Pfizer (PFE) shareholders as of May 20, have to decide whether to exchange shares for shares of Zoetis (ZTS). The deal is designed to exchange PFE shares on a pro-rata basis, and receive ZTS shares at a 7% discount in dollar terms, basically offering $107.52 in ZTS shares for each $100 in PFE shares. However at the time of the exchange the discount could be greater or less than 7% depending on the weighted avg price of each of the stocks from June 17-19, relative to the closing price on June 19th.
PFE shareholders will have the right to exchange all, some or none of their shares for shares in Zoetis by the June 20th deadline. On June 19th PFE will disclose the exact exchange terms, and the terms will prompt their shareholders to make a final exchange decision. [On that date I'll add an update in the comment area with the exact math on the exchange terms.] While designed to induce PFE holders to tender for ZTS because of the 7% discount, there is a cap of .9898 for a ratio between the stocks.
Extrapolating from past split-offs and assuming the exchange terms maintain about a 7% discount, I would expect the Zoetis exchange to be oversubscribed by 3-5 times. This means that a PFE shareholder tendering all their shares in the exchange would get 20-30% of their shares converted to ZTS. A 7% gain from the exchange could reflect a quick 1.75% paper gain on the aggregate position.
Some market mechanics to consider: Zoetis will be added to the S&P 500 upon completion of the deal. Estimates of amounts needed to purchases by index funds run as high as 52 million shares; although this depends on the ability of index funds invested in Pfizer to exchange directly for Zoetis, however there is still a good likelihood of significant fund purchases.
Also, since Pfizer will likely retire close to 400 million shares from the exchange, Pfizer's weighting will be reduced by greater than 5% in the S&P 500 due to the share reduction. The reweighting should result in the selling of close to 43 million shares, but the timing of any reweighting is unclear.
Additionally, the Russell 1000 is likely to reweight ZTS by the addition of 12 million shares & a deletion of 11 million PFE shares according to Deutch Bank index research.
-For short-term traders and PFE holders in tax efficient accounts (IRA's, pension funds, etc) the inducement of a 7% discount should be attractive & offer enough trading flexibility to tender for Zoetis shares. Yet I would recommend trading out of ZTS into any strength due to index rebalances, and conversely trade back into PFE on weakness from index related selling.
-For long-term PFE shareholders and those disinclined to trade ZTS shares, the fundamentals and valuation of Zoetis need to be considered.
Zoetis is a global leader in the discovery, development, manufacture and commercialization of animal medicines and vaccines for both livestock and companion animals. It is a solid blue chip company with over 60 years of operating history. However a solid company does not necessarily make a good stock.
ZTS currently trades at a premium valuation of a 22-23 P/E. I believe the stock been able to maintain this valuation for three reasons: There are only 20% of its shares in the float, which should increase to 100% if the split-off is successful; Zoetis is a pure play on animal health, and has no true comparison companies; and there is a well known formula on Wall Street that stocks which have been split-off tend to outperform, so their shares attract buyers who routinely follow this strategy.
However, this premium is likely to fade once all its shares are free trading, its P/E better reflects its slow but steady growth, and investors recognize that some terms of the split-off may negatively affect earnings.
I believe there are several reasons to be cautious on shares of ZTS at current levels once the exchange and market mechanics pass:
-When Pfizer spun off ZTS, Zoetis took on $3.65 billion in debt only to hand that cash back to PFE. Zoetis will also have a one billion dollar line of credit and will likely tap the commercial paper market for another billion dollars for working capital. Just for the $3.65 billion in new debt, annual interest payments will be $116 million.
-Zoetis has been under the PFE umbrella for over 60 years, and unlike many past split-offs, these 2 companies had operations, such as drug R&D and sales personnel that were very intertwined. This will likely cause some operational and cost structure issues related to their independence. Therefore, I believe it would be prudent to observe Zoetis for several quarters to quantify the costs associated with the separation, and focus on the business execution without the backing of Pfizer's muscle, resources and operational efficiency.
-Zoetis is still absorbing and integrating King Animal Health, acquired with Pfizer's acquisition of King Pharmaceutical. This poses additional operational risks.
-Lack of dividend support. ZTS initiated an annual dividend of 26 cents, for a yield of less than 1%.
With the potential 7% exchange discount and market mechanics supporting ZTS immediately after the split-off, I would be hard pressed not to recommend tendering for Zoetis shares due to some quick paper gains. However, the high valuation of Zoetis precludes me from recommending holding the shares for anything other than a trade. At some point, if the shares trade toward the mid 20's, about 20% below the current price, that would appear to be a more reasonable entry point for longer term investors.