Modified Dutch Auction Tender Offers And Ways To Profit

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Includes: CRAI, FIG, NSM, NSP, PTSI, SCHL, SNOW, SNR
by: Main Street Fat Cat

Summary

Mechanics of a modified Dutch auction tender offer.

Conditions to look for and their implications.

Recent examples and their respective returns.

What To Do When Your Company Is Undervalued

Management personnel of public companies are closely followed for good reason. Investors take note when a large shareholder within the company either purchases or sells stock. What better example than that of JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon purchasing $26 million worth of JPM stock. This gave JPM a quick 8+% boost the day that news broke. A purchase is a signal to followers that management believes the company is undervalued and/or that favorable returns will occur in the future. There are multiple reasons for an insider to sell, but generally it is a signal that they believe the price is fairly, or overly, valued by the market.

Good or bad, management is notoriously optimistic about their company's prospects. At times, management may believe repurchasing shares can provide a better investment opportunity than allocating capital to a new project, research and development, marketing, etc. This tends to happen when the share price has significantly dropped within the last year or so. To carry out this share repurchase, companies typically announce a share buyback program alongside quarterly or annual financial releases. These generally lay out the basics of the total value of stock they would like to repurchase and over what period of time the program will last (typically one year).

There are a few drawbacks to this:

  1. The company is purchasing shares in the open market and may not get the lowest price.
  2. Typically, these programs do not commit the company to buying back any shares.
  3. The time period outlined is relatively longer than another route the company can take.

Modified Dutch Auction Tender Offers

This other route is known as a modified Dutch auction tender offer (MDATO). MDATOs provide companies a great avenue to repurchase a predetermined value of shares within a set price range in a relatively short amount of time (typically a month or two). MDATOs also provide shareholders a way to liquidate their shares by tendering their shares at a price they believe the shares are worth. If a MDATO is oversubscribed, shares will be subject to proration.

The ultimate price at which tendered shares are purchased by the company is called the purchase price. Shareholders can choose to tender their shares at varying price levels within the price range in the offer. To determine the purchase price, the company will start with the lowest price and multiply that by the amount of shares tendered at that price. If that total value does not exceed the offer value sum, the company will use the next step up in price and multiply that by the amount of shares tendered at prices at or below that price. This will continue until either the max price is met, or the value exceeds the offer value sum.

A quick example: ABC company is offering to purchase $10m worth of stock at a range no less than $4.00 and no more than $5.00. If 2m shares are tendered at $4.00, 1m shares are tendered at $4.25, and 0.5m shares are tendered at $4.50. The offer value sum will not be met at $4.00 ($4 x 2m = $8m). The next price results in a value that exceeds the offer value sum ($4.25 x (2m + 1m) = $12.75m). The purchase price is $4.25. Shares will need to be prorated so that only $10m is purchased. $10m / $12.75m = ~.78. So, if I tendered 100 shares, 78 would be purchased at $4.25, and I continue to own the remaining 22 shares at the market price.

MDATOs are inherently risky if you have not picked up on that so far. Companies typically have details in the offer that say under what terms they could delay, or even cancel, the offer. Next, I will discuss common conditions and details in the offers and what those implications are.

What To Look For In The Offer Conditions

Some conditions I initially look for are as follows:

1) Is the offer subject to financing?

If not, this typically means that the company has the funds to complete the offer. Due diligence on the company's ability to pay is still needed. Having a financing condition indicates that the company would need to take on some loans and increase their leverage to pay for the shares. This is also not ideal as it brings another party and requires their approval.

2) Do a certain number of shares need to be tendered for the company to carry out the offer?

If not, that would typically mean the company firmly believes in their offer price range and they are determined to repurchase at least some shares. Having this condition in place reduces the likelihood of the offer being completed. Assuming you would like to tender your shares, you need other shareholders to take the same view in order for any of your shares to be purchased.

3) Is there a proration condition?

If not, you can expect all of your shares to be purchased, assuming you tendered at or below the purchase price. If there is a proration condition, which almost all MDATOs have, potentially only some of your shares will be purchased and you will continue to own the rest at the market value.

4) Is there an odd-lot provision?

If there is an odd-lot provision, the details will outline what defines an "odd-lot holder" and how they will not be subject to proration. Typically, this means any shareholder that owns fewer than 100 shares. In this scenario, if you own 99 shares and tender all of them at or below the purchase price, all of your shares will be purchased. This is ideal because one can be provided some sort of assurances of a return on investment. Also, an odd-lot provision increases the chances the offer will be prorated because odd-lot holders are typically paid before other shareholders.

I am a small investor, so I prefer to find opportunities in the odd-lot realm. It is cheaper for me this way so that I do not have to incur additional trading fees if not all of my shares are purchased due to the proration condition.

5) Other conditions that could delay or terminate the offer.

Most MDATOs have certain conditions that will allow the company to delay or terminate the offer if the general markets fall by >10% during the time of the offer. Other conditions would be if the company has learned of any lawsuit against the company, tender offer/merger/etc., shall have been made for the company, or a group of beneficial interests accumulates more than 5% of ownership in the company. Although these are typical conditions, that does not diminish the risks involved in a delayed or terminated offer.

My Introduction To MDATOs

I recently participated in Intrawest Resorts Holdings, Inc.'s (NYSE:SNOW) MDATO as an odd-lot holder and realized a holding period return of 9+%, before trading fees. That annual return would be greater than 110%. Because of that success, I began looking for other MDATOs.

I read about SNOW's offer the day it was announced (Jan. 12th). I initially passed on the offer as I did not find any value (pop in stock price on the day of announcement). Luckily, they filed a 10-Q on Feb. 3rd, I recognized the name from before, and decided to look back at the offer. I initiated a position shortly after at $8.20, and SNOW released the final details on Feb. 18th on the deal. The purchase price ended at $9.00. Again, I will stress the term luckily. Since that experience I have established price alerts on any company undergoing a merger/going private/tender offer, so opportunities do not slip by me again. Also, it is a great idea to set up price alerts for a 10% drop in prices on the market indices since most deals have conditions concerning a broad market drop.

Since I had a vested interest in the SNOW deal, I took note of their share price after the deal closed as well. I was curious as to why I was able to get in at a better price than the day of announcement and realize a higher annualized return because of the shorter holding period. I decided to look at the current market for MDATOs to see what information I could glean from those.

Current Environment For MDATOs

MDATOs seem to be quite popular in recent months. To my knowledge, and I am only including those for common stock, there have been eight announced since December of last year. Completed offers include Insperity Inc. (NYSE:NSP), New Senior Investment Group (NYSE:SNR), and Intrawest Resorts Holdings, Inc. Scholastic Corp. (NASDAQ:SCHL) terminated their offer due to a 10% drop in market prices throughout their offer. Current offers include Fortress Investment Group (NYSE:FIG), Nationstar Mortgage Holdings, Inc (NYSE:NSM), P.A.M. Transportation Services, Inc. (NASDAQ:PTSI), and CRA International, Inc (NASDAQ:CRAI).

Returns In Recent MDATOs

As a smaller, somewhat conservative investor, I am primarily concerned with what returns an odd-lot investor could realize in these deals. I sought to find the maximum return an odd-lot holder could have realized in these offers by finding the lowest price of the stock throughout the offer period in relation to the lowest price in the price range of the offer.

I also did calculations for investors that would have larger positions in these deals. The investment options I pondered were: initiating a position the day of announcement, midway through the offer time frame, and after the completion or termination of the offer. Based off a quick glance at the previous deals, I thought the highest return would be to short the stock on the day of announcement and hold until the date one could no longer participate in the tender offer (ex-date here). Below I will show the returns based on that initial theory, but prices are there for other interpretations as well.

Here is a quick description of the table characteristics. 50-day moving average was figured prior to the announcement to see the relation of the market price to that after the offer, the price range in the offer, closing prices for all dates, reviewed SC TO-Is for filing times and expiration dates/times, ex-date is the day one could no longer buy into the stock and tender, purchase price is the price determined in the offer, and market price and post-offer are the market prices as of those dates. The post-offer dates were picked for when the final results of the MDATOs were announced, and it just so happens to take about a week for companies to announce those.

NSP

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SNR

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SCHL (terminated their offer)

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SNOW

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For my theory of shorting the stock from the date of announcement to the ex-date, NSP was the only one to disprove that. It can also be said the general markets were in decline for these offers, so I am led to believe these offers are influenced by the overall market. One should also note that the announcement of a MDATO leads to a pop in the stock price on the day of the offer announcement.

For the offers with odd-lot provisions, one could have initiated a position below the eventual purchase price, but not necessarily below the lowest price in the price range. Although we do not know the purchase price until after the offer is completed, odd-lotters can expect the market price of MDATO stocks to dip below the price range in a down market based on these results.

I also noticed that after the offer has been completed, the prices generally revert back to their 50-day MA before the offer. If the market price was above the 50-day MA, the price would eventually fall, and vice versa.

FIG, NSM, and PTSI have ongoing offers, so the data set is incomplete. I looked for the lowest price each of the respective stocks went throughout their offers to see what returns were/are available.

FIG

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NSM

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PTSI

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CRAI

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Looking Ahead

Using these results, I decided to implement the short theory on NSM. In an ideal world (for me in this instance), NSM would drop below the price range, I would buy to cover the short, and initiate a buy to tender an odd-lot. So far, it has not been the best play. I will use it as a learning experience if nothing else. I expect to learn that I will only participate in these deals on the buying side, and when the entry price is below the price range in the offer.

I attempted to short FIG on their announcement date as well, but was given a message that no shares were available to short. I did not know this was possible, so I am basically resorting to a long position. FIG did dip below the price range last week, but I was greedy and expected the price to drop even further. It has since risen above the lower end of the price range. Already from this offer I learned not to pass on what could have potentially been another 9% holding return if the deal is ultimately completed.

I have not reviewed the details of PTSI fully, but initially I believe the pop might be unwarranted in light of how PTSI traded leading into today. I will comment on the article if I do enter a position.

CRAI announced a deal on Feb 22nd. I uploaded a review of their info so far.

Please comment below if you found this article helpful.

Disclosure: I am/we are short NSM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.