Corporations often seek to buy back their own securities. Most often they are trying to buy back their common stock in an effort to shrink the number of shares outstanding, which decreases the equity in the business and, in theory, should cause an increase in the per-share earnings of the business—fewer shares outstanding means that the remaining shares get a bigger cut of the pie.
Sometimes corporations will buy back their common stock to help drive the stock’s price up as a means to prevent or stop a hostile takeover.
Corporations also make offers to buy back their preferred stock, their convertible debt, debentures, and bonds in an effort to reduce their debt load or as part of a refinancing package.
When corporations decide to buy back their own securities there are several ways they can go about it. They can buy back the securities in the open market, which is okay if they are only after a small number of shares. But if they are after a large number, they run the risk of artificially driving the security’s price up beyond what they were initially willing to pay for it.
To avoid the risks of an open market purchase, companies will often make a tender offer directly to existing shareholders. This lets the company get a lower price than if it were in the market slowly driving prices up, and it lets it avoid extreme general stock market fluctuations, which could also drive prices out of reach.
Tenders come in basically two forms: an offer at a fixed price; and an offer to buy via a Dutch auction. In both scenarios the current market price is lower than the price of the tender offer, which creates the arbitrage opportunity. Warren has been known to arbitrage both situations.
Here the company offers to buy x number of securities at a fixed price for a set duration of time. The stockholders will tender their securities and the company will keep buying shares until they have bought the number they have set out to buy. If too many of the securities are tendered, the company will often prorate the number they buy from each of the sellers. (As an example: you tendered 10,000 shares, but the shareholders’ total tendered is 110% of the number of shares the company offered to buy. The company will then discount everyone’s tender by approximately 10%, which means that the company will only buy 9,000 of your shares, the other 1,000 being returned to you.)
Arbitraging this situation is easy; we just subtract the current market price from the fixed price and determine your return within the time frame of the tender. The deal is absolutely certain to go through, so there is no risk there. The only risk is that the company will have too many securities tendered and we will be stuck with only a prorate share sold. This means that we will have to go into the market and sell the rest, which puts us at risk for downward market movement between the close of the tender and the time it takes to get rid of the rest of the position. However, with a common stock position it means that the leftover shares are probably worth more, in that there are fewer shares outstanding as a result of the buyback.
A company that wishes to buy a fixed dollar amount of its securities will often use what is called a Dutch auction. A Dutch auction is where the company sets up a low and a high price and then invites shareholders to tender shares between those two prices for a set period of time. The shareholders are essentially bidding between a set of numbers. The company then picks the lowest price between the low and the high in which it can buy back all the shares it intended to, and it offers that price to all the shareholders who tendered shares up to that price.
Arbitraging this situation is a bit more complicated than our fixed price offer. Here the problem is that the low price of the offer is usually the market price of the stock on the day before the company made its offer, and the current market price on the day after the announcement is usually higher than the low value. This means that if we are intent on arbitraging the situation, we will have to buy securities that are already trading in the range of value of the low and high price. Lucky for us that no one is going to tender their securities at a price below the current price. Which means our tendered stock will be tendered at a price closer to the high end than the low end.
To get a better idea of how a Dutch auction works, let’s look at a recent Dutch auction that SonoSite, Inc., conducted to acquire $100 million worth of its stock.
Here is the public announcement:
A look at the material from the Information Agent would have told us that the deal was set to close on February 18, 2010, or in about 1.5 months. We can also see that SonoSite is offering to buy up to 22% of its outstanding stock, at a 15% premium to the closing price of the company’s stock the day before the announcement. Now, we can assume that a 15% premium to the closing price is probably not enough to attract 22% of the company’s outstanding stock, so we can project that the price that SonoSite will have to pay will be the full $30, to attract as much of the stock that it can.
A check of the trading price of SonoSite the day after the announcement tells us that we could buy the stock for $28.22 a share. A purchase price of $28.22 a share against a selling price of $30 a share gives us a profit of $1.78 ($30 – $28.22 = $1.78) and a rate of return of 6.3% for the 1.5 months we would hold the investment ($1.78 ÷ $28.22 = 0.063). Adjusted to an annual basis, it equates to earning 50% a year. Given that U.S. Treasury bills for that period were paying under one half of 1 percent, our little SonoSite arbitrage is looking really good.
If we used leverage in the deal and borrowed the $28.22 at an annual rate of 7%, our interest costs would be approximately $0.25 per share for the 1.5 months we held the investment. Which means that our $1.78 profit would be reduced to $1.53 ($1.78 – $0.25 = $1.53). A return of $1.53 a share on a leveraged investment cost of $0.25 equates to a return of 612% for the 1.5 month period. Which is one heck of a return.
And how did our SonoSite do with its Dutch auction? Let’s check out their press release on it:
So SonoSite didn’t get the $100 million in stock that it set out to buy and ended up paying $88.8 million for 2.96 million shares, which equates to paying $30 a share. In a Dutch auction the company ends up paying the lowest price in its pricing spectrum that will attract all the stock it set out to buy. Here SonoSite set out to buy $100 million worth of its common stock, but it ended up only getting $88.8 million, which means that it will have to pay the maximum price in the pricing spectrum to all the shareholders who tendered.
Corporate securities buybacks offer us a steady diet of arbitrage deals to invest in. What sets them apart from other deals is their high level of “certainty” of completion and the very short time they take to complete. Though the price spread is often quite small, the certainty of the deal and quickness of execution make them very attractive.