Description

AT&T Canada is a very unique situation that by all accounts must be very well known to the hedge fund world but, due to its very structure, remains cheap enough for the small guy to profit too.

First off, let's forget about the fundamentals of this business, they don't really matter much. Second, a little history into how this came about will help in understanding why this situation is present.

History:
AT&T Canada was essentially created because of a regulatory rule in Canada that prohibits foreigners from owning more than 33% of Canadian companies. When AT&T bought out Metronet in 1999, AT&T was limited to that stake, so there are a lot of minority shareholders (non voting interests) in AT&T Canada. At the time of the merger between Metronet and AT&T, an agreement was struck that made AT&T obliged to buy the rest of the newly formed AT&T Canada from the minority shareholders by July 1st 2003. Not only were they obliged to buy the minority shareholders out, but the price was set at C$37.50/sh (Canadian Dollars) starting in June 2000. Metronet was extremely smart and made this a moving floor price that automatically increases 4% per quarter, so it essentially grows at 16.98% annually. As of today, the floor price is set at C$46.96/sh. By July 2003 it will be at C$60.04/sh.

One added catch is that if AT&T doesn't buy out the minority shareholders by July 2003, it must put AT&T Canada up for auction and supplement the auction price to make AT&T Canada's minority shareholder whole. That is, pick up the difference between the auction value and the floor price of C$60.04/sh.

Most recently, AT&T made public comments assuring that they intend on making good on this obligation to AT&T Canada's shareholders. There literally seems to be no out, short of AT&T declaring bankruptcy and even then they may not get out of it. This appears to be an iron-clad agreement that in retrospect looks extremely foolish for AT&T to have signed...but hindsight is 20/20.

This situation came to my attention from the dissolving of AT&T's joint venture with British Telecom, Concert. AT&T created this joint venture with BT and essentially contributed its stake in AT&T Canada, diluting themselves down to a 24% stake in AT&T Canada and giving BT a 9% stake. Up until the joint venture dissolved last week, the markets were assuming that BT would help AT&T foot the impending bill for the AT&T Canada buyout. But the joint venture agreement stated that BT would not have an obligation to share in the buyout agreement if they were not involved with joint venture by July 2003. When the venture folded, BT's obligation shifted back to AT&T, thus the latest drop in AT&T's stock price. Because the estimated value of AT&T Canada is near zero, this buyout will result in a huge loss for AT&T of around $3 billion (US dollars). That is a big number.

So, you are probably asking why, if it seems so certain that the buyout is going to happen, is the share price sitting at the floor price today? The answer, in my mind, is two-fold. First, there exists the possiblity that AT&T can circumvent the Canadian ownership rules by creating a Canadian trust before buying out the minority shareholders. This could happen at any time. This possibility limits the amount investors are willing to pay up for AT&T Canada shares, otherwise they expose themselves to a capital loss. Second, some investors believe that AT&T could try to get out of this bind somehow. Based on their recent statements, AT&T is telling the world that this will not happen.

From a investment perspective, buying AT&T Canada at today's prices represents an opportunity to make 4% per quarter for as long as AT&T waits to pull the trigger on the deal. The longer they wait, the more profitable the holding. After a year, you make almost 17%. The price compounds quarterly, but the floor price between the quarter ends is prorated accordingly. As of today, the floor price is C$46.96 and US$29.91 using an exchage rate of 1.57 Canadian $'s to US $'s. The US traded shares under the symbol ATTC closed at $29.76 or a slight discount to the floor value.

When will the buyout happen? This is the main question that remains, and it is apparent to anyone thinking long enough about it that AT&T has every economic incentive to get it done fast. In fact, each day they wait costs them about $1.5 million. With this in mind, you wouldn't expect this situation to last very long. If it were up to you and me, we would get it done tomorrow. The reality is that AT&T is in the midst of quite a lot of stuff right now, with AT&T Canada a relatively small issue. But, based on the numbers and the Concert deal being cleared up, I wouldn't expect this situation to be out here for longer than 6 months. On the other hand, it has already been 19 months! And the buyout price has increased 25% during that stretch!

For obvious reasons, I can only assume that many hedge funds have this investment in place on a leveraged basis. Even without leverage, this 4% quarterly return, that may last as long as 6-12 months, gives everyone else the opportunity to make an easy 8-12%.

Before ending, it's important to understand that by buying ATTC, you are entering into a side currency bet between the Canadian and US dollar. It goes without saying that if the dollar weakens, there is an added bonus.

So let's pray for a slow AT&T management, which looks like a good bet based on past moves, and a weak US dollar versus the Canadian dollar!

To read the actual Metronet buyout agreement, you can go to this site and type "Metronet" in the search field.

http://www.attcanada.com/English/fAbout_SearchSiteMap.html

Catalyst

Buyout by AT&T at a pre-determined floor price that increases 4% quarterly.