Thursday, June 13, 2013

Why I'll Pass on the Pfizer-Zoetis Exchange

I am an Pfizer (PFE) shareholder and the company is making an interesting tender offer of its animal meds division call Zoetis (ZTS).

Zoetis up until a year ago was a wholly owned division of PFE. Then it IPO'ed this year. PFE tendered 20% of its shares in ZTS, so it still owns 80%. Then PFE realized that the market was strong and this is the time to unload all of its remaining stake in ZTS. It is doing this via a exchange offering to PFE shareholders.

The exchange offering expires June 19. It gives the PFE shareholder the right to get ZTS at roughly a 7% discount to the ZTS market price. To get the ZTS shares, however he must exchange his PFE shares. This is a non-cash exchange. So the discount gets reflected in the exchange ratio between ZTS and PFE. Suppose the market price of ZTS and PFE are equal, then the PFE shareholder can get 107 shares of ZTS for each 100 PFE shares tendered.

The market price for the exchange is considered to be the average of the two stock's trading price in the three days before and including June 19.

The Pfizer shareholder has the right to get up to 0.9898 ZTS shares for each PFE shares owned. The number of shares that Pfizer will actually exchange may be different from what the shareholder asked for because ZTS is a much smaller company than PFE. If PFE shareholders oversubscribe (i.e., there wouldn't be enough ZTS shares to go around) the ZTS shares will be distributed proportionally to the number of PFE shares tendered.

So, the amount of benefit to a PFE shareholder is dependent on how much other PFE shareholders tender. If plotted on a graph this would be a straight-line relationship. I didn't bother plotting a graph but instead calculated the benefit at the endpoints if I tender to exchange $100 worth of PFE shares. The endpoints are the least and most favourable cases.

In the least favourable case, we all subscribe all our shares. The market cap of PFE and ZTS are $204.8B and $15.6B, respectively. And PFE is putting up 80% of ZTS shares. So the ratio is $204.8:$12.4, or $100:$6.05. Then to get $6.05 worth in ZTS shares I must exchange about $6.05 &divide 1.0752 = $5.63 worth of PFE. And in the end for each $100 PFE I had before exchange, I would have $94.37 worth of PFE and $6.05 of ZTS, for a $0.42 gain in the least favourable case.

In the most favourable case, few people beside myself subscribe. Then for each $100 of PFE I would get about $100 * 0.9898 * 1.0752 = $106.42 worth of ZTS. And in the end for each $100 PFE I had before exchange, I would have $1.02 worth of PFE and $106.42 ZTS, for a $7.44 gain in the most favourable case.

So, it is a guessing game between PFE shareholders; the payoff is a possible 7.44% gain. The more people exchange thinking they can get the 7% the more likely they will end up closer to 1%. The more people give up and think it isn't worth the trouble, the more likely that those who do exchange will get 7%. This is a arbitrage situation. I am sure someone in some hedge fund must be dreaming of a way to make a small gain. But one major downside is the transaction cost of executing such a trade. I don't want to do such a thing because of the small gains involved. The other reason for exchanging could be because I want to own ZTS long term. But again, I don't want to because Zoetis trades at a PE of more than 30. I wouldn't own such a stock with such a tiny discount.

So I will keep my PFE shares. Tell me what you think.

Disclaimer: please look at the disclaimer section on the right column. If in doubt about what to do, please consult a qualified financial advisor.

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