Tuesday, August 9, 2016

Lockheed Martin Odd-Lot Arbitrage

The opportunity

An ‘exchange offer’ is being conducted by Lockheed Martin Corporation (LMT). LMT is offering to exchange shares of its own common stock for shares of LDOS. LDOS is also a publicly traded entity. Thus, an owner of LMT shares can trade in the stock to receive stock of LDOS. (Technically, the exchange is for LMT’s Information Systems & Global Solutions Business, a subsidiary that will merge with LDOS contemporaneously with the exchange offer).

To induce shareholders to accept such an offer, LMT is offering a discount for such an exchange. This discount is partially responsible for the profits achievable in this investment. However, because of this discount, many more shareholders of LMT can be expected to offer their shares for exchange than are being sought by the company. As a result, the company will most likely ‘prorate’ the offer, i.e. only a portion of the stock tendered by the shareholders will be exchanged for LDOS stock and the rest will be returned. However, according to the exchange documents, proration does not apply for owners of 99 shares and below (with all of an individual’s accounts taken together). This is called the ‘odd lot preference’. This is the second important piece of the opportunity.

Profit calculation

Currently, LMT stock trades at $260 and LDOS stock trades at $47.53. LDOS will pay its owners a dividend of $13.64 before the exchange offer. The exchange ratio (i.e. number of LDOS shares to be received per share of LMT) is currently at 8.2136. Hence, a buyer of 99 shares of LMT can expect to profit as follows:

1. Purchase 99 shares of LMT and tender them into the exchange offer by calling the broker (for most brokers, tendering shares cannot be done online; a call has to be made). When calling the broker, one must specify that they desire the ‘odd lot preference’ for their 99 shares.

2. Shortly after the expiration of the offer, the investor will receive 8.2136 shares of LDOS with a current value of about $33.89 per share ($47.53 current price less $13.64 to be paid as a dividend to their shareholders prior to the exchange offer) for each share of LMT. Fractional shares will be rounded down with cash paid in lieu of the rounded amount. Receipt of LDOS shares and cash may take up to 10 business days after the expiration of the exchange offer on 8/15/16.

3. Sell the LDOS shares received. The price of LDOS shares will continue to move during the 10 days that the shares are being exchanged (see Risk #1 below). A profit of ~$1,817 can be made per person, calculated as follows:

99 shares of LMT * (8.2136*33.89 – 260) = ~$1,817, equating to a ~7.1% return in a short time.

The actual profit will vary from the above profit because shares of LDOS will continue to move around while the tendered stock is exchanged and shares of LDOS (along with cash for fractional shares) are delivered back to LMT investors. This can take up to a 10 business days as noted above.

Risks

1. If shares of LDOS fall below $31.66, (about 7% from current levels after subtracting $13.64 for the dividend), the profits may not materialize. Alternatively, if LDOS shares rise, the profits will be larger than indicated. Advanced investors may think about eliminating this possibility by shorting 813 shares of LDOS (99*8.2136, rounded down) which are to be received. Even though such a strategy will ‘lock in’ the profits, the $13.64 dividend paid by LDOS per share will complicate this short significantly. This shorting strategy is being used by many arbitrageurs and their shorting appears to be responsible for the recent decline in the price of LDOS, which I consider temporary. If engaging in a short of LDOS shares to ‘lock in’ profits, I urge caution in reviewing cash and collateral requirements with your broker.

For those looking for even more details, the prospectus and other documents are available here:
http://edocumentview.com/LockheedMartinExchange/ 

Disclosure and disclaimer:

A partnership I manage owns shares of LMT. Under no circumstances should this communication be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. Please do your own due diligence prior to investing.

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