From thestreet.com
How Much is the Real Terra-Lycos Spread?
By David Brail
Special to TheStreet.com
5/23/00 7:05 PM ET
Has it struck you as odd that Lycos (LCOS:Nasdaq) announced on May 16, that it was being bought by Terra Networks (TRRA:Nasdaq ADR) for stock worth $97.55 a share, yet Lycos shares are trading for only 55? Doesn't $42-plus seem a little too generous a spread to earn over the four months or so it should take to close the deal? Simple math would show that return would annualize to 200%. Is that too good to be true?
Maybe. The Lycos transaction reminds me of another portal deal: At Home's (ATHM:Nasdaq) deal for Excite a year ago. That spread, too, was enormous. Tremendous returns were earned by buying Excite after the merger was announced. But the returns were paid in exchange for bearing certain risks, many of which are also present in the Lycos deal. Understanding those risks are the key to evaluating whether the potential lucrative return is fair, or indeed too good to be true.
I hope here to give you sense of some of the factors at work in how the market sets the spread.
Last year, Lycos broke a deal with Barry Diller's Ticketmaster Online-CitySearch (TMCS:Nasdaq) when power-behind-the-throne David Weatherall of CMGI (CMGI:Nasdaq) changed his mind and ceased to support that pact. No guarantee he doesn't do the same here.
The market reception to the Terra-Lycos deal has been abysmal -- both stocks have sunk like stones, and shareholders seem to dislike the logic behind the deal. Terra needs to complete a $2 billion rights offering to fund its future growth, and even though parent Telefonica (TEF:NYSE ADR) has pledged to support the offering, it is another source of risk.
I haven't made my mind up yet on the merits of the spread, but my early take on this deal is that it's best suited to a long-term Terra holder who might want to swap some of his Terra position into Lycos. This would be a successful trade as long as the merger closes.
Know the Payoff Currency
First of all, this deal -- like virtually all Internet deals -- is a stock-for-stock exchange. This is what is called a "collared" deal. You receive a fixed value of Terra shares for each share of Lycos as long as Terra's share price is within a band of prices. Outside this band the exchange ratio is fixed at a minimum and maximum ratio. Terra's price is to be determined by calculating a 10-day average closing price immediately prior to closing. In this case, Lycos shares will indeed receive $97.55 worth of Terra shares if the average falls between $45.37 and $68.06. If the average falls outside of this band, the ratio becomes fixed -- a Lycos share won't be exchanged into fewer than 1.433 Terra shares, nor more than 2.15 shares. The exact methodology is laid out in the company's merger agreement (called a DEFA-14A).
Terra is trading around 45. Already below the low end of the collar, you might be tempted to assume that you will receive 2.15 shares. But today's prices are not relevant -- only the prices that make up the 10-day average matter, and that is four months away. If Terra were to continue to fall, the value of the deal for each Lycos share would decline. If you do the math, you will see that today's spread means that an unhedged purchase of Lycos today at $55 a share turns unprofitable only if Terra were to be $26 a share or lower when the deal closes. If you are bullish on Terra, maybe that's a bet you want to make.
Those aren't the sorts of bets I like to make. I am agnostic when it comes to most companies' prospects -- I just look to find more-than-fair returns to be earned by investing in the outcomes of deals. The process is a little complicated, but follow me as I walk you through how I look at this spread.
There's More to the Terra-Lycos Spread Than Meets the Eye
By David Brail
Special to TheStreet.com
5/23/00 7:02 PM ET
Other than its large size and front-page prominence, the Terra-Lycos deal is not all that different from garden variety, stock-for-stock deals that utilize collars, so you can apply this methodology to lots of other similar situations.
Ordinarily, a risk arbitrager would seek to go short shares of the bidder, Terra, for each share of Lycos he bought. In this case, however, shares of Terra are not borrowable, and therefore not available to sell short. This is mainly due to the closely held nature of Terra and its small float. Any shares available to be sold short already have been spoken for.
That makes this case more difficult, so it is important to tread carefully and fully evaluate the spread.
Here's how I do it. I want to strip down the spread into its components. A collar is all about options. The low end represents a put option. If you own Lycos, you are short that put. Think of it this way -- if there were no collar and the average price were below the low end, you would be entitled to a larger ratio. The collar limits the ratio, and hence, the value, that you will receive.
The inverse is true of the high end of the collar -- that represents a call you are long. Take a deep breath, and do the following mental math: A share of Lycos represents the right to receive the $97.55 of Terra stock, less the value of 2.15 Terra puts struck at 45.37 (the low end of the pricing collar) that you are short, plus the value of the 1.43 Terra calls struck at 68.06 (the high end of the pricing collar) that you are long. Got that?
To value these options, you would throw these parameters into the option-pricing model of your choice, whether that be Black-Scholes, or another. An added twist is that the expiration date is a bit squirrelly -- it's not a single day, but rather a 10-day average ending on an uncertain date in the future.
We make educated guesses and recognize that the number spit out by the computer is only a guideline. Nonetheless, it gives a framework for understanding the true size of a spread. In this case, after adding the net effect of the options, I figure the spread is really only $17. This is mostly because the value of the puts (which in this example the investor would be short) is much greater than the value of the calls, mostly because the puts are in the money (i.e., Terra is trading below the 45.37 put strike price), while the calls are currently far out of the money (i.e., Terra is trading below the strike price of the calls).
Another reason that the puts are so much more valuable than the calls is that Terra shares cannot be borrowed. This has the effect of bidding up the price of puts, as the only way to get short Terra shares is to buy these puts. If you look at the actual, listed Terra options, you will see that the implied volatilities of the puts greatly exceed the implied volatility of the calls. Normally they would be close to equal. Volatility is a key input in determining an options price.
Unless you trade in sufficient size that you can induce a dealer to create a customized option contract, you need to replicate the collar as best you can through the available listed options. The idea is to best match available strike prices, with the series expiring as close as possible to when you think the merger will close. It isn't perfect, but when the spread is as wide as it is here, there is plenty of room for slippage.
So, if you were to buy a share of Lycos and construct an option position of short Terra September 70 calls on 1.433 shares and long Terra September 45 puts on 2.15 shares, you could take a lot of the market risk out of the transaction, leaving you with a deal spread of around $17.
A $17 spread is still enormous, even though it's not the apparent $42. In addition to the subjective reasons that might make the spread wide, insufficient liquidity in the options will limit professional arbitrage participation. It is simply too hard to hedge an institutional-sized position.
This would keep you correctly positioned until the pricing period started, when a full re-evaluation of the position would be required. And that's the subject of a future column.
P.S. I'm trying these more in-depth discussions of current deals as an experiment. If you like the depth of detail that these columns offer, let me know.
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