One M&A situation that currently looks particularly attractive to me is the Fitbit (FIT, Financial) deal. When this deal was initially announced it traded at a spread of 1.9%. The market priced in the creditworthiness and reputation of the acquirer Alphabet (GOOG, Financial) (GOOGL, Financial), and there wasn't a lot of return to be had. I didn't like the deal very much because of the potential for regulatory inquiries and tight spread (i.e. low upside).
Right now, the spread between Alphabet's offer for Fitbit and the price at which Fitbit shares trade has ballooned to 12%, meaning that if you buy Fitbit, the return when the deal closes is 12%. Meanwhile, almost a year has passed since the announcement, shareholders gave their stamp of approval and we are much further along the regulatory process.
This is a transaction where one U.S. company buys another U.S. company. That's relevant not only because domestic deals have a higher probability of success, but also because the perceived risk here (which could explain the wide spread) is the risk that the European Commission will block it.
Fitbit is in the business of selling consumer hardware. They have a line of tools including smartwatches and similar gadgets that track health metrics, such as your heart rate, how many steps you take, if you are traveling floors up and down, etc.
The European Commission (EC) has launched a second stage review that is supposed to be concluded on Dec. 9. Alphabet tried to appease the commission and avoid the second stage review. The tech giant offered not to use Fitbit's data for advertising purposes. The EC thinks that doesn't go far enough, as it communicated on its website:
"The commitment consisted of the creation of a data silo, which is a virtual storage of data, where certain data collected through wearable devices would have been kept separate from any other dataset within Google. The data in the silo would have been restricted from usage for Google's advertising purposes. However, the Commission considers that the data silo commitment proposed by Google is insufficient to clearly dismiss the serious doubts identified at this stage as to the effects of the transaction. Among others, this is because the data silo remedy did not cover all the data that Google would access as a result of the transaction and would be valuable for advertising purposes."
A casual reading of the EC's communications likely scared investors, but it is very rare for a vertical merger to get blocked. A vertical merger is when one company buys another company that competes in a different link along the supply chain. Horizontal mergers, when a company acquires a direct competitor in the same market, are much more sensitive.
When a vertical merger gets blocked by regulators, the aggrieved parties can take up the case with the courts. It is not uncommon for the courts to side with the companies.
In a recent landmark judgment, the EU General Court annulled the European Commission's decision against Hutchison's acquisition of Telefónica's "O2" mobile network. In this deal, the number of UK operators would go down from four to three. Traditionally, regulators block these types of deals. However, we've recently seen a shift in thinking when T-Mobile (TMUS) was allowed to acquire Sprint after a lengthy process.
In the recent Hutchison case, a key part of the decision was the required evidence that competition was significantly impeded:
"The Commission is required to produce sufficient evidence to demonstrate with a strong probability the existence of significant impediments following the concentration."
The EC came up with three theories of harm, but the court ultimately decided that these didn't meet this hurdle.
If a horizontal merger, where competitors go down from four to three, wasn't blocked, why would Alphabet be stopped from acquiring Fitbit?
Fitbit has a market cap of around $1.73 billion. Alphabet has a market cap of over a trillion. Fitbit tracks health-related data of 26 million active users. Over a billion users go to Google.com on a monthly basis. Alphabet is willing to silo the Fitbit data. On top of all that, it is not even clear to me that they operate in the same supply chain. Alphabet is an advertising giant while Fitbit sells electronics to consumers.
In my humble opinion, it should be quite challenging to show sufficient evidence this deal would be harmful to consumers.
There is certainly a risk that the EC is willing to go to court. I can even imagine (although I think it is low probability event) that it could block this deal. But I would be highly surprised if the deal gets blocked and the companies lose a subsequent challenge in court.
My main concern with this deal is that it gets delayed even further. The spread is so wide that I'm willing to take that risk. Alphabet or Fitbit can choose to walk away from the deal in May, according to the merger agreement, but they don't have to.
I can also see a scenario unfold where Alphabet mitigates the commission's concerns by giving up more data in the deal. When the EC initiated the second stage review it left the possibility open that Alphabet could silo all data and win their approval.
If Alphabet needs to take this deal to court that's not necessarily a good outcome. The spread is wide but that process could be lengthy and I expect annualized returns would not be very impressive.
Finally, in the low probability event that the deal breaks, I estimate Fitbit can fall 50%. Pre-deal price levels would suggest a smaller drop, but we have to consider there's a pandemic going on. Many stocks have seen their share prices slump.
My calculations suggest an expected annualized return of 19.17%. The actual outcome is likely very different, but that's what I view as the average result. If I was able to invest in this deal a hundred times, over time I'd expect to average a return of 19.17% on an annualized basis, accounting for the wins but also deal breaks.
I've sized this position in a way where a 50%-60% loss would be unfortunate but acceptable to me.
| Name acquirer | Name target | Target ticker | Acquirer ticker | gross spread | expected annualized return | Days remaining until close | estimated closing probability |
| Alphabet Inc Class C | Fitbit Inc | FIT | GOOG | 12.79% | 19.17% | 160 | 90.14% |
Image: author's spreadsheet
To get to my numbers, I used the following assumptions: 167 days before the merger will conclude on average, a closing probability of 90.14% and finally I put the post deal break price at $3 for Fitbit.
Overall, I believe this is an attractive M&A situation. The market seems overly concerned that the deal will get blocked due to the sensitive nature of Fitbit's data. The annualized return is quite high. That's very important because if the deal goes through the return is quite high, which makes up for the unavoidable potential that I'll be wrong.
Disclosure: author is long Fitbit shares and short Fitbit puts
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