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Red Hat: Nothing Much to Gain For Arbitrageurs

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A couple of days ago, I was screening for potential stocks to add to my shopping list when I chanced across Red Hat (NYSE: RHT).

Red Hat is an interesting company. It is the world’s leading provider of open-source cloud software. What it does is it creates those softwares for open-source use, and charges businesses for service support – such as maintenance, upgrades and training.

Red Hat maintains some durable competitive advantages – including being the “go-to” provider of trusted open-source applications and services, and being cost-effective and flexible enough to support a wide gamut of OS-es.

In Oct 2018, IBM announced that it would make a $34-billion deal to acquire Red Hat. Touted as one of the largest tech acquisitions to date, I wondered if it would be profitable for arbitrageurs to get a piece of that acquisition pie.

Existing shareholders of Red Hat would certainly benefit from this deal. After all, share prices of Red Hat have jumped from $116 to $175 a pop after the announcement. The target buyout price is estimated at $190 a pop.

Using Benjamin Graham’s Arbitrage Risk Equation, I deduced around a $14 projected profit and $58 projected loss. This leaves me with a 1:4 odds of making money on the deal (barring any subjective probabilities).

We then need to input our own judgement as to whether the deal will go through. As mentioned, there would be little resistance for existing Red Hat shareholders. The buyout price is at a 8.6% premium at the moment (or – more for those who bought at the $100+ range.

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For IBM, synergies are to be expected from the deal. Red Hat’s existing customers would be cross-sold peripheral services from IBM and likewise for existing IBM customers. With Red Hat, IBM will potentially be capturing a bigger portion of the cloud space pie, noting how only 20% of the IBM enterprise accounts are on the cloud. Essentially, the deal would be a win-win for both parties.

The deal will only be completed in the second half of 2019, which leaves us another 6-12 months of uncertainty. As likely as the deal can pass, we might still give a 10-15% probability of it not occurring (due to regulatory constraints, cash flow issues, etc…).

This calculates out to be a potential gain of 14*90% = 13 and a potential loss of 58*10% = 6, which turns the odds 2:1 now. All in all, an arbitrageur can expect to make about 4% p.a. (assuming 12 months) on this deal at current prices.

Pretty sub-par returns for an arbitrageur in my opinion – especially since you can make 3% returns on long bonds without the extra risk.

*Khinwai has no position in any of the above stocks mentioned.

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