Warning: The knife cuts both ways...if the deal falls apart(SDLI falls while JDSU rises).
worldlyinvestor.com Sector of the Day
Market View: JDS Acquisition Creates Arbitrage Opportunity
By Ben Warwick, Columnist
Warwick outlines basic arbitrage tactics to profit from JDS Uniphase's move to acquire SDL.
Give a man a fish and he eats for a day. Teach him to arbitrage, and he will eat for a lifetime.
-- Warren Buffett
Today's stunning announcement of the $41 billion dollar deal between JDS Uniphase (Nasdaq:JDSU - news) and SDL (Nasdaq:SDLI - news) could present a profitable opportunity for readers through merger arbitrage.
The reason that this merger holds so much promise for traders is its size: a whopping $41 billion. In order for the two stocks to converge in value, a lot of speculative cash is needed to ensure that the two stocks converge. Since there isn't as much money dedicated to the strategy, private traders will likely have a chance to cash in just like the pros.
Merger Arb Basics
Merger arbitrage usually entails the sale of the acquiring firm's stock and the purchase of the stock of the firm being acquired. In this example, one would sell JDS short and go long SDL.
The stock price of the firm being purchased usually jumps after the announcement as the market begins to factor in the higher price that the acquiring firm is willing to pay. In this case SDL was trading around $295 on Friday before the news. Today, SDL closed at $320 a share.
The reverse usually happens to the purchasing firm's stock as analysts try to determine how expensive the new company is and how quickly it will add to the bottom line. True to form, JDS shares fell 13% today.
Why doesn't the stock of the company to be acquired immediately jump to reflect the announced merger or purchase price? The answer is that there is some risk that the merger will not be completed. Take a look at the trouble that WorldCom (Nasdaq:WCOM - news) and Sprint (NYSE:FON - news) have had recently trying to get approval for their merger.
If the merger is not completed, obviously the share price will immediately lose its premium. Investors certainly do not want to be left holding the bag from the top. As a result, the price tends to slowly appreciate toward the merger date, fluctuating on the market's take on the likelihood of the completion of the transaction.
Don't Unwind One at a Time
So, how do you take advantage of this? This is a two-part transaction that should be executed at the same time. The terms of the merger state that 3.8 JDS shares will be exchanged for each SDL share. Therefore, you will need to sell 3.8 JDS shares for every SDL share that you purchase. To implement the strategy: sell short the correct number of JDS shares as a hedge, while buying the corresponding amount of SDL (see example below).
As the completion date nears, SDL should gain in value as the two stocks converge toward the approximate purchase price of $440 per share. You are simply picking up the time-value spread in this transaction. You may choose to unwind the arbitrage any time prior to the merger and take your profit. However, make sure you unwind both positions simultaneously to reduce any risk of exposure.
Why not just go long SDL and ignore the hedge? This is very important question. And the answer is simple -- SDL holders are going to receive 3.8 shares of JDS for each share they hold. If JDS stock drops by 50% tomorrow, SDL shareholders are still going to get 3.8 JDS shares, which are now only worth half of what they were the day before! So instead of getting approximately $440 a share, you would only get $220.
However, if you are hedged as we suggest and JDS loses value, the profit on your JDS short should offset the loss in your SDL. Provided the merger happens, you have locked in a profit. Obviously, you need to consider your transaction costs to see if the strategy makes sense.
Example:
Initiate trade:
Buy 10 shares of SDL @ $320, Sell 38 shares (10 times 3.8) of JDS at 101
Hypothetical Exit -- assume no change in JDS price
Sell 10 shares SDL @ $383.80, Buy 38 shares of JDSU at 101
Profit before transaction and margin costs:
$638
Return on Investment:
$638/$3,200 = 20%
Ben Warwick is a principal of The Bornhoft Group Corporation, a registered investment advisor that specializes in alternative investments, and Warwick Capital Management, a quantitative trading firm. The two companies have approximately $220 million in client assets under management. His newest book, Searching for Alpha, is now available. Warwick doesn't own positions in any of the companies mentioned. Positions may change at any time.
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