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Lockheed Martin's Tender Offer Is A Great Opportunity For A Small Investment

|Includes: LDOS, Lockheed Martin (LMT)


Lockheed Martin is spinning off, then immediately selling, Abacus Innovation Corporation ("Splitco") to Leidos Holding (NYSE:LDOS). They are offering LMT shareholders the right to exchange shares of LMT for shares of Splitco, which in turn becomes shares of LDOS, at a 10% discount. From the 424b3 form filed by Lockheed, "for each $100 in value of Lockheed Martin common stock accepted in this exchange offer, you will receive approximately $111 in value of Splitco common stock, which will, upon the effectiveness of the Merger, be converted into the right to receive approximately $111 of Leidos common stock." We perceive this to be a very low-risk way to make 10% of an investment in a short period of time.

What's in it for Lockheed Martin?

Lockheed is undergoing a Reverse Morris Trust to "sell" Abacus Innovation Corporation in a tax-free manner. If they simply sell it, they will be forced to pay taxes on the proceeds. Instead, they are spinning it off into a new entity wholly owned by former LMT shareholders, and then selling that company to LDOS. If the new entity (and therefore LMT) is seen as the buyer of LDOS rather than the seller to LDOS, the transaction occurs largely tax-free. This is why LMT is offering the exchange for 78.0M shares-currently, LDOS has 72.8M shares outstanding.

Why aren't money managers all over this opportunity?

Why wouldn't a hedge fund come along and buy, and exchange, 78 million shares of LMT (or at least a couple million)? Because, if you try to tender too many shares, the offer gets less appealing. If 78 million or more shares of LMT are tendered, then stockholders are only allowed to participate on a pro-rata basis. For every share someone attempts to exchange, he only actually gets to exchange a fraction of a share, calculated by:

(amount of shares to be expected, which is 78M) / (amount of shares tendered).

So, if several hedge funds buy millions shares of LMT, and try to tender all of them, they will only make 10% on a fraction of these shares as calculated above. Then, they will be left with unwanted exposure to LMT with an ambiguous overall gain.

So why should I buy LMT when hedge funds shouldn't?

Because there is a special odd-lot exception for this tender offer. If you own fewer than 100 shares (99 or fewer) of LMT, you are entitled to preferential treatment, and your shares will be exchanged without being subjected to proration. This is what allows a small investor to make an easy 10% on an investment of $25,000 (99 shares) but not a hedge fund manager to make similar returns on a larger investment.

Selected risks

There are a few ways this merger could fall apart, which would also cancel the tender offer. If Lockheed decides they aren't getting enough people to participate in the tender offer to get to 50% ownership of LDOS, it can cancel it (we don't think this is likely because of the high premium LMT is offering for the exchange). Similarly, if a huge market disruption happens, a war or terrorist event occurs, or serious litigation/regulation is brought against LMT during this time, LMT can terminate the tender offer. There are a few other similar conditions listed under "Conditions for the Consummation of this Exchange Offer" on the form 424b3. If this happens, all shares of LMT will be returned to participating investors. There is also a risk that, after the offer ends, LDOS prices drop as many participants sell their shares.

Upper Limit

There is also an upper limit of how many shares of LDOS Lockheed will give you in exchange for a share of LMT-about 8.2 times. This doesn't seem like a big issue, because LMT is currently trading at about 5 times what LDOS is trading at, but there is a "special divident" on LDOS of $13.64 per share. The ratio of LMT to dividend-adjusted LDOS is currently (as of August 1) 7.6877, which is still substantially below the upper limit of just over 8.2. If LMT goes up significantly or LDOS drops, though, the upper limit could come into effect. If this happens, the tender offer becomes less attractive (as you will make less than 10% of your investment), but you will still likely make a high percentage in a short amount of time. One way to avoid the risks of an upper limit would be to buy shares of LMT before the exchange rate is set, but this exposes you to downside risk if LMT prices decrease. It also does not shield you from decreases in the price of LDOS that might trigger the upper limit.

This offer expires August 16, 2016. Official exchange rate will be set August 12 at 9:00 AM New York Time.

DISCLOSURE: I own and have tendered shares of LMT.

Prospectus filed pursuant to 424(3)(b)

Updated numbers regarding exchange rates

Disclosure: I am/we are long LMT.