Description

*Submitting prior to leaving for spring break*

Situation Overview:

On October 28, 2018 IBM announced the purchase of Red Hat for $190 in cash. The total transaction value is $34 billion. IBM is paying 8x 2019 billings, 9x 2019 sales, 8x 2020 sales, and 30x FCF.

Trade:

Buy the RHT cash arbitrage spread at nearly 4-5% gross / 9% RoR (it has tightened with credit spreads and vol the last few days. I would add if spread wides). The spread is a reasonable risk adjusted return to generate profit in 2019. In the event, that market volatility leads to widening credit spreads and dislocations within merger arbitrage, the RHT / IBM spread will unlikely to be a source of funds due to no financing condition, and instead cash will likely be deployed into this spread.

Hedge Consideration: bid/ask is wide, but August puts would allow to leg into larger position on dislocation.

Duration to Exit Catalyst / Deal Close:

Aggressive Case: September 15 (depends on anti-trust timeline)

Base Case: October 30

Press Release Timing: December 31

Return:

~4.6% gross return / ~8-9% IRR

Break Price:

Unaffected price: $116.68

Comparable company adjusted price: see chart

IBM: +13%

SPX: 6

S&P Software GIC: 9

Select SPDR: 9

Morgan Stanley SAAS: 32

MS Software: 23

Blend of bottom 2 break-price: $150 per share *There is a case to be made the stand-alone base case is higher than the above range of values.

Issue Spotting:

·         Regulatory risk is the main risk: it is unlikely that RHT / IBM have assets they will dispose in order to attain HSR and EC approvals. In addition, behavioral remedies are unlikely to be cleanse / appease regulatory concerns.

·         Timing: See above

Key points:

·         Merger Agreement filed on October 29th, 2018

·         No go-shop period

·         $975mm termination fee (under certain conditions)

·         No financing condition: IBM is raising $20bn in senior debt; no equity to be raised

·         RHT Advisor is Morgan Stanley (and Guggenheim)

·         IBM Advisor(s) are Goldman Sachs, JP Morgan and Lazard

·         RHT shareholders approved the transaction, January 16th

·         IBM / RHT received a second request for more information

·         EU is reviewing the transaction

Key Filings:

Deal announcement 8k: https://www.sec.gov/Archives/edgar/data/1087423/000119312518310577/d640856d8k.htm

Merger Agreement:

https://www.sec.gov/Archives/edgar/data/1087423/000119312518310579/d640856dex21.htm

Transaction Presentation:

https://www.sec.gov/Archives/edgar/data/1087423/000119312518312328/d633614ddefa14a.htm

Shareholder Record Date:

https://www.sec.gov/Archives/edgar/data/1087423/000119312518346275/d671278d8k.htm

Deal Proxy:

https://www.sec.gov/Archives/edgar/data/1087423/000119312518347874/d654192ddefm14a.htm

Fairness Opinion Disclosures / Background:

https://www.sec.gov/Archives/edgar/data/1087423/000119312519002581/d680511ddefa14a.htm

Shareholder Vote Approval:

https://www.sec.gov/Archives/edgar/data/1087423/000119312519010422/d668489d8k.htm

Strategic Rationale for IBM:

Seems straight forward. IBM will integrate Red Hat into its Hybrid Cloud team but will be a separate business unit. The business will be led by RHT CEO, Jim Whitehurst. IBM was an early adopter of Linux, and should overall benefit IBM longer term, although from a financial perspective it doesn’t really move the needle.

·         Drive hybrid cloud architecture adoption

·         Levered to Paas Space

·         Continue to drive Linux environment

·         Customer overlap / up-sell new technologies / resolve issues quicker

Merger Agreement Key Points:

Termination Language:

Termination. This Agreement may be terminated, and the Merger contemplated hereby may be abandoned, at any time prior to the Effective Time, whether before or after the Shareholder Approval has been obtained (except as provided herein), upon written notice (other than in the case of Section 7.01(a) below) from the terminating party to the non-terminating party specifying the subsection of this Section 7.01 pursuant to which such termination is effected:

(a)    by mutual written consent of Parent, Sub and the Company;

(b)    by either Parent or the Company, if:

(i)    the Merger shall not have been consummated by 11:59 p.m., Eastern time, on the date that is twelve (12) months after the date of this Agreement (the “Initial Termination Date,” and, such time and date as it may be extended pursuant to this Section 7.01(b)(i), the “Termination Date”) for any reason; provided that if as of the Initial Termination Date all conditions to this Agreement are satisfied (other than those conditions that by their terms are to be satisfied at the Closing, each of which is capable of being satisfied at the Closing) or waived (to the extent permitted by applicable Law), other than the conditions set forth in Section 6.01(b) or Section 6.01(c), either Parent or the Company, by written notice to the other, may extend the Initial Termination Date to 11:59 p.m., Eastern time, on the date that is three (3) months after the Initial Termination Date (the “First Extended Termination Date”); provided, further, that if as of the First Extended Termination Date all conditions to this Agreement are satisfied (other than those conditions that by their terms are to be satisfied at the Closing, each of which is capable of being satisfied at the Closing) or waived (to the extent permitted by applicable Law), other than the conditions set forth in Section 6.01(b) or Section 6.01(c), either Parent or the Company, by written notice to the other, may extend the First Extended Termination Date to 11:59 p.m., Eastern time, on the date that is six (6) months after the Initial Termination Date (the “Second Extended Termination Date”); provided, however, that the right to terminate this Agreement under this Section 7.01(b)(i) shall not be available to any party whose action or failure to act has been a principal cause of or directly resulted in the failure of the Merger to occur on or before such date and such action or failure to act constitutes a breach of this Agreement.

(ii)    any Legal Restraint having the effect set forth in Section 6.01(c) shall be in effect and shall have become final and nonappealable (it being understood and agreed by the parties that only a court of competent jurisdiction or other Governmental Entity in the jurisdictions identified on Section 6.01(c) of the Company Letter shall constitute a court of competent jurisdiction or other Governmental Entity); and provided, further, that the right to terminate this Agreement under this Section 7.01(b)(ii) shall not be available to a party if the failure of such party, and in the case of Parent, including the failure of Sub, to perform any of its obligations under this Agreement has been a principal cause of or directly resulted in the issuance of such final, non-appealable Legal Restraint; or

(iii)    the Shareholders Meeting shall have been held and the Shareholder Approval shall not have been obtained thereat or at any adjournment or postponement thereof;

(c)    by Parent prior to the Shareholder Meeting, in the event (i) an Adverse Recommendation Change has occurred or (ii) the Company has delivered an Intervening Event Notice or a Superior Proposal Notice and Parent has, in response thereto, delivered a notice of its intent to terminate this Agreement prior to the expiration of the Intervening Event Notice Period or the Superior Proposal Notice Period, as applicable, and has publicly and irrevocably waived its rights pursuant to Section 4.02(c) and Section 4.02(d), as applicable; provided, in the case of this clause (ii), that Parent shall not be entitled to terminate this Agreement pursuant to this Section 7.01(c) unless Parent provides at least one (1) Business Day advance written notice;

(d)    by Parent, if the Company shall have breached any of its representations or warranties or failed to perform any of its covenants or other agreements contained in this Agreement, which breach or failure to perform (i) would give rise to the failure of a condition set forth in Section 6.02(a) or Section 6.02(b) and (ii) (A) is incapable of being cured prior to the Termination Date or (B) is not cured by the Company on or before the earlier of (i) the Termination Date and (ii) the date that is thirty (30) Business Days after written notice from Parent of such breach or failure; provided that Parent shall not have the right to terminate this Agreement pursuant to this Section 7.01(d) if Parent or Sub is then in material breach of this Agreement or if any representation or warranty of Parent or Sub shall have become untrue, in either case, so as to result in the failure of any of the conditions set forth in Section 6.03(a) or Section 6.03(b);

(e)    by the Company, if Parent shall have breached any of its representations or warranties or failed to perform any of its covenants or other agreements contained in this Agreement, which breach or failure to perform (i) would give rise to the failure of a condition set forth in Section 6.03(a) orSection 6.03(b) and (ii) (A) is incapable of being cured by the Termination Date or (B) is not cured by Parent or Sub on or before the earlier of (i) the Termination Date and (ii) the date that is thirty (30) Business Days after written notice from the Company of such breach or failure; provided that the Company shall not have the right to terminate this Agreement pursuant to this Section 7.01(e) if the Company is then in material breach of this Agreement or if any representation or warranty of the Company shall have become untrue, in either case, so as to result in the failure of any of the conditions set forth in Section 6.02(a) or Section 6.02(b); or

(f)    by the Company, at any time prior to obtaining the Shareholder Approval, if (i) the Company has received a Superior Proposal after the date of this Agreement that did not result from a breach of Section 4.02 or any other provision of this Agreement, (ii) the Company Board has authorized the Company to enter into, and the Company concurrently enters into, an Acquisition Agreement to consummate the alternative transaction contemplated by such Superior Proposal, (iii) simultaneously with, and as a condition to, any such termination the Company pays or causes to be paid to Parent (or its designee) the Termination Fee pursuant to Section 5.06(b) and (iv) the Company has complied with Section 4.02(c) with respect to such Superior Proposal.

Material Adverse Change:

“Material Adverse Effect” means any state of facts, change, development, event, effect, condition, occurrence, action or omission (each, an “Effect”) that, individually or in the aggregate, would reasonably be expected to (i) result in a material adverse effect on the business, assets, properties, financial condition or results of operations of the Company and its Subsidiaries, taken as a whole or (ii) prevent, materially impede or materially delay the consummation by the Company of the Merger or the other transactions contemplated by this Agreement; provided, however, that in no event shall any of the following Effects, alone or in combination, be deemed to constitute, or be taken into account, in determining whether there has been, or would be, a Material Adverse Effect: (A) any change in general economic, market or political conditions affecting the United States economy, or any other national or regional economy or the global economy generally that does not disproportionately affect the Company and its Subsidiaries, taken as a whole, relative to other participants of a similar size in its industry, in which case only the incremental disproportionate effect shall be taken into account; (B) any change in GAAP or applicable Law that does not disproportionately affect the Company and its Subsidiaries, taken as a whole, relative to other participants of a similar size in its industry, in which case only the incremental disproportionate effect shall be taken into account; (C) any act of terrorism, war (whether or not declared), national disaster, cyber-attack or any national or international calamity affecting the United States or any other country or region of the world that does not disproportionately affect the Company and its Subsidiaries, taken as a whole, relative to other participants of a similar size in its industry, in which case only the incremental disproportionate effect shall be taken into account; (D) changes in the financial, credit, banking or securities markets in the United States or any other country or region in the world (including any disruption thereof and any decline in the price of any security or any market index) and including changes or developments in or relating to currency exchange or interest rates that does not disproportionately affect the Company and its Subsidiaries, taken as a whole, relative to other participants of a similar size in its industry, in which case only the incremental disproportionate effect shall be taken into account; (E) any failure to meet internal or published projections, forecasts or revenue or earnings predictions for any period (provided that the underlying causes of such failures may constitute or be taken into account in determining whether there has been, or would be, a Material Adverse Effect); (F) any change in the price or trading volume of the Company Common Stock in and of itself (provided that the underlying causes of such change may constitute or be taken into account in determining whether there has been, or would be, a Material Adverse Effect); (G) the negotiation, execution or delivery of this Agreement or the public announcement (including as to the identity of the parties hereto) or pendency of the Merger or the other transactions contemplated by this Agreement, any loss of or adverse change in the relationship of the Company and its Subsidiaries with their respective employees, customers, distributors, licensors, partners or suppliers attributable to the announcement or pendency of this Agreement or the transactions contemplated hereby; provided that this clause (G) shall not apply to any representation or warranty (or any condition to the consummation of the Merger relating to such representation and warranty) to the extent the purpose of such representation and warranty is to address the consequences resulting from the execution and delivery of this Agreement or the consummation of the Merger; (H) the occurrence of natural disasters, force majeure events or weather conditions adverse to the business being carried on by the Company and its Subsidiaries; (I) any action or omission of the Company or any of its Subsidiaries taken with the prior written consent of Parent (or any action not taken as a result of a failure of Parent to consent to an action otherwise requiring Parent’s consent); or (J) any public statement by Parent regarding the Neutral Platform Model or those matters set forth in paragraphs 9-12 included in the press release issued by Parent and the Company on October 28, 2018.

SAAS M&A Comps (source BAML):

Summary:

The RHT cash arbitrage spread is an attractive relative return trade. In the event the spread widens due to market events rather than idiosyncratic, I would increase the size of the position.

Catalyst:

Transaction close

Catalyst

Deal Close

Opportunity to add to cash spread if volatility increases across markets