24th November 2009
- How to play the merger between British Airways and Iberia
- The Cadbury's bid could result in some great opportunities
Dear subscriber,
Welcome back. This week, I want to take a look at the merger announced last week between British Airways (BA) and Iberia, and how we can profit from it. I'll also take a look at the latest developments in the Cadbury's story.
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Why the BA / Iberia merger makes sense
A merger between BA and Iberia would be very positive for both companies. It would create a leader in the market for scheduled flights between Europe and the Americas. It would also create a second supranational airline to compete with Air France KLM on long-haul flights.
The deal could also kick-start some much-needed consolidation within the airline industry. The sector has been pretty disastrous for investors, most of whom would probably have been saved a lot of money and heartache if someone had shot down the Wright Brothers' plane before it had completed its first flight.
Anyway - to understand why consolidation is good news, we need to take a look at how the industry works. There are two airline business models: point to point and hub and spoke. The point-to-point model is fine for short-haul flights with no onward connections. The likes of Ryanair, Southwest Airlines, Air Berlin and Easyjet all use it. It's simple, and suits cost-conscious customers who are happy to fly with ruthlessly efficient, low-to-no-frills airlines. This model democratised air travel, enabling it to compete with trains and coaches.
The hub-and-spoke model works best for long-haul airlines. Here, short-haul flights are routed into larger hub airports to get passengers onto connecting intercontinental flights. BA, Iberia, Emirates, United Airlines, Japan Airlines and Qantas all use this model. It relies on having a large network and involves huge fixed costs. But once an airline hits the target capacity needed to cover those costs, any extra sales are almost pure profit. Plus you have the added bonus of juicy revenues from business and first class passengers.
Since BA and Iberia both use this model, a combination of the two could be great for expanding use of their networks, and their geographical coverage. BA is the market leader on North Atlantic routes the ones that connect Britain with the US and Canada; while Iberia is the market leader for South Atlantic routes, which connect Spain with Latin America.
So, if you want to fly between Europe and North or South America there is a good chance they will be able to offer the best prices in future due to the size of their combined network. This dominance could also shield the newly-formed company from growing competition in the Europe to Asia market.
So the deal makes sense the industrial logic' behind it is sound, as the City boys might put it. Now let's look at the numbers and see how we can make money from it.
The bones of the deal
This deal is reasonably complex. But bear with me!
The two companies have agreed to a merger of equals that will result in the creation of a holding company (provisionally called TopCo). It will own the two separate operating companies BA and Iberia. Whether you are a shareholder in BA or Iberia you will receive shares in this new holding company once the merger is completed at the end of 2010.
If you own British Airways (LSE: BAY) shares you will receive 1 TopCo share in exchange for each BA share you hold. And if you own Iberia shares (SM: IBLA) you will receive 1.0205 TopCo shares in exchange for each Iberia share you hold.
The deal will have to pass the usual regulatory hurdles (clearance from the competition and civil aviation authorities) but these should not pose any problems. The only condition that could derail the merger altogether relates to BA's UK pension fund, which is showing an unfunded liability of around £2.5bn. This could yet cause Iberia to walk away from the merger if talks between BA's management and the pension fund's trustees break down.
However even this is not a major barrier to our trading strategy as I explain below in the "what could go wrong" section.
The timetable for the deal is as follows:
Q1 2010 - the merger agreement will be signed after due diligence is completed;
Q3 2010 a shareholders' meeting will be held for Iberia and BA to approve the merger;
Q4 2010 - the merger is expected to close.
How to play the merger
The strategy is simple: buy ("go long") Iberia and sell ("go short") British Airways. That way we profit from the valuation gap between the two stocks (which will close as the merger approaches completion), while protecting ourselves if the broader market falls or rises before the deal is completed.
Here's the maths:
Buy 1,020 Iberia shares (or 10.205 shares) and sell short 1,000 BA shares (or 10 shares). You can change the amounts, but remember to keep the ratio constant.
Your expected profit will be:
BA's share price (1.0205 * Iberia's share price) / EUR/GBP exchange rate
So, going by Monday's closing prices:
£2.04 (1.0205 * €2.02) / 1.11 = £2.04 - £1.85 = 19p = 9.3%
You can buy Iberia stock, and short BA via your spread betting account (for more information on this please see my earlier piece on Pfizer-Wyeth, in Events Trader issue 3). For every 1,020 Iberia shares you buy, you want to sell BA at £10.00 a penny. I suggest you open the position now, while the gap between the shares is reasonably large. Then wait for the first quarter when the merger will be officially signed and the spread should narrow.
What could go wrong?
The merger could fail if pension plan discussions turn sour. But even then you might get an unexpected bonus. Such an outcome would be particularly bad for BA shares, which would probably plunge but you would be short the stock. Iberia by contrast should fall by much less in such circumstances. So, in a nutshell, if the merger goes ahead you get to take the 9.3% profit on your capital by the end of next year. And if the merger fails, you could make even more as BA is likely to fall by much more than Iberia because of the pension fund problems.
The second risk you carry is currency related Iberia's shares are priced in euros. But this only matters if you close the position early. Should you hold it until the merger completes, you don't carry a currency risk, because your Iberia shares will be converted into TopCo shares priced in pounds.
Recommendation:
BUY Iberia shares at €2.02
SHORT BA shares at £2.04
NB: for every 1.0205 Iberia shares you buy, sell 1 BA share. If spreadbetting, this means that for every 1,020 Iberia shares you buy, you should short BA at £10.00 a point.
Let's keep an eye on Cadbury
There is now talk of two or three parties launching a counter bid for the confectionery company.
The first name mentioned in the press is Nestle. The Swiss company is expected to sell the majority of eye-care company Alcon to Novartis by January for $20bn. That would free up money to use to counter bid for Cadbury. The only problem is the competition issues that a merger of Nestle and Cadbury would create. I'm not sure that the European competition authorities would approve such a deal.
The second name in the frame is Hershey. The problem here would be the ultimate need for a single class of shares in the merged entity. This could limit the power of the Hershey family trust over the company (it currently controls 80% of the voting stake in the firm), which is unlikely to be something they'd be happy about.
The third contender is Ferrero from Italy, which makes my favourite chocolate treat Nutella as well as Kinder Surprise. It has over €2bn of distributable reserves and was in talks last week with Mediobanca Italy's leading investment bank over a possible bid.
As a result Cadbury's shares have rallied to above 800p, which could provide us with some opportunities. For a start, talk may be cheap but a bid is very expensive, so the likelihood of a higher bid emerging is small (I would estimate it at around 30-40%).
Secondly, if no counter bid is made, the Kraft offer will probably fail because not enough shares will be tendered. That means 737p is not the floor for Cadbury's shares, which could fall much lower (to say 550-600p). Even if a bid is made, it's unlikely to be much above the current share price.
Let's hang back for now. As this situation develops we'll take advantage when the opportunity presents itself.
As usual if you have any comments or queries do e-mail me at eventstrader@f-s-p.co.uk.
Riccardo Marzi
Events Trader
Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.
Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit.
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Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.
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