JetBlue / Spirit Airlines Merger Thoughts
The JetBlue (JBLU 0.00%↑ ) / Spirit Airlines (SAVE 0.00%↑) merger, which is currently being contested by the DOJ, seems like an interesting situation. It is also uncorrelated with the broader market, which is exactly what I am looking for.
If the merger succeeds, Spirit shareholders stand to receive at least $30.00 / share in cash. The stock currently trades at $9.60. The spread is almost comically huge, which implies a large amount of market pessimism both on the odds of a deal going through and on the viability of Spirit as a standalone business.
There are a lot of legal nuances, which have been discussed in far more detail by far more knowledgeable people elsewhere; but, fundamentally, the attractiveness of the deal rests upon one’s estimates of:
The standalone fair value of Spirit if the merger fails
The probability of the merger going through1
Spirit Airlines Standalone Value
Share prices for Spirit have fallen 58% since the deal was announced. This is considerably more than airline stocks in general (JETS 0.00%↑) and most comparable budget airlines:
The broader domestic airline industry has been struggling, but Spirit has also suffered disproportionately from an engine recall, has a weak balance sheet, and does not expect to be profitable anytime in the near future. Given the cut-throat dynamics of the airline business, and its history of bankruptcies, it’s hard to argue that the worst case scenario can’t be zero.
On the other hand, Spirit has had a long, and up until recently, profitable operating history. It will eventually be compensated for the engine issues, which are outside of its control. The management team seems capable. The airline industry has always been competitive, and there is no reason to expect that the company won’t eventually adapt to a tougher operating environment, stemming losses.
Some analysts have argued that Spirit is worth $5 / share on a standalone basis, which would be 78% below it’s pre-deal price and roughly 50% below its current price. This is worse than the performance of other comparable airlines, but inline with my rough estimate of fair value; it seems reasonable as an estimate of immediate downside risk should a deal fail to materialize.
If you believe $5 is a realistic downside and $30 is a realistic upside, the current share price ($9.60) implies merger success odds of only 18.4%. These odds seem unreasonably low to me.
Probability of Merger Success
Again, much has been written about the legal merits of the case from both sides, and I won’t rehash all of them here, but the way I’m looking at things is:
JetBlue presumably thinks they have a strong case, because they will incur heavy financial penalties if they fail (~$470MM of reverse break-up fees, ~$350MM of which has already been paid)
The DOJ presumably thinks they have a strong case, otherwise they would not have brought it forward, or they would have settled pre-trial
Based on the above, and assuming each side is equally competent, assume the starting odds for merger approval were around 50/50 based on the legal merits alone
What could skew those odds from a 50/50 baseline?
“The deal that the DOJ will challenge in October is not the same deal it filed suit to challenge in March.” In particular, the DOJ argues that “the harm would be most directly felt on the more than 40 nonstop routes where "the acquisition is presumptively illegal,” specifically citing the Northeast (Boston, New York) and Florida (Fort Lauderdale). But JetBlue has subsequently said they will divest all of Spirit’s holdings in these regions in connection with the merger. So the DOJ’s argument regarding the “harms most directly felt” by consumers no longer seems relevant, or at the very least has been greatly weakened. This seems to increase the odds in favor of JetBlue.
The judge presiding over the case (who was randomly assigned and unknown before JetBlue decided to pursue the merger) was appointed by Reagan, under whom there were very favorable, pro-business anti-trust policies. Judges’ decisions are widely influenced by political ideology; for example, a study “showed that a small number of personal attributes—including party of the appointing president and a judge's own partisan identification—predicted much of the variance in US Supreme Court justices' voting on civil rights and civil liberties cases.” This seems to increase the odds in favor of JetBlue.
It seems plausible that the odds of approval are at least 50%. But even if you don’t believe that the odds are that high, you merely have to believe that they are higher than the market is pricing in. Arguably, the market implied odds of 18% are far too pessimistic based on the judge’s likely political ideology alone.
If the true odds are 50%, then shares would be worth $17.5, an 82% return.
If the true odds are 30%, then shares would be worth $12.5, a 30% return.
Given that the court is expected to reach a decision within a few months, the annualized return is potentially far higher.
Again, I am not an anti-trust lawyer, and this is just a super high level and amateur analysis of the situation. Betting on mergers is not for the faint of heart; losses from time to time are almost certain, and the results of a merger arbitrage strategy can only be ascertained in the aggregate, across multiple cases, over the long run. But the odds here seem severely mispriced to me, and this seems like a (small) bet worth making.
Update 11/11/2023: Another way to look at the odds is to try to determine the “base rate” of merger success given government litigation. From 2001-2020, the government won ~65% of litigated merger challenges. However, the Biden administration has only won 30% of cases, which is far lower than the historic base rate.
The government has had a better track record among recent “mergers of direct competitors.” It has won 87.5% of cases where there was “no divestiture fix”, but lost 100% of cases where there was a divestiture fix. However, the sample size here is small.
The market implied odds of ~18% seem inline with the worst case scenario of zero divestitures and direct competition. This worst case scenario seems improbable given that Spirit and JetBlue only compete directly a fraction of the time and have already offered divestitures. Something in the 30%-50%+ merger success range still seems realistic after taking the base rates into account.
Update 12/5/2023: I closed out my position. The trial concluded today, and I thought about holding until the verdict is announced, but realized that my original bet was on the odds being mispriced, not on the trial outcome. Given my estimate of current odds (~50/50), the stock seems fairly priced to me now, with little upside in expected value.
Disclosure: I am long SAVE
Some people have argued that the magnitude of the upside (~$30 / share) is also uncertain, because JetBlue could try to renegotiate the merger price, but the arguments I have seen for this seem pretty unconvincing. I’m leaving this factor out in the interest of simplicity.