When your investment catastrophically explodes, the instinctive reaction is to immediately evacuate. In the case of Orbital Sciences (NYSE: ORB), a medium-class space rocket maker, a literal explosion on the launchpad led to the perfect buy-in opportunity for Chris DeMuth of Rangeley Capital. With Orbital on the verge of a merger with Alliant Techsystems (NYSE: ATK), many of the merger arbitrage players holding Orbital reacted to the explosion with understandable negativity and confusion. Meanwhile Mr. DeMuth used a strong fundamental knowledge of Orbital to make a better assessment of deal risk and execute on the opportunity profitably.
SumZero: What about ORB initially caught your attention as a value investor? What was the market missing at the time?
Chris DeMuth, Rangeley Capital: We started to do focused work on ORB when the merger deal with Alliant Techsystems (NYSE: ATK) was announced in April of 2014. We typically will make an investment in a company like Orbital if it is fundamentally valuable with or without the deal. This particular transaction also had a hint of complexity, because it involved a spin-off simultaneous with the merger. As a result of this structure, there was no way to hedge out all the market and fundamental risk from the transaction and it did not fit neatly into a merger arbitrage playbook. So the fundamentals of Orbital along with the complication in deal structure were initially what attracted us to this potential investment.
Although this had many of the traits we like, after we finished our valuation work on Orbital and ATK, the price did not afford us enough downside protection to warrant making an investment at the time. We placed Orbital on our alert list with specific price targets and moved on to other projects. This is not an uncommon outcome for us, as value investors within the event driven category.
SumZero: So what changed to make ORB a worthwhile trade?
Chris DeMuth, Rangeley Capital: On October 28th, Orbital’s rocket launch failed in explosive fashion. It immediately erased over $300 million from the value of Orbital Sciences and another $600 million from the value of ATK at the time. Based on our understanding of the contract with NASA and how insurance payouts work in the industry, this $900 million decline in market value appeared to be a massive overreaction.
Obviously near-term, vivid, negative events can have that kind of an initial negative impact on a stock, but this also had the added component of a large portion of shareholders invested in arb spread, and that group was likely a large component of the selling pressure following the explosion.
In the midst of the crisis, we had positive conversations with the managements of both ORB and ATK. We thought the deal itself was healthy, and even if it broke, we were happy to own Orbital at $24-$25 per share as a standalone.
What was the market missing? In the period of time immediately following a broken or potentially broken deal, there is often significant downward pressure on a stock from the merger arbitrage community who are not positioned to own the standalone company based on its fundamental merits. This turnover in shareholder base can lead to some attractive buying opportunities for those who understand the fundamental value and the dynamics of the transaction.
SumZero: How did the merger arbitrage situation play out?
Chris DeMuth, Rangeley Capital: What made Orbital/ATK interesting to us was that there wasn’t a true arbitrage in this case. One could not quantitatively hedge all the risk associated with the deal before or after the explosion. To invest in this, you had to take a fundamental view of the business. This is precisely what makes wider spread merger arbitrage and broken merger arbitrage so interesting to us in looking for opportunities for mispricing.
The deal officially closed on February 9, 2015. ATK was renamed Orbital ATK (NYSE: OA). Based on the value of OA shares awarded to ORB shareholders, this worked out to be 47% return.
SumZero: What were the biggest risks associated with the trade in your view?
Chris DeMuth, Rangeley Capital: We tried to boil this down to a simple question, is this launch failure a $900 million problem? Ignoring the financial press and the stock’s volatility and just focusing in on the facts, we kept coming to the same conclusion. The market was massively overestimating the cost of this launch failure. Specifically, we focused on the language of the press releases from ORB, ATK and NASA. Our direct experience in program accounting used on long-term government projects was one of the key aspects of our research in interpreting the data from Orbital, and that gave us a high degree of confidence in our thesis.
In the end, the biggest risk in this investment had nothing to do with rocket explosions in our view; it was related to the fundamental value of ATK’s two segments. The key question was how much of ATK’s public valuation was made up of their retail sporting goods business versus their aerospace business. This is the aspect of the transaction that made it difficult to hedge. We used our valuation of the fundamental value of ATK’s aerospace business to determine the ultimate value of the combined ORB/ATK, and that had a substantial impact on the potential upside in the transaction.
SumZero: Is this representative of the Chris DeMuth and Rangeley Capital investing style?
Chris DeMuth, Rangeley Capital: I think Orbital Sciences is precisely representative of the investment opportunities Rangeley Capital is designed to take advantage of in the market. Our strategy is most closely identified in the industry as “event driven” or “value” investing because we invest in businesses that are being impacted by a corporate event that trade at a discount to fundamental value. However, internally we think of our strategy more as “counterparty driven” in that we seek pressured or otherwise non-economic counterparties (i.e. those with narrow mandates, a glaring agency problem, excess leverage, or heightened time sensitivity). We are far more interested the phenomenon of price failure itself rather than any particular market cap/geography/security.
In a situation like Orbital, you have a hard-to-hedge merger arbitrage trade with a rapidly widening spread and a vivid, recent negative event that anyone watching the morning news saw and could react to without any second or third-order thinking. Rangeley is designed to be positioned ahead of time to take advantage of precisely these situations.
SumZero: Where else do you see value in the market today in terms of mispriced merger arbitrage situations?
Chris DeMuth, Rangeley Capital: We’re currently invested in Pozen (POZN). We first stumbled on the company as we were reviewing stocks that had been sold off during the recent healthcare meltdown. Pozen is currently undergoing a transformational merger that will position them as a platform company, and the company will have significant excess cash to acquire new products going forward. While we’re normally hesitant of such an acquisition strategy, the new management team is excellent: the CEO has been involved with four public companies previously and has sold each for a significant premium; in addition, shares trade for a significant discount to our estimates of the company’s current underlying intrinsic value. Shares are up ~10% since we first mentioned Pozen on SumZero, but we see significant continued upside as the company completes their merger and management executes on their acquisition strategy.
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