Found this Briefing.com article about NTOP and IDTC. Very interesting. Oh yeah, don't fall in love with NTOP for sure.
Updated: 01-Sep-99
Net2Phone and IDTC
Frequent Briefing.com readers will know that an arbitrage strategy for a market inefficiency in Ziff-Davis/ZDNet stock was posted on these pages in the spring of 1999. That strategy eventually was fulfilled successfully, although it took nearly four months. A similar market inefficiency exists with IDT Corporation (IDTC) and the IPO of its subsidiary Net2Phone (NTOP). Here's an explanation of the IDTC/NTOP situation, and an analysis of how to play it.
Situation Description
IDT Corporation is a ten year old telecommunications company. It sells long distance services, both wholesale to business customers and retail, to individuals. It is the largest seller of phone cards. It also has an ISP business, but this is both a small portion of revenues, and is declining in absolute numbers.
IDT developed its own internet telephony software in 1995 and began offering phone calls delivered over the internet in 1996. The service was called Net2Phone, and originally allowed two users with PCs running the software to talk to each other. Since then it has expanded this service to include ordinary telephones on both the sending and receiving portion of the call, and support the use of faxes. The Net2Phone business also provides long distance calling using the internet and will soon begin selling internet phone calls for international phone calls.
In addition, Net2Phone has signed some very interesting deals, including an exclusive agreement to embed the Net2Phone technology directly into the Netscape browser.
IDT created Net2Phone as a wholly owned subsidiary in 1997. After allowing big name companies to invest in Net2Phone while private, (GE owns 5.5%, AOL owns 5.9%), Net2Phone had a public offering on July 29 at $15 a share, raising $81 million.
IDT still owns 57% of the total stock of Net2Phone. In addition, most of the shares they own are Class A NTOP shares, which gives IDT 2 votes per share. Class A shares can be converted into common NTOP at any time, at a one-to-one ratio.
The Inefficiency
The market is inefficiently pricing IDT's ownership in NTOP, as shown below. Prices are mid-day on Wednesday, September 1.
NTOP IDTC
Price 89 30
Total Shares, Millions 47.52 35.73
Market Cap, Millions 4,229 1,072
However, IDTC owns 27,158,190 Class A shares of NTOP. This gives IDTC 57% ownership of NTOP, a "value" of $2.4 billion dollars.
But IDTC's total market cap is only $1.1 billion. The 57% ownership stake in NTOP seems to be completely ignored. How can this be?
The Rational Explanation
The only rational explanation is the investors who want internet telephony are buying NTOP without any fundamental analysis. Certainly not the first time for internet stocks. This is a company which at best will do only $40 million in revenues this year, with no expectation of earnings until the year 2002. The extremely high volume seems to indicate the daytrading crowd has just chosen NTOP as its current plaything.
The rational explanation for why IDT has not paralleled NTOP is that IDT investors clearly don't believe that the NTOP valuations will be sustained long enough to be reflected in the long term value of IDT. In other words, a potential long term holder of IDT doesn't believe that NTOP is valued correctly right now. So IDT prices don't reflect NTOP's current "value."
Of course, there is no requirement that the explanation of this market inefficiency be rational, however. It certainly looks now like the market inefficiency in the ZD/ZDZ situation was simply irrational.
How To Arbitrage the Situation
Fortunately, an arbitrage play does not require either a rational or irrational explanation of why a market inefficiency exists. All if requires is a belief that the market does, eventually, price assets correctly.
All arbitrage situations involving linked securities are based on the following idea: Short the overvalued component and buy the undervalued component.
It is important to note, however, that a proper arbitrage stance does not mean the overvalued component falls, and the undervalued component rises. All that is necessary is for the gap of inefficiency to be wrung out of the market.
Both could fall, or both could even rise, but if the arbitrage position is placed correctly, it only matters that the two securities reach parity pricing.
So what is parity pricing for the NTOP/IDTC situation?
Arbitrage Ratios
One of the easier things about the ZD/ZDZ situation was that valuing Ziff-Davis's traditional publishing enterprise was relatively easy, because there are many comparables for publishing. Valuing IDT's core business is trickier for two reasons.
First, they are in a new market, which while growing, has many strong competitors.
Secondly, IDT is primarily a long distance reseller. Internet ISP business is a minimal component of their revenue. IDT has no wireless revenue component. Companies such as AT&T, MCI WorldCom, and Sprint have revenue mixes of data and wireless with long distance. If those companies choose to drop long distance rates to zero or near-zero to bolster revenues from the other components, IDT could be severely weakened. For this reason, IDT has one of the lowest valuations in the telecommunications world.
Nevertheless, for an arbitrage play, you need to calculate the relative appropriate values for the two companies. Since it isn't as straightforward, the thing to do is calculate ranges of appropriate values, in order to obtain a range of relative ratios.
To calculate a range of appropriate values, I choose four ranges. First, with NTOP currently accurately valued, I calculated the proper price ratio for IDT two valuations, one at a Price/Sales ratio of 1.0, the second at a Price/Sales ratio of 2.5.
Second, making the assumption that NTOP is grossly overvalued, and should only be 1/4 of its current value (which still makes it a billion dollar market cap), I calculated a range with NTOP again valued at both 1.0 and 2.5 P/S ratios.
Here is how those calculations work out.
The basic formula for determining the relative valuations is as follows:
NTOP share price = NTOP Value / 47.52 million
IDTC share price = (IDT core business value + 0.57*NTOP Value ) / 35.73 million
Price ratio = NTOP / IDTC = (NTOP Value / 47.52 ) ÷ [(IDT Value +0.57*NTOP Value)/35.73]
IDTC's core business did $191 million in revenue last quarter. For simplicity sake, consider this as $800 million in mixed months (half trailing, half forward) revenue. A Price/Sales ratio of 1.0 makes IDT worth $800 million, a Price Sales ratio of 2.5 makes IDT worth $2 billion.
Scenario 1: IDTC is worth Price/Sales of 1.0, NTOP is worth 4 billion. This gives a share price ratio of 84/83, or about equal price in shares.
Scenario 2: IDTC is worth Price/Sales of 2.5 (same as FON), and NTOP is worth 4 billion. This gives a share price ratio of 84/116 or a ratio of about 2/3.
Scenario 3: IDTC is worth Price/Sales of 2.5, and NTOP is worth 1 billion. This gives a share price ratio of 21/72 or about 3/10.
Scenario 4: IDTC is worth Price/Sales of 1.0 and NTOP is worth 1 billion. This gives a share price ratio of 21/38 or about 2/3.
The problem with all of these ratios is choosing the one which makes make the most "sense." You won't get an argument from me if you choose the 3/10 ratio, but it would be the riskiest one, if long distance phone calls became free, as it would destroy both IDTC and NTOP. The losses from the 10 IDTC long position might overwhelm the gains from the 3 NTOP short position.
The 1-to-1 ratio is also a little riskier because it makes the assumption that NTOP is fairly valued at 4 billion, which is pretty hard to justify, even by internet standards.
A more conservative position is the 2/3 ratio, which comes up twice in this analysis. This ratio also appears at the two extremes, which values NTOP and IDTC at their highest values, and also when NTOP and IDTC are valued at their lowest extremes. This suggests that proper valuation of the relationship is somewhere around 2/3. This means that IDTC stock should be 50% higher than whatever NTOP is!
Currently, NTOP is trading three times higher than IDTC.
Therefore, based on these premises, the ratio of the short to long position should be 2/3. In other words short 2 shares of NTOP for every 3 shares of IDTC long.
Does this guarantee you will make money? There are never guarantees. But if you believe that the market eventually prices everything correctly, this strategy should make money. But your patience may be sorely tested in the meantime.
In addition, the valuation ratios need to be recalculated during the position, in light of any new business developments that might alter the real values of the companies.
Hardest Part
The biggest problem with this particular arbitrage is getting shares of NTOP to short.
IPOs cannot generally be shorted for 30 days. This is because there is an NASD rule requiring a broker to have possession of shares before a short sale can be made. Shares are not delivered to the IPO institutions for a couple of weeks after the IPO, meaning that they don't actually have the shares. While a trail of long sales, for what is essentially when-issued stock, is permissible, short sales are not.
If you do try to short NTOP, please send me an email (rvgreen@briefing.com) letting me know if you were successful or unsucessful. I'll keep track of how the responses I get (anonymously of course), and report back later on how successful investors have been in shorting the stock.
Need Both Parts
However, to truly play an arbitrage, you must have both parts of the position.
Both the long and short positions must be made if your investment thesis is capturing the market inefficiency.
Otherwise you run the risk of being correct, but having the market inefficiency wrung out in the opposite direction of your position. The offsetting position would cover this, but without it you just lose money.
Many emails were received suggesting that an investor just buy IDTC, since it is clearly undervalued. While this thesis could possibly be justified (IDT management looks extremely good and opportunistic), from an arbitrage point-of-view, IDT's business prospects don't matter. All that matters is capturing the market inefficiency between the linked stocks. And for that, you need both sides of the position.
Comments can be emailed to the author, Robert V. Green, at rvgreen@briefing.com. |
