Description
This is an interesting technical trade related to the SHOS rights offering.
Each share of SHLD is receiving a right to purchase 0.218091 shares of SHOS for 0.218091 * $15. The right is SHOSR.
The OCC put out a memo on 9/7/12 stating that whent he rights expired, they would not be part of the deliverable once the right expired. In other words, the right is like a dividend.
However, the options market has not properly adjusted the options to account for this and so we can effectively buy the right for about $0.50 including all transaction costs.
The trade is this:
Buy 1 October 60 strike put at $6.84
Sell 1 October 60 strike call at $1.89
Buy 100 shares of SHLD at $56.28 -- note that it has not gone "ex" even though the record date was last week (see 9/7/12 press release).
Note that in normal circumstances we have no economic position. We are long the stock and short the $60 forward. And we paid $1.23 for the privilage. Not good. However, Sears is a tough to borrow stock so we can lend out our shares for a month and a half and earn about $0.75. So, now we are paying $0.48 since for the privilege. This is more or less the bid-ask spread and this has been present in Sears conversions for years. If we did this trade under normal circumstances, we would simply be throing away $0.48 in transaction costs.
However, today, this $0.48 is what we are paying for the 1 SHOSR. I believe that SHOSR is worth much more than $0.48.
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Valuation of SHOSR
This is quick and dirty.
Back of the envelope, it looks like op income of $90mm. FCF-to-TEV of $60mm (after taxes and capex). And this probably deserves a low-teens multiple . . . let's say 13x . . . so worth $800mm less the $100mm of debt and less the $350mm of exercise price. So, rights would be worth $350mm . . . or $15 for each WHOLE right --> so SHOSR would be worth $3.27.
There may also be a bonus . . . the over-allotment. It will probably not be huge in a deal like this, but there will be some holders that do not exercise the right and do not sell it! Of the 38% not held by ESL, let's say 3% fail to exercise. I am making up this number, but I could see 99% total exercise rate . . . So, add 1% to value!
I have run more scenarios and I am sure others have much more detailed valuations, but it seems to me that SHOSR worth $2-5.
and note that the numbers released last night in 10-q suggest the upside is even bigger.
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Risks
The biggest risk is that the rights offering is delayed or extended. Seems unlikely but possible. If so, you lose $0.48 in transaction costs.
Another risk is that the stock shoots up far above $60 and your short calls get exercised. This is not a disaster but it can messy and you incur more transaction costs. You can mitigate this problem by doing $80 conversions rather than $60 conversions.
I have badly erred in my valuation of SHOS and the rights are worth less than $0.48.
Catalyst
There are several major catalysts here:
- The rights start trading tomorrow.
- The options market realizes that puts past the expiration of the right should not include the value of the right (like a normal dividend).
- And if these do not work, the final catalyst is simply the expiration of the option in October.