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Focus Article: Cybex Merger Arbitrage

  • October 19, 2012

A complementary strategy that I have used over the last few years is merger arbitrage where investors attempt to capture the small spread that remain after a deal or merger is announced. We covered the strategy in detail while highlighting the 9.5% spread on Pfizer’s deal to acquire Wyeth in 2009. We revisited the strategy in 2010 in the complex deal between Coca-Cola Company (KO) and the bottling company Coca-Cola Enterprises (CCE), which represented as close to a free lunch as can be found in the markets. A CCE executive who purchased 15,000 shares right before the deal was announced was charged with insider trading. Ironically, he would have made more money if he had purchased the stock after the deal was announced and just held on to it over the next two years.  More than 95% of the deals we track through our merger arbitrage tool and database have closed over the last two years. Cheap credit and rising market conditions have certainly helped fuel this merger boom. The downside is that merger spreads have narrowed quite a bit and it is hard to come by absolute spreads greater than 4% and annualized spreads that are greater than 10% on all cash deals.

Merger spreads are much more juicier when stocks are falling and there is fear in the market. One can also argue that the risk of deals collapsing is also high in such markets. It is important to always keep in mind that this strategy is also called “risk” arbitrage for a reason. A deal that was announced this week caught my eye because it involved a company that is a competitor of our portfolio holding Nautilus (NLS). Existing shareholders of fitness equipment maker Cybex International (CYBI) want to take the company private in an all cash deal priced at $2.55/share, an 89% premium over the closing price before the deal was announced. The deal is expected to close in early 2013. With the stock currently trading at $2.45, there is a 4.08% absolute spread on the deal or an annualized spread of 9.14% if the deal closes on March 31, 2013. While the spread is not as much as I would prefer, there are several favorable factors in this deal and you could look for a better entry point during market weakness.

Some of the risks involved in a merger include,

  • financing risk in case the acquiring company has to raise a lot of outside capital to complete the deal
  • shareholder approval  in case there are dissenting shareholders who want to hold out for more
  • regulatory risk in case a government agency or politicians want to block the deal

In an all-stock deal or a cash plus stock deal, you also have to short the stock of the acquiring company and hence are exposed to borrowing costs. In the case of the Cybex going private transaction, the acquiring company UM Holding along with the CEO and a director already own 49.5% of the company. The Chairman and CEO of Cybex also happens to be the Chairman and CEO of UM Holdings. There is always the possibility that some of the usual lawsuits that are filed after almost every merger announcement might have merit and the purchase price might be revised upwards. However in the absence of a dissenting shareholder and given the 89% premium UM Holdings is paying, I would not hold out hope for a better price. It is highly unlikely the company will face regulatory issues given the size of the company and the crowded fitness equipment segment it operates in. There is a financing contingency associated with this merger but with a market cap of just $42 million and an  enterprise value of $60.9 million, it does not appear to be a big hurdle to cross unless UM Holdings already has a leveraged balance sheet.

Overall the risk/reward ratio looks compelling in this merger and it would be worth keeping this merger on your radar if the spread widens.