Is Spirit at $16 the Merger Arb of the Year?

Does DoJ make Merger Arb more fun?

The “Merger Arb of the Year”?

In a bidding war to acquire Spirit Airlines SAVE 0.00%↑ , Jetblue won Spirit shareholders’ votes with a superior proposal (to Frontier’s) at a cash offer of $33.5/share (up to $34.15/share) in July 2022.

DoJ filed the complaint in Mar 2023 to block Jetblue’s proposed Spirit acqusition.

The court date was set for Oct 16, 2023, but delayed to Oct 30. It will be held in Boston before US District Judge William Young. In March 2023, Judge Young signaled his intent to move expeditiously and target to rule on the trial by 2023’s end.

Spirit Airlines trades at $16.4 (as of 10/17/2023)

Market and Retail Sentiments

Spirit SAVE 0.00%↑ stock price suggests that the market, other than the initial excitement after Frontier (Feb22) and Jetblue’s proposal(Apr-July22), seems to write off the deal as Spirit currently trades ~50% below the deal price, and even ~25% below the pre-merger price.

However, recent excitements are abundant among retail investors on X/VIC/Reddit, esp Merger Abs bros who won decisively in the Twitter case.

Jetblue’s deal price is $33.5, pre-covid Spirit traded around $35-40/share, Jetblue’s continued efforts to address regulatory hurdles, combined Jetblue Spirit would be smaller than any of the Big 4, all of the above, plus Biden administration’s embarrassing records to block mergers (Matt Levine penned an article titled “The FTC Makes Merger Arb More Fun”), at a headline level, suggests a mispriced opportunity with compelling risk/reward.

Finding Summary

My finding as discussed in this article indicates a commonly held bulls’ view that the current price assigns immaterial odds for the deal to go through, and Jetblue has a very high chance (e.g. 85%+) to win the case, in my opinion, are both quantitatively and qualitatively exaggerated. In this article, I go under the hood to parse SEC filings, DoJ complaints, DoT OoAA data, etc to underscore that.

Having said that, my model suggests both the equity and options market imply the Jetblue winning odds at slightly above 40%. And I’m inclined to think Jetblue has a slightly stronger case, if I have to offer winning odds, I would say at ~60% (as of writing).

Let’s dive into it.

Number Dive: Search For Implied Odds

A naive napkin math goes: “At $16, $33.5 is the upside, say $12 is the downside, implying only 20% odds that Jetblue wins”.

Let us take a serious look at the market-implied odds of trial results. Yes, $33.5/share is the headline deal price but the details under the hood are more nuanced. Here is a section of a reader-friendly announcement and the merger agreement.

To help visualize it, you can find the chart below that shows the actual Deal-Through Price, starting from July 2022. We are currently at month 15 (Oct 23). Deal-through price is the proceeds Spirit shareholders receive if and when Jetblue wins the trial.

The Deal Through Price continuous drop is because the $2.5 ‘sign-on’ bonus (paid in Oct 2022) and $0.1 monthly “ticking fee” (since Jan 2023) will be deducted from the $33.5/share deal price for the final proceeds. Any ticking fee after Dec 2023 will not be deducted from the final proceeds and will continue till either the deal closes or terminates within the outside date in July 2024.

So if the deal closes in 2024, the Deal Through Price is $29.8/share.

Let us take a look at Deal Break Price - what Spirit shall trade at today without Jetblue’s proposed acqusition.

Let us start with peer valuation, I picked Jan 2022 as the starting point, right before Frontier launched its initial takeover offer.

Both Frontier and JetBlue are down ~2/3, Southwest is down 40%, United and Delta are down 13-14%. I would remove JBlue due to its active acqusition noise.

In terms of business performance, a quick 4-year operating and net income comparison reveals both Southwest and Frontier have recovered better than Spirit.

Given the above data, I use a 66% discount off Jan 2022 as the adjusted Deal Break Price ($22.2 * 0.34% = $7.5/share).

Many might counter that 60%+ off is not fair, I would suggest if one thinks cheap airlines going down 60%+ is unfair one can structure a more targeted bet (e.g. long ULCC 0.00%↑) to express that view.

Even if Jetblue wins the trial, there usually exists a price discount (to compensate for unknown unknowns) prior to the closing. For example, TWTR 0.00%↑ was traded at ~5% discount to its deal price for quite a while after the ruling.

Thus I take a 5% discount, so the adjusted Deal Through Price is $28.5/share.

So we establish the baseline.

1. Adjusted Deal Through Price = $28.5

2. Deal Break Price = $7.5

3. Current Price (as of 10/17/23) = $16.4

The equity market implies the odds of 42% that Jetblue wins the trial.

Let us take a look at the options market. The $20 (Mar 2024) call option, currently trades at $3.5/share.

Using $28.5 as Adjusted Deal Through Price, (assume the $20 call option is a 0 if the deal breaks), one pays $3.5 for a potential $5 net profit, which implies 41% odds that Jetblue wins.

So, the equity and options market points to 41-42% odds that Jetblue wins the trial.

Legal Case Assessment

A quick disclaim: I am not a lawyer.

If you haven’t, you should read Lionel Hutz’s analysis, and he also did a podcast with Andrew Walker. Both are informative and worth your time.

Bull’s arguments are DoJ did a fairly good job of laying out its case in March 2023, however, most complaints are addressed by Jetblue’s efforts to not appeal the NEA ruling and agree to divest Spirit assets in key airports. Thus the complaints filed in March 2023 are largely irrelevant today.

There is some truth to that argument.

The antitrust case is largely built upon Clayton Act Section 7, let us take a step back and read the statute:

“In any line of commerce in any section of the country” is further broken down to product and geographic market.

In summary, 2 key elements to the Clayton Act, Section 7.

1. Define product and geographic market

2. Prove (disprove) to lessen competition / create a monopoly

DoJ defines air passenger service as a relevant product market (para 61) and city pairs are relevant geographic markets (para 64).

There isn’t much debate on the product market. On city pairs as relevant geographic markets, the recent DoJ vs American/Jetblue Northeast Alliance case(*) indicates the disagreement would likely focus on a sub-segment (e.g. whether Newark shall be considered a part of metropolitan NYC), not a broad-stroke argument that the US continent or a region (e.g. northeast) as a relevant market.

Now onto 2, lessen competition / create a monopoly.

Even with the position of a city pair as a relevant geographic market, I still find Jetblue has a compelling case that the merger doesn’t create a monopoly at any city pair with a meaningful market share, especially given its recent decision to not appeal NEA termination, and agree to divest Spirit assets in a few key airports.

So I think DoJ’s focus of the trial would be on lessening competition.

DoJ’s complaint says the airline industry is vulnerable to coordination, JetBlue showed a willingness to engage in such coordinated behavior while Spirit often bucks the trend (para 45). Eliminating Spirit who often commands pricing leadership kills competition in areas where Spirit has a pronounced presence.

FWIW, DoJ’s case from Para 45 to 55 makes an intriguing case that is worth reading.

It is intriguing enough I decided to plow through some airline data from DoT to see how much merits that argument has.

The 1st chart shows how often an airline takes a pricing leadership, i.e. having the lowest flight price for each origin and destination city pair in a quarter from 2020 to 2023. The 2nd chart shows each airline’s market share by passenger miles.

Southwest is the clear pricing leader, though its pricing leadership declined from ~50% in 2020 to 43.5% in 2023. Frontier and Spirit are the most aggressive pricing leadership participants, both grew price leadership from 7-8% in 2020 to 12-13% in 2023.

Jetblue and Alaska are 2nd tier followers, slowly growing their price leadership, while Big 3 (American, United, and Delta) gradually exiting the pricing competition, taking 2-3% pricing leadership each in 2023.

The interpretation of the pricing leadership certainly varies:

Jetblue’s PoV could be Spirit and Jetblue together still only represents <20% best pricing, while Southwest leads by a mile, and Frontier is a close peer, not to mention fare price is just a portion of the total cost.

DoJ’s arguments would be Spirit is one of the only 2 (the other being Frontier) buck-the-trend pricing players, and taking it out of the market would further enable Jetblue to join Big 3’s in more coordinated behaviors and fade out of competitive pricing.

I think both can (and I bet will) slice and dice the data to make their arguments. In my view, DoJ has a slightly harder case to make, however, it is not a slam-dunk case for Jetblue. if I have to offer Jetblue winning odds, I would say ~60%.

Conclusion

Market-implied odds at 41-42%, if one agrees that Jetblue has a ~60% of chance winning the case, that 20% odds gap translates to ~25% discount in stock ($16.4 as of 10/17/23), and ~50% discount in March 2024, $20 call option (~$3.5 as of 10/17), to its odds-adjusted fair value.

I prepared a cheatsheet to provide equity and March 24 $20 call fair value at different Jetblue win odds scenarios, for easy reference.

In summary, there are merits to long but not a once-a-lifetime opportunity (like what Twitter presented in 2022) as many bulls believe.

Parting Thoughts

If you are still with me, thank you and I appreciate it.

My work is tailored towards curious-minded investors, who like to explore new ideas/industries, dig deeper, and make their own decisions. My goal is to be a part of your research process, provide relevant info, play the company's (and industry’s) movie in the past, and offer your insights/model to project what the future holds.

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Disclaimer: Nothing discussed in this article is investing, financial or legal advice.

Reference

Department of Justice’s filed complaint to block Jetblule and Spirit merger: Here

(*) Jetblue’s answer to DoJ complaint (5/8/2023): Here