A Blockbuster Arbitrage Opportunity

There are a lot of things in this world that just don’t make sense to me. Add to that very long list the relative prices of Blockbuster’s two classes of stock - the A (BBI) and B (BBI.B) shares. According to the Blockbuster Web site the B shares each have two votes vs. the A shares’ one vote. Otherwise, “there is no difference between the two classes except for voting rights”. Yet, the A shares closed at a 33% premium to the B shares yesterday. Go figure.

So I did some poking around to find out why this is and I came up pretty much dry. Some people talk about the greater liquidity of the A shares but the B volume is adequate at 234,000 per day for the typical retail investor and the spreads are no worse than the A shares. Therefore, you would expect the retail investors to jump all over the B shares and even the institutional guys could make some pocket change. Hmmm. Maybe there’s a stigma attached to something labeled B as opposed to A?

Of course, if you want to take advantage of something like this you need to have some reason to believe that the discrepancy will close in a reasonable timeframe. So I checked the historic premium between these two stocks and found that indeed the premium appears to be at an all time high.

click to enlarge

But notice that some premium has always existed. So, while the premium might dissipate over time it probably won’t go away entirely - unless of course Blockbuster goes bankrupt, which is a distinct possibility, given the industry changes that Blockbuster needs to get in front of.

However, as I was trying to figure out what drove the premium up I noticed that the increase in the premium pretty much coincided with the drop in Blockbuster’s stock price. In other words, it appeared that the premium might have actually been fairly constant in dollar terms but increasing in percentage terms as the denominator of the equation dropped. So I reran the premium in dollar terms.

Notice that the premium has fluctuated around $.30 - $.50 for the last 4 years and as of yesterday it closed at $.64, which is a bit high historically but not that much higher than it’s been in the past. So the dollar premium has not really fluctuated that much.

This has profound implications for the way one executes an arbitrage strategy on this company. If you buy and sell equal dollar amounts of the two stocks you will end up with more B shares than your short position in the A shares. This will work to your advantage if the percent premium returns to earth. However, in the event that the stocks continue their downward slide and the percent premium continues to increase you will get burned with this approach. For instance, suppose each class of stock declines by $1.00? In that case you will lose more on the B shares than you gain on the A shares.

I decided the better approach was to buy and sell an equal number of shares. This way the worst thing that could happen to me is that the current dollar premium persists and has no impact on my position. If the dollar premium drops then I will gain on every pair of shares I’m short and long. For instance, if Blockbuster stock goes to zero I’ll make $.64 per share or 33% on the value of my long position.

Of course, there’s other twist here. The A shares are difficult to short. Fidelity could have found me some but would have charged me 2.5 - 6.5% per year, which is not bad. However, I was able to short them through Interactive Brokers without, so I am told, any borrowing fee being charged. We’ll see.

But what about all those retail investors who own the A shares? Why don’t they just own the same dollar value of B shares instead? Clearly, they are bullish on the company. If the spread closes they will make more money than they would on the A shares. Even if the spread does not close they will make more money as the A shares and B shares move up in tandem, with the B shares increasing by a greater percentage from a smaller base.

I just don’t get it. If anyone out there can shed some light on this please help make my world less irrational.

Disclosure: Long: BBI.B, short BBI

Comments

[Owen]

Interactive Brokers actually does charge for borrowing BBI. As of today, the rate is 6.12%, with about 300,000 shares available for shorting. This rate fluctuates on a daily basis, and has been as high as 7.62% on Tuesday. The cheaper class B shares, on the other hand, cost nothing to borrow, which I guess is no surprise.

At over 6% a year cost against this trade, the spread only makes sense if it shrinks soon, and there's no indication that it will. As an alternative to shorting BBI, you may consider writing the BBI LEAPs. The Jan2010 2.50 Call is now going for around $1.00, and time actually works in your favour when you're short an option.

Gary, to find out the current borrowing rates, you can go to the IB Account Management site and click on Tools/Short Stock Availability.

2008 Aug 15 09:54 AM

[Gary Lucido]

Thanks. I actually did that yesterday and saw the rate quoted. However, when I called them they told me I wasn't being charged. Hence, my comment "we'll see".

2008 Aug 15 10:10 AM

[Owen]

I'm impressed! I didn't realize those borrowing rates were negotiable. I had to give up on several promising arbitrage opportunities due to steep borrowing costs.

2008 Aug 15 10:35 AM

[Gary Lucido]

I don't think they are negotiable. I'd say that there's a 50% chance I was told incorrect information and a 50% chance that there's some glitch somewhere that will work to my benefit.

2008 Aug 15 11:37 AM

[Owen]

I understand. Your daily statement should help figure it out, if you have a limited number of short positions. Sadly, IB doesn't separate interest charges to margin deficit and borrowing costs on the daily statement, but only on the monthly one, so it's up to us to do the daily math. Several of us have asked IB to add this data to the daily report, but they haven't done so yet.

I guess this must seem petty and insignificant to some of the readers, but in the world of arbitrage, one or two percentage points may mean the difference between a profitable trade and a waste of time.

2008 Aug 15 12:22 PM

[Medici]

This arbitrage is/was similar to VIA and VIA.B Shares, everyonce in a while they come along, the only downside is lost opp. value while watching the paint dry. There are many Arbitrage ops in options vs. equity that are much more expediant. Take a look at crox options, the Theoretical value is far below the premiun on long term leaps, vs. front month options and selling the equity.

2008 Aug 16 08:51 PM

[Brett Scheiner]

I wrote a piece on this in May...

seekingalpha.com/artic...

Best situation is a pre-pack Ch. 11 where the equity is wiped out and the spread is therefore zero. Anyone analyzed the company's cash burn rate vs. available cash going forward? This spread may not close without a big move up or down (i.e. bankruptcy or turnaround) both of which will take some time...

Also, in the GaryLucid piece above, the author dismisses liquidity concerns, but this is not a marginal concern. The A's traded $7 million worth of stock today (hardly enough for an institution but admittedly enough for retail). The B's on the other hand traded $500k. This is not enough to even get a large retail position on without price disruption. Even more importantly, these levels are nowhere near sufficient to close out a decent size position, a key factor in trading any illiquid security.

Hopefully this thing closes as did Mueller water as I mentioned in my piece, but it could be a while...

DISCLOSURE: I have the Long B/Short A trade on...

2008 Aug 20 07:18 PM

[Gary Lucido]

I was right. They are merging the shares.

2009 Dec 10 10:42 PM