To The Moon

Credit card giant $Capital One(COF)$ will acquire $Discover(DFS)$ marking a rare major case in the credit finance industry in recent years.

The original intention of the merger between the two companies is to jointly resist bad debt risks. COF confirmed on Monday that it has agreed to acquire DFS at a valuation of $35.3 billion, all in stock. After the merger, it will become the largest credit card company in the United States with the highest loan amount. The transaction will be realized in stock.

According to the terms of the transaction, each DFS shareholder will receive 1.0192 shares of COF. Based on DFS's closing price of $110.49 on February 16, 2024, the premium is nearly 27%.

In fact, the stock price correlation between these two companies is also very high, especially after the COVID-19 and the Silicon Valley Bank incident last year.

Key Investment points

1. From a business perspective, if there is no better complementarity and a stronger network established, there is no need to discuss the merger of industry giants like this. COF expects the transaction to generate $2.7 billion in pre-tax synergies by 2027 and to increase its adjusted EPS by more than 15% in 2027.

2. Regulatory approval may be very challenging, especially in the financial industry and for companies mainly engaged in lending business. The Silicon Valley Bank incident may lead regulatory agencies to increase the requirements for financial entities to resist risks, and mergers may be a better option, but the merger may also lead to systemic risks. Financial regulators and antitrust departments will consider the worst-case scenario.

3. A full-stock acquisition is not common at present, and it can be said that the two companies are indeed evenly matched. However, this may make arbitrage more likely.

Trading Techs

With a ratio of 1:1.0192, it's almost 1:1, making pair trading (buying one and selling the other) very appropriate.

Based on the closing price of DFS at $110.49, the actual acquisition price is $139.86, a premium of 29%, even higher than COF's stock price. Generally, half of the premium will be eroded at the opening.

Both companies have options, so it will be relatively easy to hedge with derivatives. Specifically, it should be long DFS and short COF.

Assuming it takes one year to complete, with COF's stock price around $135, a premium of over $10 may be appropriate.