Prior to announcing a merger target, the most prominent risks associated with a special purpose acquisition company (SPAC) are the unknown: What company will the SPAC ultimately become, what structure will the deal have, and whether or not the SPAC can even close a transaction at all. Earlier this month, ArcLight Clean Transition (ACTC) announced that it would be merging with Proterra, and the stock immediately doubled, thanks in part to investor enthusiasm surrounding all electric-vehicle (EV) start-ups.
Here's why I bought warrants in ArcLight Clean Transition last week.
What is Proterra?
Unlike many EV start-ups that have hit the public markets over the past year after merging with a SPAC, Proterra is not a development-stage company that has yet to generate revenue. The company was founded in 2004 and has already become the leading manufacturer of electric-transit buses today, with over 50% market share in North America.
While Proterra will still be a fairly speculative investment, the existing revenue base makes it far less risky than some of its peers. Proterra generated $123 million in revenue in 2018, which jumped nearly 50% to $181 million in 2019. As of last September, the company was expecting to report sales of $193 million for 2020. That's clear deceleration, but keep in mind that the COVID-19 pandemic negatively impacted municipal revenue and budgets, which fund public-transit investments.
Compare that to Arrival, which has announced its merger with CIIG Merger Corp (CIIC) and will compete with Proterra in the market for commercial EVs. Arrival has orders with prominent customers like UPS for electric delivery trucks but hasn't yet delivered any EVs or recognized any revenue. Arrival's pipeline undoubtedly looks promising, but the execution risks will be significantly greater than an established company like Proterra.
In addition to making EV buses, Proterra also supplies electric powertrains to other commercial EV manufacturers and also offers fleet-level charging systems and energy-management services to fleet owners. Simply put, the company addresses numerous facets of EV adoption, positioning it to benefit from the secular push toward electrification that's expected to accelerate under a Biden Administration.
Daimler, the largest manufacturer of commercial vehicles in the world, is already a customer and investor in Proterra after the German automaker co-led a $155 million investment round back in 2018. Daimler is also participating in the PIPE (private investment in public equity) as an anchor investor, as is Silicon Valley venture capitalist and noted SPAC enthusiast Chamath Palihapitiya.
I just made my biggest investment in climate change.$ACTC is merging with @Proterra_Inc to help take it public. I led the $415M PIPE.@Proterra_Inc is NA's #1 EV bus OEM. The company's technology, their lead and their revenues made this a no brainer for me. 1-pager attached. pic.twitter.com/Lv1Q6zkQwj— Chamath Palihapitiya (@chamath) January 12, 2021
ArcLight Clean Transition shares have already skyrocketed after the announcement, so I chose to buy warrants as a way to get a discount on the stock. Let me explain.
Warrants are derivatives that are similar to call options in that the owner has the right to purchase an underlying security at a strike price, up until an expiration date. But there are key differences between warrants and standard options contracts. Most importantly, warrants aren't exercisable until a later date, unlike American-style options that can be exercised at any time. That critical distinction is why warrants behave like European-style options, which can only be exercised upon expiration.
Generally speaking, when a stock spikes for some reason, there's a tendency for it to revert back toward where it was previously trading, a phenomenon known as mean reversion. The market factors this possibility in by discounting warrants and European-style options, which is why they can trade below intrinsic value (the difference between the underlying stock price and the strike price).
In the case of ArcLight Clean Transition, I paid approximately $8.50 per warrant, while the stock was trading at $29. The warrants have a strike price of $11.50, which translated into an intrinsic value of $17.50 at the time.
Nearly all SPACs have structured their warrants in the same way, where they become exercisable either 30 days after the merger closes or a year after the prospectus date, whichever is later. Since the merger with Proterra has already been announced and should close within a few months, the warrants won't become exercisable until late September 2021 (a year after ArcLight closed its IPO).
But I don't mind waiting in order to capture the discount. After paying $8.50 per warrant and exercising at the $11.50 strike price, my ultimate cost basis will be about $20. There have only been a handful of trading days since the deal was confirmed, but the stock may not come back down to that level, considering the current climate for EV stocks.
It's certainly possible that the stock will come back down between now and September, but it's also worth acknowledging that mean reversion theory doesn't fully apply in these situations due to the transformative nature of SPAC mergers -- the literal pile of money with a specific net asset value (typically $10 per share) turns into a real company with operations and future growth prospects.
Watching for redemption
There's another risk for warrant investors to consider. The company can choose to redeem the warrants at $0.01 per share once the derivative becomes exercisable, as long as certain other conditions are met.
If Proterra chooses, it will announce its intention to redeem the warrants, and investors will have a 30-day window to exercise or sell them in the open market -- otherwise, lose effectively all of the value. Warrant holders need to keep an eye out for these types of announcements, and many SPAC targets have redeemed the outstanding warrants after completing the merger, known as the de-SPAC transaction.
Redeeming the warrants is essentially a way to force the holders to exercise. Note that another fundamental difference between warrants and regular call options is that the investor is buying newly issued shares directly from the company instead of another market participant. That means that exercising warrants is dilutive but also helps the company raise more capital that it can use to operate.
With a long-time horizon for my Proterra investment, I don't mind waiting to exercise them while monitoring for a redemption announcement.