## Some more thought on a potential OI /Portugal Telecom long/short trade

Since my post last week, OI shares have clearly outperformed PTC shares (14.3% vs. 7%). As some readers commented, OI shares would have been the even better alternative so far. OI was actually the best performing Brazlian stock last week.

Some commentors argued that one basically can calculate the value of PTC shares in the following way:

0.6330 * OI common share plus 2.2911 EUR. At yesterdays OI close this would mean 0.633 * (4.66/2.95) + 2.2911 = 3.29. At a current price of 3,60, PTC looks overlvalued bei 31 cents and a short PTC / long OI trade looks like a no brainer.

However this approach ignores the fact that new OI shares will be issued at a discount to the existing ones. As PTC shareholders get the new shares at the discount and old OI shareholder do not get compensation rights, the assumption that a current OI shares equals a new CorpCo share is clearly wrong.

If we assume a 1:1 share increase at OI before the merger, we have to think about this capital increase the following way:

First, one needs to assume the impact of a discounted share issue without compensation. Lets look at an extreme example: If I double the sharecount by issuing 1:1 new shares without compensation (capital increase “Russian style”), the value of the existing shares would be clearly halfed as I have twice the shares and no change in profits, NAV etc.

Putting this into a formula, the “loss” of the existing shareholders in the assuemd 1:1 capital increase is basically the discount divided by 2 (which equals the value of the missing suncription right).

So let’s just set up a virtual long short trade with current prices:

Step 1: Long Short at current prices

At the current price of (4.66/2.95) = 1.58 EUR per OI share, I would need to do the following trade:

Short 1 share PTC at 3.60 / Long (0.633 + 2.2911/1.58) = long 2.08 shares OI

Step 2: Assume a 20% discount on the new OI shares with an issue price of 1.264 EUR per share

This would lead to the following situation after the merger:

I would be long 2.08 OI shares which would trade at (1.58 EUR – (0.2*1.58/2))= 1.42 EUR

Then, I would be short from the PTC exchange the following amount of shares: (2.2911/1.264) +0.633 = 2.24 shares

So suddenly my “no brainer trade” leaves me short 0.16 shares or 0.16*1.42 EUR = -0.23 EUR per intitial PTC share (plus cost of borrowing). So the impact of the discount destroys an “arbitrage” opportunity.

On the other hand, I can use this long/short approach to calculate the implied discount on the new shares. At the above prices, the implied discount is around ~-26% (all other things equal).

So only if I have the opinion that the discount of the new shares is lower than 26%, I make money with the long short trade. Clearly, this looks like a large discount but I would not want to bet against that.

Summary:

I still stick with my 0.5% PTC position in order to actively watch this playing out. The potential long OI /short PTC trade mentioned by some commentators could be interesting, but is clearly a bet on the discount for the new shares, not an arbitrage deal.

• joe lucid

BTW, the convergence trade is short 1 PTC, long 0.69 OI. Then at the capital raise buy the remaining 2.29 Euro of OI you will be short after the conversion. You can do that as part of the capital raise if your broker has access to brazil.

Or just go short PTC outright because I can’t imagine OI rallying hugely given the coming big capital raise and even if it has a minimal impact on PTC’s price due to the fixed 2.29 Euro component.

• hmm, this version requires either direct access to the placement which I do not have and will not get or a huge operational “gap” risk. Does not sound like an arbitrage either.

Shorting PTC outright for me makes no sense at all. From where I am coming form, I rather see the upside in PTC getting rid of the PIIGS discount.

• joe lucid

Do you seriously think a secondary offering that’s open to outside investors will be priced at 20% below market? Yes, that happens in rights offerings that are limited to existing shareholders who are compensated via the rights. But not in secondary offerings – the huge discount would immediately be arbitraged away.

Or do you have an example?

In fact I think the convergence trade is excellent because volatility of PTC due to OI movement is very low because of the fixed 2.29 Euro component.

• Well I do not know any other “secondary” placing with a 1:1 ratio. In most jurisdictions, for any placing above 10% you need to offer subscription rights in order to prevent the dilution.

So we are in pretty “untested” territory here.

• joe lucid

If the secondary comes in at a huge discount OI would immediately tank because buyers in the secondary would dump their shares for a quick profit.

OI is already selling off as expected. If you want to own the surviving entity it’s tough: buy OI now and you’ll likely lose because OI sells of in expectation of the capital raise. Buy PTC and you’re protected from the OI dilution in the 2.29 Euro part – but you lose the premium and via the OI decline of the 0.69 shares per PTC.

An option to go long the surviving entity now would be to be long 1 PTC and short 0.69 OI. That gives you 2.29 Euro OI at the capital raise price. However you’d pay 2.70 Euro for those shares at the moment (using OI and PTC prices of 3.66 Euro / 1.40 Euro) – which is an 18% premium. Which really shows how untenable your position is.

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