By now, the proposed merger of Baker Hughes (BHI) and Halliburton (HAL) is not news. Yet despite a deal that shareholders on both sides are adamantly in favor of, the spread between the Baker Hughes acquisition price and its current stock price remains extreme. This, in part, reflects the widespread view of intense Department Of Justice (DOJ) concern about the deal. Many shareholders seem unsure if the deal will ever come to fruition, but both companies appear to be committed to doing everything they can to get final approval from the government.
The current pessimism in the markets represents a good opportunity for investors. Analysts are not nearly as a pessimistic as the broader market about the deal’s chances of closing with several citing “noise” around the deal as a good opportunity to invest and earn a handsome return.
The merger will create a company with significant synergies and economies of scale, giving the new Halliburton better ability to compete with Schlumberger (SLB). Given that, it makes sense that Halliburton will do whatever it must to close the deal in the end.
In a sign of some regulatory hold-up, the companies recently announced that they were amending the timing portion of the merger agreement to the later of December 15th or 30 days after both companies certify final substantial compliance with the DOJ second request.
Essentially what this means is that the DOJ is still thinking about whether it has any objections to this merger.
The reality is that, given the turmoil in the energy markets, the substantial deflation in the supply chain, and the lack of evidence for a quick rebound in oil prices, it’s difficult to imagine the DOJ seeing the merger as a serious anti-competitive threat. With every energy company on the planet looking to cut costs and putting intense pressure on all suppliers across the value chain, it’s going to be very hard to make a compelling case that BHI-HAL does anything other than let both firm’s compete better with SLB while weathering the downturn. This view is enhanced by the fact that many other relevant countries have already cleared the deal including Canada, South Africa, and Turkey.
That said, the DOJ is likely to take its time reviewing the case, so a 2016 merger closing is much more likely than a December 2015 closing. Under the terms of the deal, Baker Hughes shareholders will receive $19 per share in cash plus 1.12 HAL shares for each BHI share they hold. At the 52 week low price for HAL of $31, this gives BHI a value of about $53.75 a share. That is essentially near where the stock is trading right now. At current prices of HAL, BHI carries a value closer to $60 a share. That represents about a $7 a share profit over BHI’s recent trading around $53.
This return opportunity is asymmetric though.
First, even if the deal does not close, HAL still have to pay about 10 percent of the deal’s value to BHI which represents billions of dollars of cash that could be paid out to BHI shareholders. That’s a pretty good consolation prize if the DOJ does end up fighting the merger.
Second, investors can protect themselves against further falls in HAL stock by going long 5 shares of BHI for every 6 shares of HAL short. Once this spread is locked in, as long as the two stocks move in the same direction, investor profits are largely protected. In recent weeks, BHI and HAL have been moving in sync virtually every day and given the expected $2 billion a year synergies from the deal, it is likely that if the merger were cancelled, both BHI and HAL would fall, so a long-short position in the two stocks offers some measure of protection.
Most of the time merger arbitrage is a safe and staid investment strategy with small returns and little drama. In this case, the drama is more intense, but the return opportunities are considerable. Investors should look carefully at the opportunity.