Mergers in the Sky
There has been a “buzz” in the media of late surrounding mergers and acquisitions within the airline space. The latest chatter concerns a potential stock-for-stock deal between Continental Airlines (NYSE: CAL) and UAL Corp.’s (NYSE: UAUA) United Airlines. The New York Times reported that talks broke down late Sunday evening when the companies failed to come up with an agreed-upon ratio of United shares for Continental shares.
The sticking point in the deal is that both CAL and UAUA have agreed to an “at-market” deal, but they are in disagreement as to is whether the companies will use stock prices prior to the merger talks becoming public or after (perhaps closer to the closing of the actual merger).
The difference is substantial; United’s shares are up more than 15% since April 7, when news emerged of UAL’s talks with U.S. Airways Group (NYSE: LCC). UAUA and LCC ceased talks last Thursday, according to the Times. Continental’s stock, meanwhile, is up only 9.6% during the same time period.
Merger and acquisition talk can not only cause movement in stock prices, but can also have an effect on options prices, increasing /decreasing volatility and/or changing the “skew” of option volatility. For example, many stocks that are not a possible acquisition target have a negative upside call skew. In other words, implied volatility of out-of-the-money (OTM) calls (as you move above the at-the-money (ATM) strike) tends to decrease.
One of the reasons for this is that many investors write or sell covered calls against their positions. In a takeover or rumored takeover scenario, the targeted company may see an extremely positive upside skew, where implied volatility increases as the strikes move higher.
Overall volatility may also be affected, as parties involved in talks and even companies that are can see their options become more expensive. Even companies that are tangentially related by sector (but not directly involved with rumored takeover talks) can experience changes in their options pricing.
After a merger – if one does take place – the larger new company will often take on volatility characteristics all its own. In many cases, the larger, hopefully more stable company will have a lower volatility (both observed and implied) than the small parts that formed it.
In this case, if an agreement is finally struck, it would simply be a stock-swap deal. This means the acquiring company would use shares of its own stock to purchase the target company without taking on additional debt or leverage. Assuming additional debt could actually increase volatility in the newly-formed company due to the need for that company to service that debt, regardless of market conditions. If business gets worse and the company is more leveraged, this could in turn cause lower earnings, or in extreme cases possible defaults, both of which could have negative repercussions on the stock.
Regardless of what the outcome is for UAL and Continental, use caution and tact when using rumors and/or merger contenders as your basis for investing. The rewards can be high, but there are also many factors that could potentially have a negative impact on the proposed deal. Even deals that are announced formally can still unwind and may face regulatory approval.
For the airlines involved in these deals, even a new, larger company will be sensitive to the price of oil and the strength of the American and global consumer, which are among the risks a potential investor must consider before investing.
Photo credit: Deborah Austin
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