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Type of situation: Mispriced merger arb situation due to regulatory issues

Updated: October 30, 2023 (see end of article for update)

Market Cap: $1.8B – Share price at publication: $16.80

Why look at this?

This is a mid-cap merger arbitrage situation that has been dragging out for over a year but is reaching an inflection point in the coming weeks. After a takeover battle between Frontier Airlines and JetBlue Airlines, Spirit Airlines’ shareholders agreed to a takeover by JetBlue for $33.50 cash/share in October 2022. The Department of Justice, the Department of Transportation and a class action lawsuit are attempting to block the deal which will go to trial at the end of October (barring there is no government shutdown). The merger spread currently stands at around 85%, implying that the market gives the transaction little chance to go through. JetBlue has made substantial concessions, including surrendering in an antitrust case over a partnership with American Airlines and agreeing to divest a number of assets in certain markets with overlap between both airlines to the competition.

While this is a merger with many eyes on it, I am inclined to say that the market is underestimating the odds of the deal going through. The spread is probably the most attractive merger spread in non-obscure stocks in a long time and the risk-reward here looks compelling, though comes with its risks.

The angle here is to bet on the odds implied by the market will move higher once the trial starts. JetBlue’s share price has crashed, implying a 90% chance that this deal goes through as the market seems to believe that they are overpaying here. Odds implied by Spirit’s share price are much lower (around 30%) and there is ample room for the stock to at least close the very wide merger spread before or during the trial.

Also, there is a non-zero chance that the DOJ may settle with the defendants here given that many of the deal metrics have substantially changed over the course of the year.

Deal metrics and motivation behind the transaction

JetBlue and Spirit have agreed to merge. The decision came after a long bidding war between Frontier Airlines and JetBlue. In the proposed deal, JetBlue will buy Spirit Airlines for $33.50/share, including a pre-payment of $2.50/share at the time of shareholder approval by Spirit’s shareholders (which has already been paid-out in 2022). JetBlue is also currently paying Spirit’s shareholders a ticking fee of $0.10/month since January 2023 until closing of the deal. The ticking fee is also being deducted from the original $33.50 buyout price until December of 2023 (after which JetBlue will pay out of pocket). Assuming the deal closes at the end of Q1 of 2024, the cash consideration on the table therefore currently stands at $30.10/share when deducting the $2.50 pre-payment and 12 months of $0.1 ticking fee, and adding another $0.30 for three months of additional ticking fee not deducted from the original purchase price. Spirit’s share price is currently trading for around $16.80, implying a potential upside to the takeover price of close to 80%.

Should the deal be blocked by the regulators, JetBlue will pay a break fee of $70m to Spirit Airlines and $350m to Spirit Shareholders. The latter, however, includes the $2.50/share pre-payment as well as the ticking fees – and has therefore essentially completely been paid out already.

In the case that the deal goes through, the Spirit brand will cease to exist and the company is to be integrated into JetBlue, which will then be competing head-to-head with the big 4 full service carriers that together hold about 70-80% market share in the US domestic segment (American, Delta, Southwest, United).

JetBlue’s motivation behind the transaction is obviously driven by a desire to grow and become another major carrier in the US next to the big 4. Although in a perfect world it could theoretically achieve this goal by growing organically, there are severe constraints on organic growth due to shortages of planes, pilots and gates. Merging with Spirit would allow JetBlue to achieve approx. 10.5% market share in the US and would make it the fifth largest carrier domestically.

Deal history

As mentioned before, this deal has been in the making for quite a while now. For the analysis on the regulatory front, I believe that it makes sense to go through the history of this transaction briefly:

• February 7, 2022: Frontier Airlines (ULCC) and Spirit announce a merger in which Frontier would be buying Spirit in $2.13 cash/share and 1.9126 shares of its own stock. Following the announcement of the deal which was aimed at closing in H2 of 2022, a number of consumer advocacy groups voiced their competitive concerns around the transaction.

• April 5, 2022: JetBlue enters the bid and offers $33/share in cash, then a 50% premium to Spirit’s share price. Key differentiator in the offer was that it came as an all-cash offer, compared to Frontier’s combined cash and stock offer.

• May 2, 2022: Spirit turns down the JetBlue offer in favor of merging with Frontier. It was reported that Spirit saw the potential deal with JetBlue as too risky on the regulatory front.

• June 2022: Regardless of Spirit’s antipathy of a marriage, JetBlue continues its pursuit for Spirit: While Frontier announced it would pay Spirit a $250m break-up fee if the deal fell through due to regulatory issues, JetBlue in response increased its break fee to $350m and said it would pre-pay $164m in the latest offer to shareholders, should they accept the proposal.

• July 2022: Spirit repeatedly delays shareholder votes. Shareholder group ISS advised Spirit’s shareholders against the deal with JetBlue. However, the airline subsequently announced it was no longer pursuing a deal with Frontier, paving the way for a shareholder vote for the proposed transaction with JetBlue.

• October 2022: A majority of Spirit shareholders approved the merger with JetBlue. The companies aimed for a closing in early 2024.

• November 2022: 25 private citizens filed an antitrust action in the Northern District of California under Section 7 of the Clayton Act, arguing that the merger will limit competition and be in violation with antitrust laws.

• February 22, 2023: Spirit’s flight attendant union supports the merger with JetBlue.

• March 2023: The Department of Justice (DOJ) filed a lawsuit against the merger, citing concerns about the competitive landscape. However, observers noted that JetBlue had a significant bargaining chip on its hands in potentially giving up its Northeastern Alliance with American which the DOJ always viewed as anti-competitive. The merger then ran into another roadblock after the U.S. Department of Transportation denied an exemption request by the two airlines to operate under common ownership before the deal would close.

• May 2023: JetBlue and American Airlines lose their court battle brought forward by the DOJ regarding the anti-competitiveness of the “Northeastern Alliance”, prompting both airlines to end their partnership within 30 days. U.S. District Judge Leo Sorokin said the partnership “substantially diminishes competition in the domestic market for air travel.”

• July 2023: JetBlue decides not to appeal the ruling against the “Northeastern Alliance” and to focus on the court battle to save the deal with Spirit.

• August 2023: A report by Law360 said that JetBlue was planning on raising airfares on routes flown by Spirit by up to 40% if the two airlines were to merge. The report cited leaked documents that were improperly redacted by JetBlue’s lawyers as part of discovery in a private lawsuit to block the deal.

• September 2023: JetBlue’s pilots support the merger, saying it would be beneficial to pilot’s career opportunities and good for the company. The airline’s flight attendants had already supported the deal in February. Later that month, the airline’s flight attendant union also voices support for the merger.

• October 2023: The lawsuit brought forward by the DOJ against the merger will go to court at the end of October. The U.S. district judge William Young has said that he plans to issue a ruling on the matter by the end of the year or early next year (as the trial was recently delayed by a month).

Target company profile

Spirit Airlines, trading on the NYSE under the ticker SAVE, is one of the leading ULCCs (ultra-low-cost carriers) flying 197 Airbus narrowbodies throughout the United States and to a small number of international destinations. The airline has 104 Airbus A320/21neo on order. Other players in the ULCC sub-segment include former bidder Frontier Airlines (132 in fleet/204 on order), as well as Allegiant Airlines (126/50), Breeze Airways (33/64), Avelo Airlines (16/0) and Sun Country Airlines (55/5).

Spirit began its history in 1964 as a trucking company and in 1992 bought its first aircraft. After multiple strategy changes, the company in 2006 saw an investment by Indigo Partners. Indigo is a private equity firm founded by airline entrepreneur Bill Franke with a focus on investing in low-cost airlines. The firm holds interests in Frontier Airlines, Spirit’s largest direct competitor, Mexican budget airline Volaris (VLRS) and European low-cost carrier Wizz Air (WIZZ.LN). Indigo no longer has an interest in Spirit. Under the private equity firm’s ownership, the carrier focused on a ULCC business model and has grown to be the largest one in this specific sub-sector. Spirit has a 5.0% market share in the US domestic air travel segment (vs. JetBlue with 5.5% and Frontier with 3.5%).

Spirit Airlines is headquartered in Miramar, Florida and is organized as a Delaware corporation. The company does not have any major active shareholders and trades with 100% free-float.

The airline has been loss making since the pandemic and was unable to turn a profit during the current travel boom. In a note to investors recently, the company said that it sees weaking demand going into the winter season.

Catalyst

The shares of Spirit are trading with a potential 80% upside to the takeout price. The catalyst to lift shares to a higher level would ultimately be a favorable outcome of the forthcoming trial in which the DOJ is seeking to block the transaction or a settlement between JetBlue and the DOJ. It can also be argued that currently, the market misprices the odds of the deal going through at just about 30% and that shares have a good chance of re-rating higher even before the trial begins at the end of October. The case brought forward by the DOJ will go to trial on October 23, 2023, barring a government shutdown. The judge assigned to the case has been cited as seeking a ruling originally before year end. The trial, however, has most recently been delayed by a week with a potential delay to the ruling. JetBlue and Spirit are still aiming at closing the deal in H1 2024. Should the trial be won by JetBlue/Spirit, there is potentially another roadblock ahead as the DOT may also seek to block the transaction. JetBlue/Spirit will have the opportunity to fight such a situation in case the DOT goes through with those intentions. This challenge may delay the deal further from closing. In any case, a win in the upcoming trial should have the stock re-rate closer to its proposed buyout price given the enormous spread.

While there are a number of severe risks that this transaction won’t ultimately go through, I believe that the market is currently underpricing the odds of closing in regards to Spirit Airlines’ stock. While JetBlue’s shares have sold off heavily over worries that the airline is severely overpaying for its competitor, the acquirer’s shares almost fully price in a closing of the deal. With the spread standing at about 90% in Spirit’s stock price, a re-rating as the trials moves closer to slightly higher odds seems very much possible.

Regulatory issues

As already outlined above, the U.S. airline industry is already highly concentrated with the four largest airlines owning between 70-80% of the market, depending on which factors are considered. It is a de-facto oligopoly that is the result of a wave of mergers in the early 2000s. American absorbed TWA, Eastern, US Airways, Piedmont and America West. Delta and Northwest merged, United and Continental joined forces and Southwest acquired AirTran. The most recent sizable merger was the combination of Alaska Airlines and Virgin America in 2016 (although tiny in comparison to the big 4).

The DOJ and the FTC (although the latter is not directly involved in this situation) have been championing the idea that “big is bad” under current ideological thought. The U.S. Secretary of Transport, Pete Buttigieg, has been cited that his department is seeking to actively induce more competitiveness into the sector. In short, the regulatory bodies in the United States hate the thought of more consolidation in the airline industry and are trying to block any such initiatives.

A common argument against future mergers in the airline industry runs that service overall has declined in recent years and fares have gotten more expensive across the board as competition waned amid the consolidation waves. The DOJ, DOT and the private lawsuit all allege that a combination of JetBlue and Spirit, although each owning just about 5% of market share, would harm competition further as it will effectively eliminate one of the cheapest options of air travel given that Spirit is a ULCC and often the by far cheapest option on the routes it serves.

So, what are the chances that the lawsuits go against JetBlue and Spirit? And are there any odds that may turn this deal in the airlines’ favor?

There are four areas that the DOJ focusses on in its complaint against the airlines:

• A merger would put an end to head-to-head competition between both airlines;

• JetBlue could eliminate “basic fares” and make travel more expensive;

• Less choice will lead to rising fares and reduced seat capacity;

• Merger potentially facilitates increased coordination between JetBlue and other large competitors;

Let’s try to analyze each point. I’ve taken some inspiration for this analysis from a very solid blog post by lawyer Lionel Hutz and I recommend everyone considering doing research on this situation read his Substack article he recently wrote.

Merger would end competition between both airlines

The Department of Justice argues that once both airlines have merged, they obviously would stop to compete with one another on routes where they currently overlap. While this is obviously an accurate assumption, JetBlue has already taken drastic steps to ensure that this argument won’t hold up as it has signed extensive divestiture agreements at key airports where both airlines compete head-to-head with each other.

These agreements were revealed both in June and September of 2023. In June, JetBlue announced it would be transferring all of Spirit’s holdings at New York LaGuardia (LGA) airport to Frontier Airlines (6 gates and 22 slots). Frontier has no presence at LGA and will therefore enter into a new market to continue to provide ULCC service at one of New York’s most important airports in regards to domestic air travel.

Additionally, in September, JetBlue said it would divest all of Spirit’s gates and slots in both Boston (BOS) and New York-Newark (EWR) to Allegiant Air. Part of the transaction would be a further transfer of assets in Fort Lauderdale (FLL), where both Spirit and JetBlue currently have a large presence. While the September agreements seem as if they were solving issues of competition in some key markets, they may raise some questions: Allegiant, while also a ULCC, runs an operation that focusses on rather infrequent budget flights as opposed to high frequency-services by Spirit. Also, in Fort Lauderdale, Spirit and Allegiant are the two biggest players; divesting assets there would create some form of dominance for the acquirer Allegiant and not necessarily solve the equation for more competition in that market. A divestment to Frontier here would have made more sense given that it operates a base at FLL. This market could potentially become dangerous in the trial given the choice of acquirer of Spirit’s assets there.

However, in light of the surrender of the “Northeastern Alliance” as well as the extensive divestments, one must view the competitive landscape in those particularly contested markets in a new light. Essentially, in regard to the argument brought forward by the DOJ, the competition between Spirit and JetBlue will continue to exist, although the competitors will now be other airlines.

Less consumer choice

In the lawsuit, the DOJ says that other airlines are only offering “basic fares” due to Spirit pioneering a so called “unbundled” fare structure where passengers purchase only the right to fly but must pay extra for virtually everything from seat reservations to bags to drinks. As the legacy carriers in the US (and everywhere in the world) are now mirroring this concept with their own “basic fares”, the DOJ is worried that by eliminating Spirit as a market participant, basic fares will vanish and that customers will have to pay more across the board.

First of all, basically every single airline in the world now offers a basic fare. I would even doubt that the idea of such a fare structure was not pioneered by Spirit but rather by European LCCs. Be that as it may, airlines will highly likely continue to offer such fares as they are demanded by cost conscious travelers. As these fares are offered in almost any aviation market in the world now, most of which have obviously no presence of Spirit, I find this argument hard to fathom.

As has been pointed out by some in the antitrust community, JetBlue could be forced by the court to continue offering such basic fares by a consent order that would make the airline to keep those kind of fare structures in place. In my personal assessment of the situation, JetBlue will continue to offer such fares regardless of the merger simply as this pricing structure has become industry standard.

Less seats and lower capacity

In September, there was a leak of incorrectly redacted documents from parts of the discovery in the private lawsuit against the merger. The documents were leaked due to a clerical error of the court. Those documents include passages that can be interpreted as JetBlue planning to increase ticket prices on current Spirit routes by 24-40% and remove 24 seats per plane following the merger.

Spirit operates its aircraft in a high-density configuration to cram as many seats into its aircraft as possible / as many as regulations allow. JetBlue plans to remove seats to lift the standard of comfort to that of its own fleet which is lower density and also offers a true first class (whereas Spirit offers a kind of third-rate business class on board its planes). The DOJ is therefore worried that by removing seats and capacity, prices will rise. Likely, the DOJ complaint in this particular case rests on the worry to what happens when Spirit leaves certain markets all of a sudden that don’t have other ULCC presence. Say LaGuardia, Newark, Fort Lauderdale, Boston. JetBlue seems to agree or anticipate on the worry and as described above, have already agreed to divest assets (slots, gates) in those critical markets to other ULCC players.

The stock of Spirit dropped heavily on the news of the document leak. One must consider, however, that it is not clear just what kind of documents these were; they could have been internal projections by JetBlue, or some advice from a consultancy firm of what JetBlue could do or an assessment of what the DOJ may fear and what could derail the merger.

Loss of the “Spirit Effect”

The DOJ also argues that there is a “Spirit effect” which results in lower fares once the ULCC enters a route. Spirit ceasing to exist would put an end to this effect and the DOJ fears that ultimately, there is no one left that will enter a market with low fares and force the competition into lowering their ticket prices. In their view, even if JetBlue continues to fly those routes, the lower seat count and their higher fares negate the effect of their presence on pricing of the competition.

The problem with this theory which is also explicitly named in the complaint, is that people have been talking about all sort of effects: The “Southwest effect”, the “Frontier effect” and even more recently the “JetBlue effect” as they entered the transatlantic market from the East Coast to London and Amsterdam.

Personally, I would argue that whenever a LCC or ULCC sees that a market is served by only one airline that is jazzing up prices, they have an inherent incentive to enter that very market, regardless whether they are Spirit, JetBlue, Frontier or Allegiant.

Merger would facilitate deeper cooperation between JetBlue and other airlines

This is another interesting angle that the DOJ is criticizing in its complaint as it fears that a larger JetBlue is more likely to coordinate their strategy with other (large) airlines following a merger. Essentially, the DOJ is worried that the “new” JetBlue would enter more agreements similar to its JV named “North Eastern Alliance” with American Airlines that was deemed anti-competitive earlier this year by a judge followed by a DOJ complaint.

I would assume that this is a justified fear by the DOJ as behavior like this is pretty anti-competitive and seen by regulators as something they need to act on. However, let’s take a quick look at the now defunct “North Eastern Alliance”: JetBlue and American cooperated under a JV mostly on the US East Coast. Both airlines have a different strategy as American is the world’s largest airline and a classic “Global Network Carrier”, whereas JetBlue is (mostly) a domestic/North America-ex-US airline. But they both have heavy presences in New York and Boston, the area that was part of the now defunct JV. Through their JV, JetBlue and American hardened their grip on those two important markets and consolidated their position in the North East. One could argue that they had created a sort of monopoly or highly consolidated oligopoly in the Northeast of the US.

In May, the District of Massachusetts ruled the JV anti-competitive. JetBlue then issued a statement that it was not going to appeal the decision but rather focus is resources on completing the merger with Spirit.

The decision by JetBlue to not appeal the ruling of the court regarding the JV with American was not a move to appease the DOJ. JetBlue was ordered to shut down its JV. Therefore, giving up the appeal regarding the JV is not an automatic bonus point to complete the Spirit acquisition. It is not an “either the JV or the merger situation”, but rather JetBlue will need to make its case in the upcoming trial.

The unwinding of the JV with American in the Northeast, being ordered by a judge or not, will, however, have positive implications for the upcoming trial. Odds of the merger being cleared must have increased now that the competitive landscape in the Northeast is a different one before the ruling.

What I find hard to believe though is the worry of the DOJ that a larger JetBlue would continue to strike deals with some of the other large 4 airlines in competition sensitive areas. They got burned pretty badly in the American JV and I can’t see how they would go into that same direction once again. And that is a strategy decision regardless of its size.

Conclusion of the complaint review

Taking all the arguments brought forward by the DOJ, I would certainly agree that they had a case when they filed the lawsuit. However, the case is now a pretty different one with JetBlue already having agreed to divest many critical assets and due the ending of the JV with American in the Northeast. Further, some arguments are very weak, e.g. the complaint about the elimination of the basic fare structure.

Further, had the DOJ defined the relevant market in its complaint as “ULCC air travel in the United States” the merger would have a real problem. However, the DOJ has defined the relevant market as the “entire domestic U.S. air travel segment”. Well, in this case one is looking at the combination of some of the smallest airlines to form the fifth largest airline to introduce more competition against the large incumbents.

Factoring in all the changes since the complaint was brought forward, considering the relevant market and that the DOJ is contradicting itself in many arguments vs. its complaint in the case against the “Northeastern Alliance”, I would argue that the merger has a much better shot at going through than what is currently priced-in.

Risk of the DOT blocking the merger even after a potential positive ruling

The U.S. Department of Transportation has said that it supports the stance of the DOJ. In March, the DOT has denied an exemption request filed jointly by JetBlue and Spirit that would allow both carriers to operate under common ownership. The DOT said that such a move was “premature” given the pending lawsuit brought forward by the DOJ.

The application to operate under common ownership was filed by the airlines with the caveat that they would stay separate entities until the merger was consummated. Both airlines had argued that granting this exemption would be in-line and consistent with previous DOT practices.

JetBlue and Spirit essentially are seeking to combine their individual AOCs (air operator certificates) under one in order to operate as a unified entity.

There is of course a political motivation behind the tactics of the DOT. In March, U.S. Secretary of Transport, Pete Buttigieg, said in an interview with Bloomberg, that his administration was seeking ways to inject more competition into the sector. It’s important “for us to use all of the tools that we have as an administration, including those that are in the DOT toolkit, when it comes to competition issues. We’re looking at everything we can do.” Further, he was quoted with the words that “We’re going to be using our own tools to examine the public interest issues at play. [Should the deal still] “remain on the table after the DOJ’s case is acted on, that’s where we’re gonna reach for that.”

It is important to note that the DOT has never used its authority to block the transfer of an AOC since the airline industry was de-regulated in the late 1970s. The DOT could theoretically keep up their decision even in case the trial brought forward by the DOJ is won by both airlines. However, there are two avenues for the merger parties to respond to such a potential unprecedented action: Either sue against the DOT’s decision (potentially dragging out the closing of the deal) or simply operate under two AOCs. While the latter option is not ideal to both airlines, this would be a way to complete the deal regardless of the DOT’s objections. I find this option plausible but would expect the merger parties to sue against the deal in order to truly close their merger.

While there obviously is a risk that such a lawsuit is not successful in court, there is zero precedent of the DOT objecting to the transfer of certificates. The main risk here that one could argue for is that a blocking from the DOT drags out the closing of the deal even further.

Judge

The judge assigned to the case is William Young, Senior Judge of the United States District Court for the District of Massachusetts. He is a semi-retired veteran jurist who was nominated back in 1985 by Ronald Reagan. Judge Young has a reputation for being a highly respected judge in arbitration cases. While JetBlue could have fared worse with the assignment of a judge, this conservative and republican judge won’t just waive this matter through. However, I am leaning towards saying that the assignment of judge Young is a slight positive in regard to the odds that JetBlue and Spirit have in winning the case.

Timeline

Originally, the trial between the merger parties and the DOJ was scheduled to begin on October 16, 2023. Due to other criminal trials held prior to the commencement of the trial regarding the merger, the start date has been pushed back to October 23. Barring any shutdown of the U.S. government, the judge had originally stated that he was seeking to rule on the case by year end, which could now be possibly pushed into January due to the delay. One should expect a ruling on the case somewhere around the turn of the years.

Downside risk

The downside in this merger arb play is the big turn-off of this situation. Airlines are famous for being terrible investments over the long term (“want to be a millionaire? Be a billionaire and buy an airline” as the famous saying goes) and shares of all major and minor airlines in the US have traded down significantly over the course of the year amid fears of higher oil prices, lower demand, and a plethora of profit warnings from carriers.

Shares would likely crash given how well they have held up due to the upcoming case vs other airlines. With EPS in the range of $2.3-6.0 before COVID, assuming a worst case scenario of a P/E ratio of 5, that would result in a break price of around $11.50, a 30% downside from current levels.

Potential to play the merger arb

The cleanest way here would be to play the merger arb by purchasing common stock in Spirit Airlines. One could theoretically also hedge this position with a long in JetBlue as shares in the acquirer would certainly rate higher should the merger collapse in court.

Given the risk of action by the DOT and a potential delay of the DOJ trial due to a shutdown, I personally would stay away from options here given the timing risks.

Update October 30, 2023

There are a number of new developments regarding the upcoming trial on the merger arbitrage case regarding JetBlue and Spirit Airlines.

Delay of trial

The trial has been delayed a total of three times now due to scheduling issues at the court. It will finally commence tomorrow, on October 31, 2023. Unfortunately, there won’t be a livestream available as the hearing will be conducted in-person only.

Operational challenges at Spirit and related sell-off

On Friday, October 26 before market open, Spirit Airlines published its Q3 results and gave an update on its current operational challenges related to the engine issues on its A320NEO fleet. Shares sold off heavily the next day, closing almost 9% lower. The slide continues today by another 9% as of this writing.

Not only did the airline post pretty dismal financial performance with a loss of $1.44 a share on an EPS basis, but it also gave very ugly guidance going forward. This lower guidance was said to relate to significantly lower demand and operational challenges relating to its Airbus A320NEO aircraft on which almost all engines will need to be repaired as a manufacturing error by Pratt & Whitney makes this necessary.

Due to the engine issue, Spirit expects to ground 13 planes by January of ’24 and a maximum of 41 planes by the end of the year (current fleet size being 202 Airbus A320-family CEO and NEO aircraft).

Shares have so far sold off by about 18% since the earnings update. Even questions have arisen whether Spirit can remain a going concern on its own. This not only would significantly revise the break price down but also begs the question whether JetBlue might try to renegotiate or try to get out of the deal as it is becoming increasingly clear that they will significantly overpay in this transaction for a target that is in trouble.

Risk of deal break outside of trial

With the abysmal performance posted by Spirit, one must now question whether JetBlue might have a case in getting out of the deal. I am not convinced that they will try this path given just how much they have invested into this transaction and how almost impossible it is to exit a merger agreement, but the risk exists now, nonetheless. Even though the risk that they can actually get out of the deal is very small to non-existent as explained in the following, a mere attempt by JetBlue would have an impact on Spirit’s shares.

Spirit already said in its quarterly update that they see the merger with JetBlue as the best (and potentially only) way forward for the company, so they would not back out in any case here given their current situation.

The only way JetBlue could get out of the transaction would be to claim a Material Adverse Effect (MAE). This essentially means that something in the course of the transaction has changed so materially that the transaction is no longer feasible. However, claiming this is not easy, to say the least. In history, only once has a claim to invoke a MEA led to a merger being canceled by a court under Delaware law (Fresenius Kabi AG vs. Akorn, Inc. in 2018).

In that case, Fresenius had agreed to acquire Akorn for $34/share. Then, a “dramatic, unexpected and company specific downturn” in Akorn’s performance had occurred. Not only that, but whistleblower allegations had emerged that the company was in regulatory violation on various fronts. Perhaps most importantly, regarding the financial performance aspect, was that the court found that it was “directional”, meaning that the issues were not of temporary but terminal importance. The case is actually quite interesting in light of this and future merger arb case and a nice write up can be found here.

Per the SAVE/JBLU merger agreement, the parties cannot backout of their merger, except for an MAE. Now, there are two issues at hand where JetBlue could try to find an MAE: (i) The dismal financial performance of its target, Spirit, and (ii) the fact that a large portion of Spirit’s fleet will need to be grounded due to its Pratt & Whitney engine issues on the NEOs which will affect its performance going forward.

Now, looking at the merger agreement, the agreement is relatively clear: There is no straight forward way for JetBlue to claim (i) or (ii). Regarding the financial performance, JetBlue knew what it was getting into before signing the merger agreement. Softer demand for air travel is also something that currently all carriers have to deal with, so it is not a Spirit-only issue. Drawing parallels to the Fresenius/Akorn case, the target in that case had back then lost one of its major customers (among other things that went south). That is not something that is happening here as lower demand affects the entire industry.

On the engine issue: RTX (that owns Pratt & Whitney, one of two engine manufacturers for the A320NEO series) have deemed it necessary that a total of 650 airplanes globally need to be grounded due to an issue with their engines. That’s half of the fleet powered by these engines. While this is very bad news for Spirit, it’s also very bad news for a whole lot of other airlines, including Frontier, Hawaiian, JetBlue in the U.S., and Lufthansa and Wizz Air in Europe, among many more affected. Therefore, it’ll be difficult for JetBlue to argue that this is a company specific issue as it hits a large portion of the industry. Further, RTX will compensate airlines for their grounding time, although details on that are still sparse.

Obviously, even though chances are quite bad, JetBlue could still just attempt to get our of the merger agreement. The fear of such a scenario which would obviously weigh on the stock and the now lower break price in the range of $5-8 for Spirit are the culprits of the current slide.

Some have also argued that JetBlue could try to re-negotiate the purchase price should the transaction get through in court. Judging from the merger agreement, there is no room to do so, however.

As the original thesis revolved around the chances of the merger getting through in court, these have not changed in any way. The risk/reward profile has changed with the stock sliding due to fears of a now much lower break price which is wholly justified. I am keeping the position for now as nothing has changed regarding the upcoming trial and there is still a possibility that there may be a settlement, which have become increasingly small, however.