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Spread analysis: Does the Covidien-Medtronic merger make sense?

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Merger spread analysis

To perform merger arbitrage, the investor will generally buy the stock of the company being acquired and sell short the stock of the acquiring company. When the deal is completed, the investor will exchange the stock of the company being acquired with the stock of the acquiring company and cash. The investor will then deliver the shares of the stock received to close out the short position.

COV-MDT Spread

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As you can see from the chart above, here are the cash flows and the timing involved. These prices are based on the close of Monday, June 23. First of all, the investor will be buying Covidien (COV) for $90.53 and selling short 0.965 shares of Medtronic (MDT), which is trading at $64.12. Provided Medtronic is an easy borrow, there should be no cost of carry on the short side. It’s important to remember that to short a stock, you need to locate a borrow on the stock. If your broker can’t find you a “locate,” you’ll have to find a way to set up the position using options. If there’s no borrow and no options on the stock, you’re out of luck unless you’re willing to take market risk.

When you’re short a stock, you’re also short the dividend. So, you have to factor in the dividends you’re short as a cost of carry. On the other side of the coin, you’ll be long Covidien and receive its dividend. As you can see from the chart above, there’s a modestly positive carry on the trade, which is a slight benefit if the deal drags on longer than expected. As an investor, you should always do these calculations based on different timing estimates. The companies are guiding end of 2014 or early 2015, but that’s a point estimate, and some things are simply out of their control (particularly antitrust reviews and the SEC approval of the proxy statement).

Other merger arbitrage resources

You can find Market Realist’s primer on merger arbitrage analysis here.

Other important merger spreads include Time Warner (TWC) and Comcast (CMCSA) as well as DIRECTV (DTV) and AT&T (T).

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