FA Alpha Daily

This fund pictured out the FTC’s secret

Amid the FTC’s regulatory scrutiny of major corporate mergers, a group of savvy investors has turned challenges into opportunities. These merger-arbitrage specialists bet on the success of mergers and acquisitions. Pentwater Capital, a standout in this field, has not only survived but thrived. In today’s FA Alpha Daily, we’ll delve into how merger-arbitrage investors, exemplified by Pentwater Capital, navigate FTC challenges and leverage their expertise for success.

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The FTC has had investors on guard this year.

With constant investigations and efforts to block acquisition deals, the conviction of merge-arbitrage investors is being heavily tested.

Regarded as a hedge fund strategy, merger arbitrage funds make plays on the likelihood that a proposed merger and acquisition (M&A) deal will close. This typically consists of buying and selling stock of the two respective companies, ultimately hoping to buy positions in the target company at a discount before the deal is completed.

The opportunity is in the uncertainty of the deals closing. And with recent government intervention, there has been doubt on every corner.

Understanding the strength of the FTC’s investigation provides an upper hand in these scenarios, something that Pentwater Capital’s Matthew Halbrower has seemingly mastered.

Halbrower launched the fund in 2007 with a primary focus on an event-driven strategy. Before launch, Halbrower accumulated years of experience managing event-driven and distressed securities portfolios at Deephaven Capital Management as well as Citadel Investment Management.

Under Halbrower’s guidance, the fund has averaged an 11% annual return, outperforming the HFRI Event-Driven Index’s 4.5% return under the same time frame.

Pentwater’s involvement in high-stake acquisitions has acted as the catalyst for its returns in recent years. Notably, the fund bought shares in Twitter amidst speculation of Elon Musk’s purchase of the company as well as made private investment commitments towards former president Donald Trump’s social media firm efforts to go public.

This year appears to be no different as the fund has reportedly made $100 million upon the closing of the Amgen-Horizon deal.

After talks of a potential takeover of Horizon Therapeutics, Halbower purchased 7 million shares eventually amounting to a 7% stake in the drugmaker. Additionally, with FTC intervention appearing inevitable, Halbower also bought option contracts on Horizon stock as protection against a stock plummet.

When the FTC enacted a lawsuit on May 16th, Horizon’s stock dropped 20% and the options were exercised. However, upon examination of the lawsuit, Halbower quickly understood the weakness that the FTC presented in the case. Leading to his next move, buying more shares.

As predicted, the FTC agreed to stop its pursuit in stopping the deal and on October 6th it was announced that the deal was closed.

With Pentwater’s large stake in Activision, (ATVI) and Seagen (SGEN) we could see a similar story play out in the future.

Today, let’s take a look at Pentwater Capital’s top 15 holdings and see the position of its portfolio after its big win against the FTC.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Looking at as-reported accounting numbers, investors would see that Pentwater Capital invests in extremely low-quality companies.

On an as-reported basis, many of the companies in the fund are significantly below-average performers. The average as-reported ROA for the top holdings of the fund is -1%, which is notably lower than the 12% U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return of Pentwater Capital’s top holdings is actually positive compared to what as-reported metrics show, coming in at 11%.

As the distortions from as-reported accounting are removed, we can see that Seagen Inc. (SGEN) isn’t a -10% return business. Its Uniform ROA is 5%.

That being said, to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Pentwater Capital’s top holdings is actually 11%, which is way above the corporate average in the United States.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Pentwater Capital paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to slightly increase profitability. Moreover, the market has expectations for these companies to also exceed current valuations.

Analysts forecast the portfolio holdings on average to see Uniform ROA jump to 16% over the next two years. At current valuations, the market has higher expectations than analysts and it expects an 17% Uniform ROA for the companies in the portfolio.

For instance, The Boeing Company (BA) returned -3% this year. Analysts anticipate its returns to increase to 9%. Similarly, the market seems to think optimistically about the company’s future and its pricing in an increase in profitability to reach a Uniform ROA of 15%.

Looking at the overall portfolio, Pentwater Capital appears to invest in average companies where the market is pricing in an increase in profitability in the future. However, a large weight of the portfolio’s performance is tied to the outcome of its top two holdings.

Similar to Pentwater’s wager on Horizon Therapeutics (HZNP), Seagen (SGEN), and Activision (ATVI) have been pending FTC approval to be acquired. Pfizer (PFE) has expressed its interest in taking over Seagen and is in the midst of trying to close down a deal. However, the FTC has launched an investigation into the legality of the deal.

Seagen is a biotechnology and pharmaceutical company with a specialty in cancer research and treatments. It appears that Pfizer wants exposure to the cancer space, but this brings into question the power that it will hold if the acquisition goes through.

As for Pentwater, the fund is heavily invested in the deal passing regulation. It is the fund’s top holding and they have about $2 billion worth in stock currently. If things go according to plan, Pentwater could see a heavy cash out in the future.

Moreover, recent news suggests that Pentwater may have accurately called the bluff on the FTC again. UK regulators have approved the Activision-Microsoft (MSFT) deal, which has officially allowed the deal to close as of October 13th. After continuous buys, Pentwater is speculated to be holding about 21.3 million in Activision shares, equivalent to about $1.9 billion.

This $69 billion deal has sparked further questions about regulation and the FTC’s anti-trust initiatives. However, for Pentwater, it means another win in the books. Exact numbers have not been reported for Pentwater’s profits on the play, but this will definitely contribute to its already successful 2023 year.

As for Pentwater’s future, it’s hard to say where the fund will go next but you can bet that Halbower will be following the Seagen-Pfizer deal very closely.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Pentwater Capital’s largest holdings.

SUMMARY and Seagen Inc. Tearsheet

As one of Pentwater Capital’s largest individual stock holdings, we’re highlighting the Seagen Inc. (SGEN:USA) tearsheet today.

As the Uniform Accounting tearsheet for Seagen Inc. highlights, its Uniform P/E trades at 53.5x, which is above the global corporate average of 18.4x, but below its historical average of 81.8x.

High P/Es require high EPS growth to sustain them. In the case of Seagen Inc., the company has recently shown 46% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Seagen Inc.’s Wall Street analyst-driven forecast is for EPS to grow by 19% and 182% in 2023 and 2024, respectively.

Furthermore, the company’s return on assets was 5% in 2022, which is below the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. These signal low operating risk and low credit risk.

Lastly, Seagen Inc.’s Uniform earnings growth is above peer averages, and above peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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