Wright Medical Group: 10% Spread Looks Attractive (NASDAQ:WMGI)

Stryker / Wright Medical Deal Overview

On 4 November 2019, Stryker (SYK) signed a definitive agreement to acquire Wright Medical Group (WMGI) for an equity value of $4.0 billion ($5.4 billion enterprise value) or $30.75 per share. The offer price represents a 24.9x EV / 2020(est) adjusted EBITDA multiple and was set at a 48% premium to the unaffected weighted average share price. With WMGI currently trading at $28.02 per share, the merger spread is 10%. This is an all-cash deal set to complete by the end of July 2020.

The board of directors of both companies have approved the transaction. The deal follows the acquisition by Stryker of spine solutions maker K2M Group, another all-cash deal valued at $1.4 billion.

The acquisition is highly strategic bringing together complementary product portfolios expanding Stryker’s presence in the fast growing $5 billion extremities markets, particularly the global shoulder market, where Stryker has been sub-scale for years. Cost synergies of $100-125 million have been pegged.

Dislocations Still Abound in the Merger Arbitrage Space

Ordinarily, announced non-complex mergers and acquisitions trade on fairly tight spreads. Indeed, as early as 3 March, prior to the onset of the coronavirus crisis, deal spreads traded as tight as 0.5%. Since the coronavirus crisis spread outside of China and became a global phenomenon, it has wreaked havoc on global capital markets. Companies subject to announced mergers and acquisitions have not been spared.

Arbitrage spreads tend to widen during market dislocations for the following reasons:

1. Merger arbitrage investors that deploy leverage are forced to unwind positions to meet margin calls
2. Multi-strategy ‘pod shops’ cut M&A books as risk limits have been breached
3. Some merger arbitrage strategies become forced sellers to meet redemption requests
4. Investors liquidate deal stocks to buy non-deal stocks with greater potential upside
5. Arbitrage investors re-assess the stand-alone value of target companies given declines in comparable companies in the same sector

In the last couple of weeks spreads have gradually started to tighten, reflective of a more normalised and rational pricing environment, yet in many cases current spreads more than sufficiently compensate investors for the underlying risks.

What Does Wright Medical do?

Wright is a global medical device company focused on upper extremities (shoulder, elbow, wrist and hand), lower extremities (foot and ankle) and biologics. The company makes orthopaedic devices and developed the Cartiva treatment for osteoarthritis, a procedure which involves implanting a synthetic cartilage to replace damaged cartilage surface in the big toe joint. This procedure costs around $4,500.Wrightt has also developed an automated surgeon controlled software called BLUEPRINT, which provides 3D construction tools.

Is the Deal Likely to Go Ahead?

The deal is not subject to a financing condition with Stryker funding the acquisition through a combination of cash and debt. Stryker has already issued €850m of notes due 2024 at 0.25%; €800m of notes paying 0.75% due 2029 and €750m of notes due 2031 at 1.0%.

The merger allows Stryker to compete more effectively against big industry players, such as Zimmer BioMet and Johnson & Johnson Syntheses.

A pandemic is not even explicitly listed in the carve out in the material adverse effect section of the purchasing agreement. If COVID-19 was considered a natural disaster, national emergency or force majeure event, it would have to disproportionately impact Wright Medical versus its peers in order to be construed as an event which could reasonably prevent Stryker from consummating the transaction. This would be very difficult to prove in a court of law.

The deal is subject to US and certain non-US anti-trust regulators. After Stryker filed a pre-merger notification and report form with the FTC in December, the FTC sent a second request – a discovery procedure performed by the FTC to investigate mergers and acquisitions that may have anti-competitive consequences. If there is an issue, it is likely to concern Stryker’s foot and ankle segment, which the company may have to divest since Wright already has a 70% share of the total ankle replacement market.

What is the Downside?

Clearly there is downside to Wright’s share price should the merger not be consummated. This is the nature of investing in a merger arbitrage deal – there is a negative return asymmetry and losses may be compounded in the short-term as merger arbitrageurs become forced sellers.

Guggenheim conducted a DCF analysis of the company in November 2019 and derived a fair value of $22.25-40.25 based on the following key assumptions:

	Min	Max
Discount rate	7.0%	8.4%
Perpetual growth rate	2.0%	3.0%

This analysis provides some indication of the downside floor for WMGI should the deal break.

Summing it Up

Strategic deals by and large should complete as there is a willingness and ability from both sides. There is a question on financial sponsored deals, particularly where the offer is at a high premium to the unaffected share price, trading conditions have deteriorated and there are levers that can be pulled to exit the transaction.

Merger agreements today compared to 2008-9 are by and large much more solid and more protective of shareholder interests and the ability of an acquirer to back out of a transaction is much more limited. The current opportunity set is highly likely to be short-lived and spreads should normalise in the next four months. As such, shares of Wright Medical Group are recommended for purchase.

Disclosure: I am/we are long WMGI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.