Few things in finance scare me so much as a "sure thing," a "lock" or a "layup." Nothing causes me to question myself like a trade that seems to be a straight arbitrage with dollars in it (not a penny or two). In my experience, that goes double when it involves trading corporate actions. This is all probably because this is not where my expertise lies - arguably (usually by me), that my expertise is in options trading and more macro-type scenarios. It turns out that I am an owner of Pfizer (NYSE:PFE) and they have recently spun off part of Zoetis (NYSE:ZTS) in an IPO. Here is the interesting part: PFE wants to get rid of its remaining shares via an exchange of PFE shares for ZTS shares at, roughly, a 7% discount. That means one can buy PFE, tender those shares and end up with ZTS 7% off (about $2.20 on market prices I'm using). Sounds like a "layup."
My first thoughts are that this is a nice opportunity and start working through the mechanics. The rough plan is to short ZTS, purchase an appropriate amount of PFE, tender the shares and pocket the difference. It looks a $20 bill left on the sidewalk for a slick operator to pick up. Part of this will require shorting ZTS, so I checked to see whether it has become hard to borrow. Sure enough, it has. My check on the Interactive Brokers system has it as an 8% charge to borrow. As this deal should be done by June 19th or within a few days of then, that will not be a large charge. Figure about 10c, or $32*.08*14/365 = .098. On the other hand, this could get a little nutty going into the tender offer and ZTS could get very hard to borrow and force a buy-in. The option market is pricing in more than 10c.
I started thinking about the structure of this deal. As background, I had invested in PSX when it was spun off from Conoco and still have shares of ABBV which was spun off from Abbott. PFE chose a different route by creating an IPO of ZTS shares. We have the same type scene, spinoff, but with different details. Call me cynical, but this set up is making me nervous. My first question is why IPO? Before answering that question, another should be answered: why were only 99M shares floated when there are about 500M in total? It is a tough argument to make that Pfizer had no idea prior to the IPO that it wanted to be rid of all of Zoetis. I have looked through filings, documents and news headlines but cannot find anything indicating any public disclosure of the complete divestiture until May 22.
Don't get me wrong: this is not a conspiracy. Instead, I view it as a plan to maximize return for Pfizer shareholders. I see it as a test of how well the public would like ZTS and, if possible, take advantage of a pop in the price of the shares. Shares have popped about 20% from the IPO price. Zoetis is the only pure-play animal pharmaceutical company that is publicly traded and part of its appeal is due to that, but it also has a lot to do with the small float (about 20% of ZTS shares). Pfizer now has bought itself an option: if market conditions favor the selling of more shares, it can. If not, it sold a minority position at what is apparently a good price.400
Leonidas had 300, but PFE has 400. That is, PFE is going to exchange 400,985,000 shares of ZTS for a variable amount of PFE. PFE has stated that if this exchange offer does not take them completely out of their ZTS position, they will pursue other strategies until ZTS is completely divested. To repeat, as far as I can tell, Pfizer had not explicitly notified the market if and when they would be divesting ZTS completely. My research has May 22 as being the announcement day. Any information and reference to the contrary is very welcome.
Think if you were a corporate buyer and had paid $26/share for Zoetis to buy 20% of the company. Four months later, Pfizer announces it is going to divest itself of the rest of the shares, i.e., the 80% you didn't buy. As a corporate buyer, you probably would be feeling like you got a sub-optimal deal. I know I would. Sure, we can all buy more. But, really, any purchaser would be pricing it differently for 99M shares than for 500M shares and would therefore appreciate the knowledge that more was coming down the pike.
Had PFE sold all of its shares right at the beginning, then they would have had to pay on the entire 500 million shares 1) investment bank underwriting costs and 2) a concession to IPO investors who would be expecting a lower than market bearing price for the risk of taking on the new issue. As it turns out, those fees tend to look a lot like 7% -- the concession that Pfizer is giving to those tendering their PFE shares. In other words, in rough numbers, Pfizer is getting a good deal so long as the ratio of the deal delivers a price greater than or equal to $26.
I do not see how Zoetis's share price can hold the weight of 401M additional shares. 400M shares hitting at once even for PFE would be a lot: about 10-12 days' worth of volume. For ZTS, it is hard to see it not having a devastating impact. The short interest is merely 1.7M shares. One might argue that the divestiture is priced into the current price of ZTS, but I don't see any evidence of that. The stock has not come down significantly from its IPO pop. ZTS trades at 28 P/E and has a substantial amount of debt. Looking at Zoetis competitors, 28 P/E is within a normal range of valuation, perhaps a touch to the high side. That level of valuation is also significantly higher than the market level. While Zoetis may be worth it and has a certain scarcity value as an independent developer of animal drugs, 28 P/E is not a dirt cheap price for such a leveraged, newly floated company. In short, I simply do not see this 400M share overhang priced into the market.Checkmate
Instead, I see Pfizer playing an excellent game of chess with the public markets. First, create artificial demand for a valuable piece of their business by launching an IPO with only 20% of the outstanding shares floated. Second, allow the IPO to pop, in this case about 20%. Third, wait for things to slow and announce a tender offer that is really a secondary offering. Fourth, price it at a discount that matches what Pfizer would have paid anyway to investment banks with the option to cut back if they don't like the terms (the minimum size is 160M shares). And, fifth, cap the ratio of PFE to ZTS shares to Pfizer's advantage. Pfizer has structured a free option for itself in this deal. This is truly Nirvana for Pfizer.
Like I said at the beginning, nothing makes me more nervous than what looks like a "sure thing." Nevertheless, I predict that ZTS will be trading below the IPO price of $26 by the time those 401M shares hit the market which is in less than 2 weeks (it is scheduled for June 19th but there are circumstances that might cause delays). Please keep in mind that this is strictly based on the overhang of shares; this is not a judgment of the ultimate long term value of Zoetis or Pfizer.How to Play It
From where I sit, there are three ways to play this situation:
1) 1) Long PFE, short ZTS
2) 2) Simply short ZTS
3) 3) Option strategies
The first is the most structurally complete of the three and the most "traditional." One knows that PFE shares can be tendered and the short position closed via the tender offer. On the other hand, it actually entails more risk if you agree with my thesis. My thesis is that the ZTS price cannot support over 400M new shares hitting the market along with no opinion offered on the value of PFE shares. Shorting ZTS on its own without regard to PFE is the more direct trade. After all, PFE shares could suffer alongside ZTS shares and impact the ratio. The ratio gets calculated over the last 3 days of the tender offer so that there is risk of getting less than the 7% discount (or worse). The bottom line is that I prefer the more isolated "short ZTS" play.
However, I've seen this type of scenario play out before when 3Com spun off Palm. Read more here. The PALM spinoff is a great instructional scenario: merely because it was absolute FACT that the prices would converge did not help a trader manage margin calls or forced buy-ins. One could be forced out of the trade despite its obvious and direct economic value. This is unlikely to happen with PFE/ZTS; right now the short interest is small and shares are available. In my current trading set up, it is not easy to term borrow the shares - if you can, that is likely to be the best trade structure but it depends on the pricing of the stock loan. I'm a bit of a nervous Nellie and prefer to look at what is available in the option market.
I get two advantages and one disadvantage to playing in options. First, I won't need to pay a stock loan desk to short ZTS as I'll be doing that with options. Second, I'm looking at long option positions, so my second advantage is that I know what I am risking. Based on my expectation for ZTS, I can figure out what the likelihood of the event is. My disadvantage is, of course, that I have to pay for the time value of the option.
The timing turns out to be tricky. The tender offer expires June 19 and option expiration is June 21. That means that if all goes well, June options are the way to go. But there could be a delay if the ratio hits the maximum. On the other hand, it seems perfectly reasonable to expect the actual movement of ZTS to occur prior to June 19. Anyone looking at this will have to choose the June or July expiration or a mix of positions in each.
For simplicity sake, the July 30 puts are trading around $1. Given my thesis that ZTS will be trading at or below $26, those puts should be worth more than $4. Normally the Black-Scholes-Merton (BSM) framework is an excellent paradigm for evaluating option values, but not always. In this case, we are looking at what I expect to be a "binary" event. That is, if I am correct, ZTS will be $26 (or under) and if I am wrong, ZTS will stay the same price. Further, this will all occur in the next 11 days. Rather than value the option as a function of volatility, I choose in this case to value it as a standard bet. Bet $1 on the July 30 put to earn $3 (the put is worth at least $4) if the thesis is correct: it pays 3:1. As discussed, I see this as being much better than even that ZTS shares tumble to the IPO price. I might end up being wrong, but I think that these are cheap odds.Conclusion
Pfizer is divesting itself of the remaining 80% of Zoetis that it still owns after selling 20% in a recent IPO. Given the magnitude of the divestiture (400 million shares) and the seemingly unaffected shares of ZTS, this secondary offering in disguise does not seem to be priced into the market. Although traditional exchange offers involve positions in both companies, it is more direct and less risky to simply short ZTS shares until the tender offer is completed. The options market is also providing a way to position for this that simplifies the trade and provides what looks like attractive odds.
If you do have interest in this, please be sure to make your own decisions based on the documentation available. I have not covered all of the details of how the ratio and the cap in the trade work because that is not the focus of this article. The tender offer has some complexity.
Additional disclosure: Long PFE.