Weyerhaeuser-Domtar Odd-lot Tender Offer

Domtar Weyerhaeuser Exchange

 

Thesis:

The thesis of this trade is simple: take advantage of an odd-lot tender offer that will create a 10% price discrepancy.

“The exchange offer is designed to permit holders of Weyerhaeuser common shares and Weyerhaeuser exchangeable shares to exchange their shares for shares of Company common stock at a 10% discount to the calculated per-share value of Company common stock. Stated another way, for each $1.00 of Weyerhaeuser common shares or Weyerhaeuser exchangeable shares accepted in the exchange offer, the tendering holder will receive approximately $1.11 of Company common stock, based on calculated per-share values, subject to (i) a limit of 11.1442 shares of Company common stock for each Weyerhaeuser common share or Weyerhaeuser exchangeable share accepted in the exchange offer and (ii) proration.”

According to the prospectus filed by Weyerhaeuser on February 2 the stated goal of the transaction is to incentive current WY shareholders to tender their shares and participate in the Domtar spin-off.

How the Price is calculated:

The website, www.weyerhaeuserdomtarexhchange.com, determines the daily volume weighted average price (VWAP) of both stocks, and prices in the 10% discount. According to the prospectus the price will be set by:

The final calculated per-share values will be equal to (i) with respect to Weyerhaeuser common shares and Weyerhaeuser exchangeable shares, the simple arithmetic average of the “daily volume-weighted average price” (or daily VWAP) of Weyerhaeuser common shares on the New York Stock Exchange on the last three trading days (the “Valuation Dates”) of the exchange offer period, as it may be voluntarily extended, but not including the last two trading days that are part of any mandatory extension triggered by the limit; and (ii) with respect to Company common stock, the simple arithmetic average of the daily VWAP of common shares of Domtar Inc. on the New York Stock Exchange on each of the Valuation Dates. The Valuation Dates will be February 28, 2007, March 1, 2007 and March 2, 2007, unless the exchange offer is voluntarily extended. Those dates will not change if the exchange offer is extended solely as a result of any mandatory extension of the exchange offer triggered by the limit.

Below is the chart that can be found on the website:

Proration:

The reason that a mispricing will occur to small investors is because of this odd-lot preference. The reason that companies have odd-lot preference is to get ride of people holding 100 or less shares because of the expense that it costs the firm to service the smaller shareholders. Below is WY’s description of the proration and odd-lot preference:

Any proration of the number of shares accepted in this Exchange Offer will be determined on the basis of the proration mechanics described under “This Exchange Offer—Terms of this Exchange Offer—Proration; Odd-Lots.” An exception to proration is that shareholders who beneficially own “odd-lots,” that is, fewer than 100 Weyerhaeuser common shares or 100 Weyerhaeuser exchangeable shares. Beneficial holders of less than 100 Weyerhaeuser common shares or 100 Weyerhaeuser exchangeable shares who validly tender all of their shares of the class in which they hold less than 100 shares may elect not to be subject to proration with respect to that class.

Risks to Investment:

This is not an arbitrage situation but a simple mispricing scenario. The reason this mispricing exists is to give an incentive to smaller investors to get ride of their WY shares, and because larger market markers cannot be guaranteed to partake in the deal. The odd-lot and proration rules of the deal limit the total investment to less than $10,000 dollars, thus making it a waste of time and effort by most professional investors who would be likely to participate. The first risk is that DTC price goes down past the 11.1442 threshold thus eliminating the benefit of the transaction. Looking at the recent price performance of the two stocks this has happened but is currently at 10.0545, so it is unlikely that would happen. If it did happen the tender-offer can be remove all the way up to March 2, 2007, so that is the price moves in the wrong way you don’t have to participate. In other words it is a free option. The next risk is that the performance of the market outpaces the return from the deal. Another risk is that once you have tendered the shares, the price of DTC continues to decline so that it destroys all of the value created from the tender and possible some of the original equity investment. This is a real possibility since most spin-offs have intense selling pressure after the transaction is completed. However, since this transaction is a spin-off merger, the selling pressure should not be as a normal spin-off.

Expected Returns:

This is a strait forward calculation of returns. Since the transaction has to be an odd-lot, which requires that the number of shares controlled or owned is less than 100. Simply stated, the maximum number of shares you can purchase is 99 shares of WY. So that would be of an cash outflow of ($8,175.42),(99*$82.58). Then based on the last three days average of VWAP is 10.1764 shares of DTC for each share tendered share of WY. This would result in receiving 1,007.46 shares of DTC. The last step would be to sell those shares which at close were $8.91 per DTC share, which would value at $8,976.47. The net result of the transaction would be $801.05, or a return on investment of 9.79% in a just two weeks. This return annualized would be 238.22%. This is based on current prices and the last three days average VWAP, thus this would not be the actual result. However, one can expect that a total the actual results would be within plus or minus 4%.

Timing of Events:

The timing of the events in this spin-off are strait forward. The first event is that one has to be a shareholder of WY. The second event is that the shares have to be tendered by March 2, 2007. The third event will be the acceptance of the odd-lot tender share, which will be in the after market of March 2, 2007. The last event is that the exchange is accepted and one receives their DTC shares. The last step to make the thesis that is not included in the transaction is to sell the shares in the open market.

 

Locking in the Gains:

I was thinking more about the risks in this transaction and wanted to update you on some of my thoughts.  First is that I think there will be significant selling pressure on DTC on the first trading day post-spin-off.  This should make the return smaller; however I still think with the 10% margin of error, we should still end up in the green.  The easiest solution would be to take advantage of the fact that DTC is currently being traded.  What one could do is to simple use the expected share conversion rate based on the WY-DTC website and sell the DTC shares short at the end of the day Friday.  This would lock in the gain and significantly reduce the risk.  This would simply cover the transaction with the new shares issued through the spin-off.  It would be fairly accurate to predict the distribution amount within a few DTC shares rate based on Wednesday’s and Thursday’s conversion rate and the trading action of WY and DTC on Friday.  One could clean up the transaction on Monday if they had too, by selling or buying a few DTC shares in the open market.  I think this approach makes the return much more probable and will lock it in before the market opens on Monday. 

 

 

 

Links:

http://www.weyerhaeuserdomtarexchange.com/

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