Tuesday, December 15, 2009

Bristol-Myers (BMY) : Mead Johnson (MJN) - Understanding a Tender With Options

This is an advanced discussion which will lead to relatively complex options orders. Understanding the underlying framework is the key. This situation does occur from time to time. This is how the pros trade.

First, here is the situation - provided by theflyonthewall.com news service:

"BMY and Mead Johnson announce amendment and extension of exchange offer
Bristol-Myers Squibb (BMY) and Mead Johnson Nutrition (MJN) announced that Bristol-Myers Squibb has amended and extended its offer to exchange up to 170M shares of common stock of Mead Johnson Nutrition for outstanding shares of Bristol-Myers Squibb common stock that are validly tendered and not validly withdrawn at an exchange ratio determined by a formula described in a registration statement filed by Mead Johnson Nutrition on Form S-4,Reg No. 333-163126. BMS is amending the offer by: Increasing the upper limit on the exchange ratio to 0.6313 shares of MJN common stock per share of BMS common stock from 0.6027 shares of MJN common stock per share of BMS common stock; however, the final exchange ratio may be less than the upper limit; Extending the exchange offer�s expiration to 12:00 midnight, New York City time, on December 17, 2009, unless extended or terminated, from December 14, 2009; and Amending the current expected three-day period over which the final exchange ratio will be determined to December 11, 14 and 15, 2009 (which previously was expected to be December 8, 9 and 10, 2009)."

In English: If you own BMY shares, you can swap them for 0.6313 of MJN. The two summaries are below - you can see the stock price implications.

The Opportunity
Owners of BMY stock get 0.6313*$42.49 = $26.82 for each share of BMY tendered and converted into MJN. That BMY share as of present is worth $25.68. That's a $1.14 gain.

Complication #1
A maximum of 170 million shares of MJN can get created. That's 170M/0.6313 = ~270 million shares of BMY can be converted. There are 2 billion shares of BMY outstanding. If you take an extreme, where every single share of BMY stock is tendered, then ~13.5% (270M/2B) of shares will be converted. In this case, if I have 100 shares of BMY, and tender all of them, I will get 13 BMY shares taken away and turned into 8.2 shares of MJN. I will be left with 87 shares of BMY from my original position.

Complication #2
All of the shares of BMY will almost certainly not get tendered. Why? Think of all the ETFs and Index funds that need to mirror their indices. They want their BMY and will not tender. There are several other scenarios where owners would not tender, but that's a big one. So the percentage of shares of BMY that will be converted to MJN is some number > 13.5%.

Complication #3
MJN is hard to borrow - see below for details and implications.

Let's start from zero position in either company. Clearly, the first step is to get long BMY shares if you care to tender. You can buy naked BMY and then sell MJN with the hope that you will collect that 1.14 above. But, only a small proportin of your BMY stock will turn in to MJN (some number > 13.5%). So what do you do with the other long stock? That's a delta risk.

One Approach
You can do a conversion in BMY to get long stock.
Sell Calls
Buy Puts
Buy Stock

That is delta neutral (selling synthetic stock and buying real stock 1-to-1). You can do that and pay 0.05 right now (paying 0.05 to make 1.14 sounds good). Ok, so now you have no delta risk in BMY and you can tender all your shares. Right?

But what about after tender? Your position will be:
Short Calls
Long Puts
Long less stock (some is now MJN).

So you have delta risk all of a sudden. Specifically, you are short BMY delta (short synthetic stock and long real stock but now less than 1-to-1).

Also, you are now long MJN stock - which of course can move.

You could buy cheap puts in BMY to protect that downside. The puts are cheap enough that the hypothetical $1.14 spread is still a winner.

But... what about MJN? You might end up shorter than you think or longer than you think depending on the actual percentage of tenders that are turned into stock.

Second Approach
Skip the BMY tender complication. You can reverse in MJN for a credit.
Sell Puts
Buy Calls
Sell Stock

That's buying synthetic stock and selling real stock 1-to1 so it's delta neutral. You can do this right now and receive 0.35.

Since so many people are buying BMY and selling MJN, the number of shares available for borrow in MJN are reduced. The brokerages are forced to charge a large negative rate to people selling short (borrow stock and then selling it). As of right now, the short rate is low enough that this reversal is a big winner (depending on your broker ~0.20 winner).

But... As MJN continues to get shorted - the rate to borrow it becomes more negative. It can go to -100% or even several times more. All of a sudden receiving 0.35 isn't enough to be short stock.

If you think the possibilites out carefully there could be a play. But no matter how you look it at, it is definitely not a free $1.14.

Legal Stuff:

1 comment:

  1. Looks like a rather complicated trade to me... why bother?

    Back to collecting them credits...

    Excellent post and well explained nevertheless. You guys rock!

    -from Canada