Merger arbitrage is when one company has made a takeover bid with the prey trading well below the price that the suitor has offered. Investors try to capture the differential.
There are many different ways to make money in the stock market and one "game" that we sometimes like to play is merger arbitrage. This is when one company has made a bid to take over another with the prey trading well below the price that the suitor has offered. We try to capture the differential. In October, Benj purchased Rite Aid Corp., a drugstore chain in the United States at $7.26 (U.S.), about a year after Walgreens Boots Alliance Inc. made a bid of $9.
The sheer length of time that this marriage has been up in the air indicates that there are lots of questions about whether the companies will walk down the aisle. Rite Aid is the third largest drugstore chain in the United States while Walgreens is No. 1. The U.S. Federal Trade Commission fears that this merger will reduce competition in many regions thereby eliminating consumer choice and it would also give the new behemoth too much pricing power, again weakening the public interest. It appears that they are insisting that if the union takes place, 650 of the almost 12,750 stores would need to be jettisoned. Finding a buyer for these units has been a challenging process.
Rite Aid has been on our Stock Watch List for almost 10 years. From 2008 to 2010 it had periods when it traded under a buck and we wish that it had joined a Contra portfolio back then. However the heavy debt load made the bankruptcy risk too great. It ultimately became one of the countless stocks in the "woulda, coulda, shoulda" camp.
When assessing deals of this nature, considering the downside is vital, for virtually whenever an arrangement falls off the table, the stock price tumbles. Rite Aid is in far better shape than in years past and the feeling here was that if the transaction does unravel, it is unlikely that the stock price will fall below $5. Even if it does, there is a reasonable probability that it will climb back above $8 over the next few years. That would not mean a great gain, especially absent a dividend, but better than a thrashing.
Sometimes in takeovers like this, an investor can dream that the bid might be raised or that another party will come to the table with a higher offer. In this case, both of those possibilities seem exceedingly unlikely.
Soon after Benj bought in, it did seem as if the promising nuptials were unravelling. The stock price swooned and while holding his nose, he added another 50 per cent at $6.61 in November. This is a classic situation of hoping the short game will transpire with a takeout at $9, while recognizing that the long haul might ultimately become "Plan B" if the agreement does not occur.
Until a couple of months ago, the expectation was that if the compact closed, it would be done lock, stock and barrel before the end of the year. The likelihood of that has diminished and Walgreens has extended the deadline until toward the end of January.
Rite Aid currently trades just below $8, so for investors wanting to take a shot, the potential two-month gain is about 13 per cent, rather fetching in this low interest world. If the deal does not close until later into 2017, which would not surprise us, the annualized gain is still huge. If the transaction dies, look for Rite Aid's stock price to tumble like a patient having a vasovagal attack. That won't be Benj, though, as he is prepared for the worst, while hoping for the best.
Benj Gallander and Ben Stadelmann are co-editors of Contra the Heard Investment Letter.