Get 40% Annualized Returns With This Merger Arbitrage Stock

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- By Ryan Vanzo

There's no such thing as a free lunch. That's especially true when trying to profit using merger arbitrage.

In a yield-starved world, investors have been looking everywhere for easy returns. That's caused the spreads of many merger deals to narrow considerably. Recently, many merger spreads have turned negative, with investors willing to accept a potential loss in order to roll the dice on a bidding war.


Most multi-billion mergers don't offer much arbitrage value today, but if you look at more niche corners of the market, especially in the small-cap space, attractive returns can still be had.

Take Pacific Biosciences (PACB), for example. Illumina Inc (ILMN) announced its takeover bid in November for $8.00 in cash. The deal is expected to consummate in mid-2019.

Now trading at $7.30 per share, Pacific Biosciences offers a nearly 10% return based on the buyout price. The annualized profit is close to 40%.

Why is there such a big discount? Is this a low-risk arbitrage opportunity, or is it picking up pennies in front of a steamroller?

A rare opportunity

Prior to the buyout deal, Pacific Biosciences was valued at just $600 million. Today, it has a market capitalization of only $1.1 billion, meaning few large institutions are paying attention.

Only 7 million shares trade daily, which makes it difficult for most large funds to participate without bidding the price up quickly. Unlike most merger arbitrage opportunities, only retail investors and a handful of smaller funds are able to tap this deal in any meaningful way.

Additionally, the deal isn't in a better-known sector like consumer packaged goods or energy. As I wrote recently, "The small-cap biotech space is one of the least efficient corners of the market."

The small size of the deal combined with the discount applied to many biotech companies only compounds the arbitrage opportunity.

At this point, there are only three risks to this investment.

  1. Execution Risk--Management anticipates the deal will close by "mid-2019." As with any merger, delays can occur for a variety of reasons. While a delay can impact your annualized return, the spread is wide enough that it doesn't matter much. Even if the deal is finalized in December, the annualized yield would be above 10%.

  2. Financing Risk--As we've seen across the energy industry recently, many merger deals go sour after the buyer fails to come up with enough cash. If the biotech sector crashes, for example, Illumina may find itself less willing to pay a premium for Pacific Biosciences. While that's still a possibility, Pacific Biosciences is only 2.5% the size of Illumina. The $1.2 billion purchase price is dwarfed by Illumina's $48 billion market cap. Additionally, Illumina has $3.5 billion in cash on its balance sheet, making the financing risk extremely low in this case.

  3. Regulatory Risk--This is perhaps the only risk on this list with enough uncertainty to warrant true consideration. Illumina currently has a 75% share of the gene sequencing market. It makes the machines that companies like 23andMe and Ancestry.com rely on. According to a recent Morningstar (MORN) report, "By nearly every measure -- sample preparation time, run costs, turnaround time, read lengths, throughput, and error rates -- Illumina squashes the current competition."



    Pacific Biosciences seems to compete in the same market, but there are some big differences considering it takes a different approach. Illumina's technology is based on short-read technology, which often has the lowest costs. This is great for use cases like 23andMe. Pacific Bioscience's sequencers look at much longer strands of DNA, known as long reads. While this approach is more expensive, it makes more sense for higher-risk areas like disease and medical settings.



    The market is growing quickly, so both companies want to protect their competitive positions. Illumina expects the market to grow by 30% annually through 2022, with plenty of room to run over the following decade.



A reasonable bet

In total, this isn't a completely clean arbitrage opportunity, but then again, that's exactly what provides investors with an ability to profit. If Pacific Biosciences wasn't a small-cap competitor within the biotech space, the spread would likely be much narrower.

The only factor that warrants a discount is the regulatory uncertainty. Given the different technologies, use cases, and customer bases, there's still a high chance the deal is approved, especially since it's fairly small. Neither company has given any indication that regulatory agencies will strike down the deal.

This looks like a great way to earn a 10% return in as little as 90 days.

Read more here:

2 Arbitrage Ideas From Warren Buffett and Seth Klarman

This Small-Cap Biotech Stock Could Triple in 2019

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This article first appeared on GuruFocus.


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