Description

If you don’t like catalyst trades, don’t bother reading this writeup. The value is pretty much irrelevant here, but there is an interesting opportunity to arbitrage the treatment of options and the market being made in the options themselves.

The situation:

Sears is merging with K-Mart in a “mix and match” transaction where shareholders are offered the choice between cash and stock. Shareholders of Sears will be given the choice between $50 per share in cash and 0.5 shares of the “newco” (sears and KMRT). Since KMRT shareholders get 1 share of newco, the stock consideration is equal to 0.5 shares of KMRT and can be hedged accordingly. The actual consideration received by Sears’ shareholders will be subject to proration such that 55% of the total consideration will be paid in stock and 45% of the consideration will be paid in cash.

According to Sears’ management, the merger should close in March, 2005. This timing is consistent with a merger that does not get a second request. Our legal counsel believes that the merger is very likely to be completed in this timeframe and that the possibility of a second request is remote.

We believe that holders of Sears’ stock who do not make an affirmative choice (the “Non-Electors”) for their preference on merger consideration (i.e. cash or stock) will be given the consideration that is underallocated. For instance, if 85% of Sears’ shareholders make an election and choose stock, the remaining 15% of the shareholders will be deemed Non-Electors and will automatically receive cash. Conversely, the 85% of shareholders who chose stock will receive about 65% of their consideration in stock and 35% in cash.

The arbitrage:

Holders of options on Sears will have the reference security for the option equivalent to the consideration given to the Non-Electors. Hence, if the Non-Electors get cash, the options get treated like an option on cash.

The Investment Recommendation:

Long: April ’05 Puts at $60 (Cost: $9.70)

Optional Investment: Short April ’05 Calls at $60 (Proceeds: $0.90)

The Payoff:

Investment 1 Only:

Scenario 1: KMRT = $90
Reference Security = 0.5 Shares KMRT
Payoff: $15 per Contract ($60 - $90 * 0.5 shares)
Gross Return: 54.6%
IRR: 191%

Scenario 2: KMRT = $120
Reference Security = $50 cash
Payoff: $10 per Contract ($60 - $50 cash)
Gross Return: 3.1%
IRR: 8%

Investments 1 & 2:

Scenario 1: KMRT = $90
Reference Security = 0.5 Shares KMRT
Payoff: $15.00 per Contract ($60 - $90 * 0.5 shares)
Gross Return: 70.5% ($15 proceeds / ($9.70 cost - $0.90 call proceeds))
IRR: 270%

Scenario 2: KMRT = $120
Reference Security = $50 cash
Payoff: $10 per Contract ($60 - $50 cash)
Assumed Sears Price: $55.50 (45% * $50 + 55% * 0.5 shares KMRT * $120 price)
Gross Return: 13.6%
IRR: 37%

Scenario 3: KMRT = $150
Reference Security = $50 cash
Payoff: $6.75 per Contract ($60 - $50 cash - $3.75 option value)
Assumed Sears Price: $63.75 (45% * $50 + 55% * 0.5 shares KMRT * $150 price)
Gross Return: -29%
IRR: -57%

The Risks:

Merger Timing - Both Investments: If the merger does not close in time, you could get stuck with the underlying reference security on the Puts / Calls being Sears’ stock as opposed to being the Non-Elector’s consideration. This can be hedged by using the January options (Put cost: $11 / Call Proceeds: $1.90)

Counterbidder – Both Investments: You get hammered if someone else bids. I doubt a counter-bidder for many reasons, including the presence of ESL on both sides of the deal and the much higher valuation of Sears than it had several weeks ago. Vornado has been rumored to be looking. I guess that you can hedge this by being long Sears’ stock to take the delta out of the trade, but this increases capital employed a lot (although it does decrease risk and should increase the “financablility” of the trade)

Other Potential Payoffs:

Merger Timing – If this takes much longer due to antitrust reasons, Sears could trade down due to merger uncertainty.

Sears’ underlying performance – Has been terrible. If it turns into a meltdown, you have a lot of upside with a renegotiation or termination of the merger agreement. ESL has a much larger stake in KMRT, so they have an incentive to cut the deal.

Catalyst

Completion of merger without a counterbidder by 4/15/05