AFR artical by Anthony Macdonald and Yolanda Redrup from late yesterday below - on topic regarding arbritrage opportunity for those interested.

Fast money floods into Afterpay; new pairs trade alive and kicking

Introducing the new capital markets game in town.

The fast money offshore is coming for Australia’s Afterpay, snapping up shares from domestic fund managers and matching it with a short position in suitor Square, which is listed in the United States.

The trades streamed in on both Monday and Tuesday - days when more than $1 billion of Afterpay stock changed hands, or about 15 per cent of the value of all shares traded on both days. Traders said not much else was getting a look in on equity desks.

Stockbrokers reckon it will continue all week, and likely get to the point where hedge funds will quickly own 10 per cent of Afterpay’s register. The spread between Afterpay’s share price and the implied valuation of its offer is about 7 per cent. If you assume the deal takes six months to complete (and also assume it will actually complete), then it’s a 14 per cent annualised return.

The fast money funds can trade out in the meantime or, if everything goes swimmingly, wait until their Afterpay stock is swapped for Square shares. At that stage, they will take Square’s US-listed Class A shares for their Afterpay shares, and close out their Square short position.

In the meantime, local investors are keen to swap their Afterpay shares for cash, knowing the way that the stock trades they’ll likely have a chance to buy back in later or just say goodbye to what has been a wild ride. They’re viewing the transaction as a stock swap as much as a takeover; swap your shares in Afterpay for shares in Square.

There’s also a bit of caution around how Square’s ASX-listed CDIs would trade, following similar deals from Unibail-Rodamco-Westfield and Iron Mountain which were underwhelming. (Even Amcor, which swapped its primary listing to the US when it acquired Bemis in 2019, has lost a bit of its presence in local investors’ minds).

So Afterpay is once again proving to be a boon for the big institutional equities desks. UBS, Morgan Stanley and Merrill Lynch topped Afterpay market share on Monday and Tuesday, ahead of Credit Suisse and Goldman Sachs. Together the five brokers had about 60 per cent of Afterpay trade on Tuesday.

In terms of Afterpay blocks - the highly sought after trades worth more than $10 million - Goldman Sachs, Merrill, UBS and Morgan Stanley all got a piece of the action. The biggest line went to Goldman Sachs; a parcel of 199,115 shares worth $25.6 million.

Cash App EcosystemI hold SQ and have always wanted to buy APT but never bought - high valuations and general fear of BNPL valuations. Here are my thoughts and notes  which includes notes from SQ earning call this week:

• Square has developed an ecosystem to cater to small merchants and SMB's. (Platform Play) 
• Square's Cash App - which will be integrated with AfterPay is high growth BU within the company and is already on the path to be a dominant force in digital payments
• SQ has returned 23x over the last 5 years if you have held that long
• SQ is trying to create a network effect as with each new module they will penetrate more into the businesses, make them spend more with SQ and eventually make it difficult to leave sq platform.
• Cash App is more like a digital bank - offering deposits, p2p payments, access to cards with additional benefits if used at SQ merchant (rewards programs) 

Highlights from SQ Q2 2021 results released on 2nd Aug 2021

* They have mentioned AfterPay 84 times during the call and Nick Molnar was also on the call. 

• Launched Square Banking for our U.S. sellers - gaining bank's market share. 
• This new suite of products will help business owners better manage their cash flow and get more out of their money. Square Banking now includes 3 core products, 2 deposit accounts, Square savings and Square checking, joining Square's existing lending products now called Square Loans.
• Integrates seamlessly with seller solutions like payments and Square Payroll, sellers now have a unified view of their payments, balances, expenses and financing options.
• APT: On average, our top 10% of consumers globally used Afterpay more than 30 times in the U.S. and 50 times in Australia in the financial year 2021.
• SQ: In the second quarter, our ecosystems delivered a gross profit of $1.14 billion, an increase of 91% year-over-year, which was our strongest quarterly gross profit growth as a public company
•  Cash App generated a gross profit of $546 million, an increase of 94% year-over-year or 128% on a 2-year CAGR basis
• Seller business, which generated gross profit of $585 million, an increase of 85% year-over-year or 30% on a 2-year CAGR basis.
• For Cash App, we expect gross profit growth of greater than 110% on a 2-year CAGR basis 

Future: 

Integrating the Afterpay App into Cash App has the opportunity to drive further consumer engagement that also benefits merchants in the form of lead generation. This means that consumers will be able to browse merchants, purchase goods or services within Cash App and use Buy Now Pay Later at the checkout, allowing the consumer to pay for interest -- pre-instalments directly from Cash App, again, driving that recurring engagement.

Competition:

• There are lots of large players entering this attractive BNPL sector, PayPal, Amex and even Apple. So how does Afterpay/Square differentiate solution versus the competition?
• A lot of competitors with a seller ecosystem or a consumer ecosystem, but there are very, very few with both together (APT + CashApp). So our model and our strategy is really focused on this fundamental principle of we have 2 ecosystems at scale serving both sides [ together ]

SQ was up 10% overnight in the US so APT should be up 10% today.  From here on in we should see APT share price track SQ and the discount to the buy price should close.

Normally a stock trades below a take over price, the discount made up of a probability that the deal wont go ahead and a time value discount.  In the case of SQ buying APT, because it is an all script offer (ie paid for in shares) and you would expect SQ's share price to go up over time, there shouldn't be a time value discount and the deal looks to be locked in so I don't see a reason for a probability discount.

In short, the APT share price should equal the 0.375 x SQ share price divided by the current FX rate...  Anything less is an arbitrage opportunity.

As mentioned before, I already have a lot of APT so adding more for a 5-10% arbitrage doesn't appeal.

I have a question I would be interested to hear people's take on: considering Afterpay is trading lower than the takeover price, does this appeal to anyone as an investor for one of the two following reasons?:

1. For the fact that it is trading below the value of the takeover offer and therefore you find the stock more attractive than what you would have before the news this morning?
2. That Square is such a leader in it's space and regardless of whether Afterpay is now trading above or below value, it presents an opportunity to get your hands on a piece of Square through a different channel (that may or may not be cheaper than aquiring it on the ASX when it cross lists, or may or may not be cheaper than buying shares on the NYSE)?

DISC: do not currently hold.