So, You Wanna Be An Arb?

This is the second page of Luskin's column on the JDS Uniphase/SDL deal. To return to part one, click here.

Now, What Can Go Wrong

But there's a kicker that makes the estimate of the worst-case scenario slightly optimistic: A tidy little $1 billion break-up fee payable by SDL to JDS Uniphase, if SDL walks away from the deal and merges with someone else. That's about 13 points per share of SDL. But it's not payable if the deal busts for antitrust reasons, so let's bake only half of that into our estimate of the no-deal spread, which makes it about 152 3/4.

That means if you do the trade today at an arb spread of 82 7/8, and then the deal comes undone and the spread moves to 152 3/4, you'll be unwinding the trade at a loss of about 69 7/8.

That's the bet: Risk 69 7/8 to make 82 7/8. That's a risk/reward ratio of a little better than 1-to-1. So if you think there's a better than 50/50 chance of the deal going through, then you should do some version of the arb trade.

By the way, note that I said you risk 69 7/8, not that you invest 69 7/8. When an arb buys SDL and shorts JDS Uniphase, he's not spending any money up to do the trade. He just posts securities as a margin, and the proceeds from the short sale more than cover the cost of the long. So whatever gains or losses he makes represent a return on an investment of zero.

The same is true if you sell your pre-existing long position in JDS Uniphase and replace it with SDL -- you're not putting any new money on the table: In fact, you're taking money off the table.

Let's Talk Odds

That leaves the $6.3 billion question: Will the deal go through? The spread is telling us that the market thinks there's less than a 50/50 chance it will. Is the situation really that pessimistic?

According to Mark Langley, an analyst with Epoch Partners who covers both JDS Uniphase and SDL, the deal faces serious risks. Langley thinks the deal would be a big win for both companies, and that acquisition-savvy JDS Uniphase would make the post-merger integration a "smooth transition." But he is concerned that the Department of Justice will throw difficult antitrust barriers in the way of the deal, either aborting it outright or forcing JDS Uniphase and SDL to make painful divestitures.

A combined JDS Uniphase/SDL would enjoy 80% market share in the key 980 nanometer pump chip market; JDS Uniphase's share is more than 50% already. What's a 980 nanometer pump chip, you ask, and who cares? A pump chip is a semiconductor the size of a grain of salt, and it's a critical component for fiber-optic networks, which allows light signals in the fiber to be amplified and regenerated without being slowed down by normal electronic processes.

By weight, 980 nanometer pump chips may be the most precious material in the world. A year's production of these beauties in JDS Uniphase's Zurich factory is worth hundreds of millions of dollars, and the whole thing could be shipped inside a single coffee mug!

Langley thinks the pump chip business is a "crown jewel," and says it's unlikely that JDS Uniphase/SDL would ever divest it. So the antitrust hawks at the Department of Justice might look for other divestiture targets -- perhaps PIRI, the "arrayed waveguide" maker that SDL acquired earlier this year at bargain prices, while JDS Uniphase was distracted in negotiation with the DOJ over its E-TEK merger.

Langley won't let himself be pinned down on the odds of the deal going through. He says, "The deal is a good deal for the companies and very possibly for their customers." But he remains very cautious about the significant regulatory hurdles ahead.

My Take

In my own opinion, the probability of the deal going through is somewhat worse than the 50/50 necessary for you to want to do the arb trade. I'm concerned that this troublesome megamerger may be a bridge too far for JDS Uniphase's new CEO Jozef Straus. And I'm positively paranoid about the Department of Injustice, which in my opinion is on an irresponsible high-tech antitrust rampage.

Call me cynical, but the JDS Uniphase/SDL merger -- the biggest high-tech merger ever -- would make a lovely scalp to hang from Joel Klein's belt.