June 19th is the target date for the exchange offer from Pfizer (PFE). I wrote my first article here and I concluded at that time to sell Zoetis (ZTS) into supply. High quality comments, particularly from bwputts, indicated a necessary analysis of buying interest from index funds. As we are now a day away from the target expiration of the exchange offer, it is time for a follow-up. There are two main issues to cover: the payoff and buying interest from index funds.
Index Fund Buying
I need to emphasize that this is an estimate. Rather than just give a final number, my goal is to communicate my methodology and potential error. That should provide for better conversation in the comments and advance everyone's knowledge including, hopefully, my own.
The Investment Company Institute provides a great deal of data about the industry and it is a good place to start. End of year 2012, the industry managed $870 billion in domestic equity index funds (see here). According to ICI ETF data, there is about $640B in equity ETF assets. It is reasonable to use that number as being all indexed as so little of ETF assets are actively managed - about 1%. That gives a total potential buying base of $1.5 trillion. That is clearly an upper limit as there are many index funds with substantial assets that have no mandate to purchase ZTS, e.g., XLU, the Sector SPDR for utilities. ICI notes that of indexed assets, nearly half of domestic fund assets are indexed to the S&P 500. I'd argue that half of the $1.5 trillion is a lower limit. Probably 75% of the $1.5 trillion has potential interest in ZTS. That means that I'll use $1.13 trillion as my estimate for the base.
Using the Bloomberg machine, I looked up other companies that had similar market capitalizations to ZTS. STX and SYMC were both very close at right around $15.5B and both made up about 0.1% of the SPX index. Using that figure along with the prior asset base figures gives an estimate of $1.13B or 36.5M shares at $31/share for ZTS. The estimate for the floor on share interest is about 24.2M shares; the ceiling comes out to 48.4M shares.
Even at my high estimate of index fund demand, that leaves over 350M shares for retail, actively managed funds and arbs. Although commenters from the prior article indicated that they thought the tender would be over-subscribed, I respectfully disagree. Allow for the fact that I am most definitely NOT one of the underwriters and don't have great feel for investment banking at this level. I simply see 350-375M shares coming to the market in a handful of days and don't see how Wall Street will find sufficient demand to keep it above its IPO price. I think that a reasonable parallel is Facebook (FB), which came to the market already pre-popped as it had traded actively prior to its IPO.
Pfizer will average share prices for both PFE and ZTS in the three-day period including June 19. As I am writing this, it is after the close of June 17th so that one of those days is locked in. At current prices, the exchange offer is at its "upper limit" meaning that it will provide those tendering PFE shares less than a 7% discount to current ZTS prices. Here is something of a heat map to show how the tender will work for different combinations of ZTS and PFE:
(click to enlarge)
To read the chart, the vertical prices on the left are PFE prices and the horizontal prices along the top are ZTS prices. I used coloring from default settings in MS Excel. Here, any rich green cell delivers the full 7% discount. Right now, PFE is $29.16 and ZTS is $30.96. As cells become more reddish, it becomes worse for those tendering shares. Right now, the "upper limit" is in effect and the discount is around 4.8% -- still likely attractive to arbs and ZTS investors.
One thing that I would like to point out: this is a short option position for those tendering. Or, conversely, a long option position for PFE. The most that those tendering can make is 7%, but it is possible to actually lose money - at the line in which ZTS = PFE/.9898. Any lower than that and one will actually pay more for ZTS than the market. For example, if PFE and ZTS are the same price, those tendering would give up a full share of PFE to get .9898 shares of ZTS. That's not such a good deal.
Impact of the Upper Limit
The most immediate impact of the upper limit is that it will extend the tender by one day. That's how I understand "automatically extended until 12:00 midnight NYC time, on the second following trading day to permit stockholders to tender or withdraw their shares of Pfizer common stock." This is from the Zoetis exchange site.
If the upper limit causes the discount to collapse or even go negative, then things will be tricky for arbs and, probably, everyone else. It would be a media feeding frenzy if index funds came in to use the tender and ended up squeezing the discount out of the deal or losing money in the process. They could possibly drop the tender on the extended time period. Any way that you look at it, as the discount decreases, uncertainty increases.
While I disagree with others in that I don't feel the offering will be over-subscribed, I believe that the best way to play this is as I discussed before: in a cheap, limited risk way. That way, one accounts ex ante the possibility of being wrong - another way of saying that there are cheap odds being offered, not a guarantee. The upper limit could throw a curve ball if PFE and ZTS prices converge; arbs will have to abandon their positions, which would put upward pressure on ZTS. Still, eventually, PFE will be selling its remaining stake in ZTS - unless they change their mind again. I believe that if they do change their mind, it will be because my thesis has occurred, that is that ZTS fell below its IPO price.
Additional disclosure: I am short ZTS via options and long PFE.