Description

I just posted a value idea with a fair amount of risk (YRCW), so it's only fair that I provide something for the more conservative value investors here. 

In March of 2009, jet551 posted the SPWRA/SPWRB arbitrage, suggesting a short of SPWRA versus a long of SPWRB in equal dollar amounts.  My idea is very close to that (though I suggest matching the shares one for one rather than by dollars invested).  I think it is worth reposting because the catalyst that jet551 suggested (and in which I believed at the time, too) has proved not to have occurred, but two, more certain catalysts, one fairly minor but another  that will achieve the same result are approaching, and I present some additional information to illustrate the potential risks and rewards.

Sunpower has two classes of shares, Class A (SPWRA) and Class B (SPWRB).  As of the close on Friday, June 4, the B shares traded at a 14% discount to the A shares ($12.89 versus $11.33).  The two-class structure is a result of the IPO of Sunpower , in which Cypress Semiconductor, formerly the owner of 100% of Sunpower, in November, 2005.  Cypress created and sold Class A shares while retaining its majority interest in Class B shares.  The two share classes have identical economics and vote together as a class on almost all matters; Class B carries 8 votes per share versus 1 vote per share for Class A, so Class B holders (at the time, only Cypress) collectively control the company.  Cypress spun its entire interest in Class B shares out to Cypress shareholders on September 22, 2008.

There are currently 55.5 million Class A shares outstanding versus 42.0 million Class B.  SPWRA is in the Russell 1000 index, whereas SPWRB shares are not (neither is a member of any Standard & Poors index at the moment).  SPWRA shares are considerably more liquid (trading around 4 million shares a day) than the SPWRB shares, which trade around 1 million shares per day.  The index membership and liquidity differences explain the premium in SPWRA.

Sunpower management, since its first earnings call following the spinoff, has consistently maintained that it intends to combine the two classes into a single class.  Recent conversations with management confirm that this is still their intention, though this is subject to approval by the Board of Directors.   importantly, Sunpower's corporate charter provides that both classes will vote together should the company seek to consolidate the share classes, and SPWRB shareholders, who have far more votes than do SPWRA shareholders, have every incentive to approve the consolidation.  The only real barrier to completion of this share class consolidation is the federal income tax consequences.

Section 355 of the US Internal Revenue Code provides that a corporation my spin off a division or subsidiary, provided that the transaction meets several criteria.  Section 355(e) of the Code, added in 1990, causes the corporation that spins a subsidiary off to shareholders that is part of a "plan or series of related transactions)" that results in the acquisition of 50% or more of either the parent or the spun-off subsidiary.  There is a rebuttable presumption that a spin-off, followed within two years by an acquisition, is part of such a plan.

 For technical reasons, combining two classes of shares into a single class is treated as an acquisition, even though both classes are represented by public shareholders of Sunpower.  To prevent being forced to pay a corporate-level tax on the Sunpower spinoff, Cypress has the right to prevent Sunpower from combining its two classes of shares into a single class before the end of this two year period.  The two-year period will end on September 29, 2010.

Cypress had indicated that it would permit the collapse of the share classes before September 2010, but only (as is the common practice), if Sunpower obtained a ruling from the IRS that the consolidation of the classes was not part of a plan of acquisition in place at the time of the spin-off.  Sunpower has tried to obtain such a ruling, but so far has not received one.  This was the basis of jet551's recommendation to buy SPRWB and short SPWRA 15 months ago.

The IRS used to refuse to give such opinions, but started again when MetLife split off its Reinsurance Group of America subsidiary in September 2008, shortly before Cypress spun Sunpower off.  The company is tight-lipped about the reasons, but lawyers who have spoken with the IRS in similar circumstances have told me that the IRS will not get letter rulings where the companies did not discuss the issue with the IRS before the spinoff.  For what it's worth, this is a ridiculous position, since discussing the idea with the IRS before the spinoff makes it, if anything, more likely that there is a plan that violates Sec. 355(e) at the time of the spinoff, not less likely, which is why I had the same position on that jet551 did.  Nevertheless, that's the way the IRS has chosen to work, so Sunpower has been stuck with two share classes since the spinoff.

Because the two-year period will expire in four months, Sunpower will be able to complete the transaction this year.  Though technically they could hold the board meeting and shareholder vote necessary to achieve this in advance, my guess is that to avoid any potential Section 355(e) issues, they will wait until after the deadline, so it may take an additional two to three months to complete the spinoff, but I expect an announcement shortly after the 2-year restriction period ends.  Management may raise the issue, either directly or in questions, in the next few earnings calls, though I suspect that their answer will be limited to stating that they would like to combine SPWRA and SPWRB, but are not free to do so before September 29, and they have neither Board nor shareholder authorization for such a transaction at present.

Monthly Spread Performance

For your reference:

Risk

Historically, the spread has a zero beta, but if the price of Sunpower stock increases significantly, either because the market generally rises quickly or because the solar industry rebounds, the spread could widen considerably.  It still revert to zero in the end.

Catalyst

First catalyst (the minor one):  On June 25, 2010, Russell Investment Group will rebalance its major US indices, including the Russell 1000The index is rebalanced based on market capitalization as of May 31.  Sunpower's market cap is large enough that it will remain in the Russel 1000 index.  However, over the last year, SPWR has significantly underperformed the Russell 1000, with SPWRA falling by 55% versus a 15% decline in the index, yet Sunpower has issued no shares this year.  Russell 1000 passive indexers hold about 2% of the market cap of member companies as of the May 31 preceding the last reconstitution, so indexers probably hold around 1.7 million shares of SPWRA.  This will decline by around 45% when the index is reconstituted on June 25, so there will be approximately 800,000 shares for indexers to sell, or 20% of average daily volume.  This is not enough shares to make a significant difference in the price given the extra liquidity that will materialize on the reconstruction date.

Second catalyst (the major one):  Announcement shortly after September 29 of the company's intention to consolidate its two share classes, though I expect market anticipation of this event will cause the premium to decline to minimal levels before then.