a bit crazy. So it is great that the states lost here. Great for M&A. Great for the merger arbitrage business, certainly, we will monitor this one, but it looks like it is going to cross the finish line here.
Julian Klymochko: Antitrust officials from the Federal Trade Commission announced a new wave of scrutiny of Big Tech acquisition activities. Now what happened here is the FTC issued orders to Microsoft, Amazon, Facebook, Google and Apple, all the big tech companies to obtain information regarding acquisitions they have closed over the past decade, which is this is really just a significant undertaking to get all this information because these companies are just acquisition with machines.
For example, I got some stats here. Last year, these five companies spent over 7 billion on acquisitions compared to 29 billion in 2016 on deals.
They have spent an average of about $3.4 billion a year on sub 1 billion acquisitions over the past five years. Another frame of reference is these five companies have done a total of seven hundred and sixty seven acquisitions since the late 80s.
Google 235 acquisitions, Apple 112, Amazon 101, Facebook 82 and Microsoft at 237. To give you just another example of the acquisitive nature of these companies. Between 2010 and 2011, Google was buying a company every week. In May 2019, Tim Cook, Apple’s CEO, stated that his company was acquiring a company every two or three weeks. Few examples of some large deals that these companies have done. Google did a nearly $13 billion acquisition of Motorola. Apple did a $3 billion acquisition of Beats. Amazon did nearly 14 billion acquisition of Whole Foods, which, of course, was not a technology deal. Facebook buying WhatsApp for 19 billion and Microsoft buying LinkedIn for 26.2 billion.
Now, this investigation by the FTC is not focused on these large jumbo deals. They are really focused on the deals that were too small to get regulatory scrutiny and the deals in which there is this emerging technology, which is potentially threatening to these companies.
So they execute a strategy called buy and kill where they go and buy the start up just to kill it, such that it doesn’t threaten their own market, really just trying to eliminate their competitors by acquiring them prior to them obtaining any sort of size within the market. Now, the FTC move, which will probably involve the review of hundreds upon hundreds of deals, this really comes amidst widespread criticism that antitrust officials have been too permissive in allowing tech giants to buy rivals, which is really just strengthen their dominance.
One example that is often talked about is Facebook’s acquisition of Instagram. And now they’re completely dominant in the social networking space. I mean, there is practically zero competition, perhaps Snapchat, which, of course, Facebook has tried to buy. They are really just trying to get that entire market under their control. Now, this FTC investigation has focused on small deals and by small deals, these are largely defined as sub one hundred million dollars, either ones that weren’t previously reported to the regulators. So it’s a real interesting situation with big implications in terms of number one, tech M&A and number two, potential exits for budding start-ups.
Michael Kesslering: Absolutely, and really, it comes down to potentially increasing the scope of the Hart Scott Rodino, HSR act is what it would basically do. And just to touch quickly on the Instagram example with Facebook, is yes, Instagram has become a massive success in terms of advertising, but really like that was them plugging into the Facebook advertising platform that Facebook had already built. So to look at it now and say, you know, that they acquired this and there’s less competition. Well, I mean, Instagram would have had to build out that entire infrastructure, which is not really an easy task. But really, I just want to look at this from a founder perspective. As you mentioned, this does limit the exit options as a founder, which is a very risky proposition, stuck, launching a tech start up. But I think it’s really important to distinguish between innovative technology and a business model, as you can have innovative technology without a viable business model. You know, creating technology is difficult, but creating and executing the viability of that business model is just as difficult. After you have the technology aspect, you have already come through with that innovative technology. You have to find a way to acquire customers and users efficiently and then monetize those customers and users, which ends up in a business with favourable unit economics.
Julian Klymochko: One of the thing is a lot of these acquisitions is these large tech companies buying perhaps a feature to integrate into their key product. So not necessarily a standalone business, but something that they can incorporate as a small portion of their current products.
Michael Kesslering: Absolutely a feature that could have a very flawed business model, but yet still does have value. And so with that in mind, you know, there is a pretty solid case that can be made that without the option of being able to exit to these large tech companies, that there would be a lot less investment into risky technologies. The tech blogs, trajectory lays out a pretty solid rationale for this. I mean, this is a situation where typically these founders are bought out at a significant premium. It allows them to take risk off the table and in a situation where the execution aspect is far from a predetermined outcome.
Julian Klymochko: And not only that, but, you know, if you get bought by Facebook or Apple or Google or whoever, it is one of these large tech companies, you know, tremendous resources behind your business plan in terms of building that target market.
Michael Kesslering: Absolutely. And I would just like to highlight as well that for the most part, the critics, the most vocal critics I’ve seen of tech companies and these acqui-hires, for the most part.
Julian Klymochko: By Aqui-hires, you mean buying a company in order to get the team, not necessarily the technology.
Michael Kesslering: Yes, as engineering talent is in high demand in Silicon Valley. But what I would mention that these vocal critics are not founders themselves. But for the most part I’ve seen a couple of VC mentioned this, but for the most part it is academics and economists at think tanks that really have no skin in the game. And so the fact that you’re not hearing a lot of outcry from founders for these types of deals implies that, you know, this really may not be as well thought out by these academics and think tank economists as they may lead you to believe.
Julian Klymochko: The net result, well, this can lead to enforcement actions from the FTC on deals they do find problematic. However, this does present its own issues because, say, you acquired a company five years ago fully integrated. And how do you go on and unwind that deal if those two companies already kind of melded together? The other major implication is a potential slowdown in tech M&A. This is largely in the private space. These companies don’t acquire a ton of other public companies, so not a ton of applications for public company merger arbitrages. However, they do acquire the odd public company right now. Obviously, Google trying to buy Fitbit, which some regulatory concern is involved with that one. But we’ll see how this situation plays out. No doubt, it will lead to at least a temporary freeze, or at least the cooling of tech M&A.
Simon Announces its Acquiring Taubman
Julian Klymochko: Simon Property Group announce that it is acquiring rival Taubman Centers in a three point six billion dollar deal. What Taubman does is they own 26 super regional shopping centers in the U.S. and Asia. Now this is a friendly deal. All cash struck at 52.50 per share. Now this was a premium of nearly 52 percent, which is significantly higher than the average premiums we see of roughly 25 percent. I should indicate that Taubman stock was heavily shorted, sentiment within the mall space is pretty bad. So I think the stock was near a 52 week low and it was declining pretty rapidly. So that does make the premium seem higher than typical.
And you’ve got to ask why the market was so down on these companies. Well, it is really easy. It is the e-commerce Amazon effect, but that is really putting pressure on mall landlords as retailers and department stores are really shrinking their bricks and mortar footprints. The other interesting aspect of this deal is if we go back to 2002. Simon made an unsuccessful, attempt to purchase Taubman back then at 18 bucks per share shares, so 18 years later and the price goes from 18 to 52.50. From a strategic rationale standpoint, I find it interesting because Simon now is levering up buying another mall company, trying to gain scale when many of their competitors, their strategiss really stand in stark contrast to what Simon’s doing because their competitors are more so focused on shedding assets, reducing debt and reducing exposure to traditional malls. What are your thoughts on the strategic rationale here?
Michael Kesslering: Yeah, in terms of the aggressive nature of this transaction, it really speaks to the strong nature of Simon’s cash flows and their solid balance sheet. I mean, right now it looks like they do have a pretty significant cost of capital advantage relative to these other players, which gives them a leg up in any sort looking to do acquisitions such as this. You know, it is this seemingly nice premium for Tubman shareholders at 51 percent, although the stock was down 43 percent in the year leading up to January 31. So, you know, on paper, a nice premium, but in reality, not that nice. Not really too much else to say on the deal. I mean, in terms of the actual retail landscape for mall owners, we have talked about on the podcast before how it is a very difficult landscape, but that difficult landscape really has brought about some interesting and unique moves in the space as well as a couple of weeks ago. Simons announced a different deal where they were buying a tenant Forever 21 out of bankruptcy. Now, this was for $81 million. So a lot smaller deal, but it was done in conjunction with Forever 21 other largest landlord being Brookfield Property Partners. So really trying to integrate the tenants and the landlords in a situation where the tenant is quite distressed and they likely want to keep the cash flow of that rent coming through into their reach.
Julian Klymochko: Yeah, and that is the thing about real estate. It is really a cash flow game, and I wanted to touch on valuation. This deal was done at a 6.2 percent cap rate and what the capitalization rate in real estate means, it’s basically defined as the net operating income divided by the purchase price. So six point two percent as basically the cash flow yield of the Taubman asset, you compare that to how Simon funded the deal. They did that by raising $3.5 million in senior notes at rates between 2 percent and 3.5 percent. So basically Simon can earn that spread between the 6.2 percent cap rate and the roughly 3 percent interest rate, which is really, you know, that highlights the strategic rationale here. From a merger arbitrage perspective, this deal is currently yielding 3.4 percent on an annualized basis. This is an implied chance of success of 96 percent. I should note that this does come with a 45-day go shop provision. However, overbid here is pretty unlikely in my opinion, and the market’s are not really pricing in that at all with a merger yield at 3.4 percent positive. Sometimes when the market’s speculating on the go shop provision, a deal could even trade through the terms i.e. a negative yield. But this one positive 3.4 percent. So decent one to look at if you are an arbitrageur, an interesting megamall merger.
Alpha + Beta
Julian Klymochko: Put out a blog post this week titled Alpha + Beta: The Next Frontier in Investment Management. So we are super bullish on the strategy. We love it; I wanted to start off by defining what we mean by Alpha + beta. Alpha + beta refers to a strategy that combines the index returns (beta) with a long, short multi-factor overlay portfolio being the alpha component. What makes this strategy great conceptually is it combines two major psychological forces to the benefit of investors. Now the beta component of the strategy tracks the broad market index. By that, we mean the S&P 500 in the U.S. or if it is a Canadian alpha plus beta strategy, the TSX 60 up North. So the strategies return exhibits a reasonable correlation to the broad market index. Now, this is important because it allows investors to stick with the strategy long term by eliminating the psychological challenges that accompany strategies that move too differently from the index, i.e. the index is up 30 percent last year and their strategy is down. Many people have a tough time stomaching that irrespective of long-term performance.
Now, number two, the alpha component, as represented by a long, short multi-factor overlay portfolio, not only adds long term upside given the overweighting of securities with the highest expected return, but mitigates downside risk by shorting securities with the lowest expected return. This provides investors with additional performance along with risk mitigation characteristics. Now, I wanted to chat about how we describe this long, short multi-factor overlay portfolio. So our multi-factor model looks at a number of factors as indicated by a multi-factor nature.
So we like to look at value, quality, price, momentum, operating momentum and trend. And each month we rebalance the portfolio based off these five factors. And from that, we pick the long overlay portfolio from the top decile of this multi-factor ranking and the short portfolio from the bottom multi-factor decile. So top 10 percent of ranked stocks will go along and the bottom 10 percent will go short. The reason we are doing that is basically systematizing what a human portfolio manager would do, but making it unbiased, systematic in nature such that, you know, you’re not swayed by any sort of biases, et cetera. Basically, what it’s doing is going long, high quality stocks with attractive valuations, good price momentum, solid operating momentum and a good share price trend. And we’re shorting the complete opposite, so how we like to implement Alpha plus beta is as follows. So it’s 100 percent index exposure, for example, in the US that would be on a percent allocated the S&P 500. Then on top of that, 50 percent exposure to the long multi-factor overlay, plus 50 percent exposure to the short multi-factor overlay. And to give you some numbers behind the results of this historical 20 year simulation of this strategy is over the past 20 years, the S&P 500 has compounded at 6.1 percent annualized. Compare that to alpha + beta, which did over double thirteen point six percent annualized, which is great. However, what makes it even better is that it did it with lower correlation sorry, lower standard deviation or volatility of returns.
Alpha + beta had a standard deviation of an eighteen point three percent while the index had eighteen point eight percent. And if we look at that on a risk adjusted basis, return per unit of risk, alpha + beta had nearly threefold the performance of the S&P 500. The other thing that is great about this is that Alpha + beta has relatively high correlation to the S&P 500, which indicates that it does a pretty good job of tracking the daily movements in the S&P 500. Again, reinforcing that concept that investors are more likely to stick with something if it is tracking the underlying index so you don’t suffer that fear of missing out or envy that your neighbour is getting rich when your portfolio is stuck in the mud.
The other thing is Alpha + beta does exhibit or it has exhibited more consistent returns. For example, over the past 20 years, Alpha + beta was positive in 17 of those years while the S&P 500 was in positive in only fifteen of those years. I should mention alpha + beta in the US outperformed the S&P 500 in fifteen of the past 20 years.
I wanted to touch on one other aspect. The notion of risk mitigation and downside protection now alpha + beta in the U.S. had an upside participation of nearly 90 percent versus downside participation of only eighty one point two percent. So you do get some risk mitigation to the downside, which investors always like, especially in a bear market.
Looking at alpha + beta in Canada, it is even better. Seventeen point four percent annualized over the past 20 years versus 6.3 percent annualized for the TSX 60. Also alpha + beta had lower standard deviation or lower risk than the index at sixteen point nine percent vs. the TSX 60 at nearly 18 percent. This leads to a Sharpe ratio or return per unit of risk of north of 1 for the Alpha + beta Canada strategy compared to 0.35 for the TSX 60 again + plus beta highly correlated with the TSX 60 in Canada nearly zero point nine, indicating very good tracking of the indexes daily performance.
Lastly, just covering some consistency measures. Canadian Alpha + beta positive 18 of 20 years. Only 10 percent of the years were down years beating me index, which was positive in 16 of the years from an upside downside participation perspective of a plus made Canada having an upside participation of eighty eight point two percent with downside participation of only seventy six point four percent. So just really highlighting some of the risk mitigation measures of Alpha + beta, which is really one of the key selling features. So you do see that long term performance while tracking the market really well. So you don’t kind of feel left out, so it tracks market action with some performance and risk mitigation, plus slightly lower volatility levels. So what has not to like?
Michael Kesslering: Yeah. So just to drill down here a bit, what do you think are the reasons for this strategy’s relative outperformance in Canada vs. the U.S.?
Julian Klymochko: Well, we don’t know for sure, but my thesis is that multi-factor investing works better in Canada because it’s less practiced here. Far fewer hedge fund firms would be operating those types of strategies as they do in the U.S. because the U.S. is by far the most competitive market. So I think that largely boils down to a lack of competitive dynamics in Canada. One thing that I should mention is in terms of access to these strategies of alpha + beta, we do offer our Canadian Alpha + beta strategy as the Accelerate Enhanced Canadian Benchmark Alternative Fund trading as ATSX on the Canadian Stock Exchange, the Toronto Stock Exchange. If you want access to that in it, it is really functioning as we indicate in this blog post, 100 percent long, the index puts a 50 long, 50 short multi-factor overlay portfolio meant to generate all those key qualities of this alpha + beta strategy so number one there tracking the index reasonably well, but aiming for higher annualized returns with market in line or slightly lower volatility and that downside risk mitigation. So that summarizes our thoughts on alpha plus beta, certainly a strategy that we think is worthwhile taking a look at.
And that’s it, folks, for episode 54 of The Absolute Return Podcast. If you liked it be sure to leave us a review. You can always check out additional episodes on absolutereturnpodcast.com. Before I close out, I should mention since we did talk about a couple stocks in which we do hold a position just for disclosure compliance purposes, we are long of Apple and Microsoft shares. So we got to let everyone know and disclose that. In addition, I would like to encourage you to follow us on Twitter. Your handle is.
Michael Kesslering: @M_kesslering
Julian Klymochko: And you can find me the people’s hedge fund manager, it is at @JulianKlymochko, K-L-Y-M-O-C-H-K-O. And until next week, wish you all the best in their trading, investing and speculating, but until then, we will chat with you soon. Cheers.
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