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Stock Reaction Says Market Still Believes in AOL-Time Warner Deal

The stocks' steadiness in the face of possible regulatory action shows traders expect the deal to fly.

Talk of European regulatory action had little effect Monday on

America Online

(AOL)

and

Time Warner

(TWX)

, as traders continue to expect the deal to pass muster.

Shares of both AOL and Time Warner retreated from their early gains Monday after the online edition of

The Wall Street Journal

reported the

European Commission

, which is reviewing the companies' planned merger, had drafted a plan to block the deal.

But risk arbitragers -- investors who, in deals such as this, try to profit from the gap between the acquiring company's stock price and the target firm's shares -- say they're still confident the deal will go through.

The EC's reported activities are part of the normal negotiating process through which the commission is trying to extract concessions from the companies, says Mike Roth, managing partner of Milwaukee-based

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Stark Investments

. "They're probably going to want to have some sort of comfort that

AOL and Time Warner are not going to crush everyone in Europe," Roth says.

Yet Roth says he doesn't see anything going on in Europe that would cause AOL and Time Warner to say, "The Europeans are being too tough on us. Let's abandon the deal." Roth's firm, which operates an arbitrage hedge fund, has a small stake in the deal.

This optimism was reflected in the recent stock price activity of AOL and Time Warner.

Under the terms of AOL's planned acquisition of Time Warner, Time Warner's shareholders will receive 1.5 shares of AOL stock for each Time Warner share they own. On Friday, AOL's shares closed at $55.25, a price at which each Time Warner share would be worth $82.88 in AOL stock. But Time Warner's Friday close was $79.81, a 3.7% discount from the implied value in AOL shares. An arb who's confident the deal will go through would try to take advantage of the spread by going long on Time Warner's stock and shorting AOL.

But though shares in both AOL and Time Warner fell from their intraday highs Monday afternoon on the European Commission news, the spread between the two stocks narrowed, indicating that arbs hadn't lost confidence in the deal. At Tuesday's close, Time Warner -- up 1.8% to close at 81.25 -- was trading at only a 2.5% discount to equivalent share in AOL, which rose fractionally to close at $55.56.

The big ho-hum from the arb community comes about two weeks after news that regulatory threats to the deal from the

Federal Trade Commission

weren't worrying arbs, either.

"This doesn't faze either one of the companies," says another arb in the deal, speaking on condition of anonymity. "It's fully expected you'd get a comment like this" out of the European Union.

Continues the arb, "You never like to see a comment like this, but it's not unexpected."

Both arbs say that AOL and Time Warner still have time to reach an agreement with European regulators.

"It's obviously not great news, but I don't think this is by any means the final word," says Roth. "We're still early in the game here."