Saturday, November 3, 2018

Wall Street sees 20%-25% regulatory risk for IBM's envisioned acquisition of Red Hat

Last Sunday, IBM and Red Hat announced a merger agreement under which "Big Blue" (NYSE:IBM) would pay $34 billion, or $190 per NYSE:RHT share, to acquire the company that once started as a Linux distributor.

I may very well talk about the strategic ramifications of the proposed transaction some other time, but the focus of this post is exclusively on what the stock market appears to think of the deal.

On Monday (October 29), Bloomberg already reported on what was then a 12% spread, "among the highest for North American deals." The article quoted a portfolio manager who said he didn't want to bet on a deal that may be about a year away from closing, and IBM CEO Ginni Rometty as denying "any regulatory inhibitors," which she obviously had to say.

The time frame certainly affects demand, given that risk arbitrageurs could in the meantime use the money they would spend on RHT shares now to bet on a couple of other mergers, provided that those other deals would close more quickly and happen sequentially. But there's more to it. The spread does indicate that merger-focused investors are far from convinced that the deal will materialize.

On Friday (November 2), RHT closed at $172.24. If the deal went through, those investing now would then rake in a profit of more than 10%. Even if it took a year, a 10%+ gain would be a great deal. The only explanation for why there isn't stronger demand, at a higher price, is skepticism. Since I can't imagine anyone doubts that IBM is a serious buyer, the reason must be concern about the merger review process in the U.S. (DoJ), EU (European Commission, DG COMP), and China (MOFCOM). While China prevented Qualcomm from acquiring NXP, IBM reportedly claims it's not critical for the Red Hat deal. I haven't formed a definitive opinion on it yet, but for now I'll take IBM's word for it.

Without going into detail (yet) on the issues presented by the transaction, we can "reverse-engineer" the stock price in order to get an idea of how likely the deal is--in the eyes of sophisticated Wall Street investors--to go through or fall through. Let's start with the roughest and simplest approach, and then fine-tune it a little bit to take the time value of money into account.

The potential upside based on Friday's closing price is $17.76. Theoretically it's even greater since someone else might try to outbid IBM, but that doesn't appear to be considered too likely by anyone.

The potential downside here would not realistically be a complete loss of the investment. Red Hat is doing too well to go out of business anytime soon. The closing price over which IBM offered a premium of about 60% was $116.68, pretty much at a level with RHT's 52-week low of $115.31 (an intraday price as far as I can see).

If the deal falls through, it's a reasonable assumption that Red Hat's stock price will go back to that level, though it's obviously hard to predict what the market environment would be at that point in time somewhere in the second half of 2019. In order to keep things simple, let's not consider that investors might think they could mitigate their loss by getting out once there's a serious negative sign, such as a powerful Statement of Objections (SO) by the European Commission.

Assuming that the pre-merger-announcement closing price is where the price would fall, the potential per-share loss is $55.56 ($172.24 - $116.68).

If the likelihood of closing is estimated to be 76%, and the risk of things falling apart is (consequently) 24%, then there would be an equilibrium (76% x $17.76 is at a level with 24% x $55.56).

Let's fine-tune this by assuming a financing cost of $4.00 per share (roughly the Fed rate, assuming that you have this cost for 12 months). In that case, the potential gain (by placing the right bet on the deal going through vs. doing a far safer investment that would have a 2.5% yield) is $13.76, and the potential loss increases to $59.56. There would then be an equilibrium if the risk of the deal being blocked (or remedies being imposed with the effect of the deal falling through) was estimated at 19% (19% x $59.56 is at a level with 81% x $13.76).

Even in the aftermath of Qualcomm-NXP, that is a fairly skeptical perspective, given that mergers of this kind normally go through.

I've received a couple of independent invitations to meet portfolio managers in New York to discuss the deal, plus various calls and emails. Investors used to follow my coverage of the Google-Motorola process with great interest, and many still remember my vocal opposition to Oracle's acquisition of Sun Microsystems in late 2009 and early 2010. It was funny for me how the numerous Wall Street people I talked to always called the company "JAVA" (based on the stock ticker symbol). Java--the programming language--wasn't an issue at the time; MySQL, the open-source database, was the reason for which the European Commission conducted a Phase II review and issued an SO. It's about open source again, and this time around, Java will be part of the discussion.

As a matter of transparency, Red Hat contributed to my NoSoftwarePatents campaign in late 2004 and early 2005 (two other companies, including one far smaller than Red Hat, were much bigger supporters of the campaign), but there hasn't been any business relationship with Red Hat since. I've never had any relationship with IBM, other than having the greatest respect for the work of its patent department.

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