Stub Investing:
Doing a Digex
By David Brail
Special to TheStreet.com
9/8/00 4:08 PM ET
URL: thestreet.com
WorldCom's (WCOM:Nasdaq) recently announced deal to buy Intermedia Communications (ICIX:Nasdaq) for $39 per share in a stock swap represents one of the great triumphs in an obscure backwater of the event-driven world known as stub investing.
This is a technique where parent company assets are distilled from a complex holding company by selling short shares of the parent's publicly held subsidiaries. The idea is to create the remaining assets for absurdly low prices. In the case of Intermedia, the price was so absurd it was actually negative. The market paid you to own parent Intermedia's competitive local exchange carrier assets. So, when WorldCom swooped in to acquire the assets of the parent, the shareholders who had bet on this unlikely outcome made out like bandits.
Earlier this year, 3Com's (COMS:Nasdaq) spinoff of its Palm (PALM:Nasdaq) subsidiary generated quite a bit of publicity for this type of trade. Because of the high profile of the companies involved, the business press devoted an unusual amount of space to explaining the mechanics. For many, this was their first introduction to stub investing, a little known but potentially highly profitable strategy.
What made the Intermedia/Digex trade such a blockbuster was its element of surprise. Several months ago, Intermedia said it had retained an investment banker to "explore strategic alternatives" at its Digex subsidiary -- a transparent code phrase which means "auction it off to the highest bidder."
The Intermedia parent assets were difficult to value, as they were buried under $2.5 billion of debt and were performing poorly. It seemed likely the parent company was worth no more than a few dollars a share, while its Digex stake was worth as much as $40 per Intermedia share. With Digex trading in the $60s, the Intermedia stub (the combination of a long position in the parent, and a short position in the subsidiary) was valued at minus $13 per share.
While my firm was very familiar with the math, we stayed away from investing. My concern was that the company would do exactly as they said: Sell Digex. The problem was to whom and for what. We thought it unlikely a cash buyer would surface, and I could envision a scenario whereby Exodus, Global Crossing or WorldCom purchased Digex in a stock-for-stock merger. Even if done at a premium to Digex's then-$60 share price, Intermedia would then be just a cheap play on the acquirer. There was no guarantee that the discount would narrow.
By buying Intermedia, WorldCom is able to get control of its desired target, Digex, in a manner more attractive to the Intermedia board. While WorldCom is essentially paying Friday's closing price for Digex, it is able to offer an enticing 100% premium to Intermedia's $20 share price.
By virtue of Intermedia's 54% economic stake, and 90%-plus voting stake, WorldCom will control Digex when the deal for Intermedia closes. The losers: Digex public holders. There is no guarantee when or for how much WorldCom will buy in the balance of the public's stake.
An Unlikely Deal Made Likely
That's why Tuesday's deal produced such an extreme reaction -- Intermedia up $8.50 and Digex down $17. And the value of the stub went from negative $16 to zero. No one expected a sale of the parent while the subsidiary is left outstanding, with no takeover premium paid to it. This was the ultimate grand slam outcome for the stub players, an outcome viewed as so remote that the market had discounted it to zero. This outcome has renewed my faith in this niche strategy. There will always be clever stub trades out there; the tough part is finding the next Intermedia.
One Possibility
One high-profile current example is AT&T (T:NYSE), where fully $13.25 of its $31.25 share price is represented by its holding in AT&T Wireless Group (AWE:NYSE).
The parent company is widely expected to eventually offer its wireless shares in an exchange offer, retiring parent-company shares. When this will actually happen is uncertain. The AT&T stub -- created by going long one share of AT&T for every 0.52 share of AT&T Wireless sold short -- will vary with the market's belief as to when this will occur, and how extensive the distribution of the wireless shares will be.
Note that this type of transaction is modeled off previous "split-off exchange offers" such as Dupont/Conoco, General Motors/GM Hughes and Martin Marietta/Martin Marietta Materials. This method, developed by the financial engineers at Morgan Stanley, is a tried and true device to unlock stub value. Depending on how aggressively the AT&T board moves to distribute all of its stake in wireless, this may be an interesting opportunity, later this fall.
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