T For Two

by | May 22, 2001

On Friday investors will have to decide whether to exchange their shares of AT&T for shares of the AT&T Wireless tracking stock. When the big index funds decide, it will move the market. In the exchange offer that expires Friday, AT&T will accept up to 427 million T shares, exchanging each one for 1.176 shares […]

On Friday investors will have to decide whether to exchange their shares of AT&T for shares of the AT&T Wireless tracking stock. When the big index funds decide, it will move the market.

In the exchange offer that expires Friday, AT&T will accept up to 427 million T shares, exchanging each one for 1.176 shares of AWE. If the offer is fully subscribed, then AT&T’s holdings of AWE will fall from about 70% today to just under 50%. Then in midsummer, AT&T will distribute its remaining AWE shares to all T shareholders, and AWE will convert from a tracking stock to a regular stock.

Should you exchange your T shares for the AWE shares on Friday? Well, if it helps, I can tell you that here on our trading desk we refer to AWE as “AT&T Worthless.” But then we don’t exactly love the parent company either. So, for us, Friday’s offer is little more than the opportunity to exchange a frying pan for a fire.

If you manage some of the $1 trillion indexed to the S&P 500, the decision is pretty much already made for you. You don’t want to exchange your T shares for AWE shares, because AWE isn’t a member of the S&P 500, and probably isn’t going to be anointed as one by Friday.

But that doesn’t mean the indexers will do nothing on Friday. Because the exchange offer will effectively extinguish shares of T, its market capitalization will go down — so indexers will have to hold less of it in order to track their capitalization-weighted benchmark.

Right now T’s index weight is about 0.74%, and after Friday it will be 0.65%. That means indexers will have to sell about 38 million shares market-on-close on Friday, and redistribute the proceeds across the other 499 stocks in the index. The market value of that trade is about $839 million on each side.

There are two potentially complicating factors.

First, since the exchange offer was announced, T has traded at a discount to AWE. In other words, the value of a share of T was less than the value of the 1.176 shares of AWE for which it could be exchanged. I’ve seen the discount as high as 9%, but today it’s closer to 2%. Lots of arbs have tried to take advantage of this by buying T and simultaneously shorting AWE, planning to tender on Friday to unwind the trade at a profit.

The risk in that trade for the arbs is that they don’t know how fully the exchange offer will be subscribed. If it’s oversubscribed, they won’t get all their T shares exchanged for AWE shares, and on Monday morning they’ll be scrambling to sell T and buy back AWE. Some have hedged with options, but that doesn’t make the risk go away — it just transfers it to someone else who will have to do the scrambling.

If AWE is still at a discount on Friday, perhaps the more aggressive indexers will short AWE instead of selling T at the close, and then tender their T shares to cover the short. This would eliminate a little bit of the direct selling pressure on T. But I don’t expect much of this. The discount is steadily narrowing to zero, but the risk of not knowing how many tendered shares will be exchanged remains just as great.

The second potential complication is that Standard and Poor’s just might anoint AWE as an S&P 500 Index member on Friday. If that happens, indexers will still sell their T, but they’ll need to replace it with shares of AWE instead of replacing it with shares of the other 499 stocks.

Exchanging their T shares for AWE is an imperfect solution, because they don’t know how many of the shares they tender will actually be exchanged. But even if they were all exchanged, indexers would still be buyers of AWE — because the fraction of AWE’s market capitalization represented by the exchange is only 20% of its total capitalization. So indexers would need to buy about four times as much AWE market-on-close on Friday as they would get, at maximum, in the exchange offer.

That means they’d be net sellers not only of T, but of the other 499 stocks in the index as well, in order to raise the money to buy the extra AWE shares they’ll need. But remember, it only plays that way if S&P adds AWE to the index. Odds are they won’t do that — so the indexers will be sellers of T and buyers of the other 499 index stocks, size by large.

I have no idea whether this event will be exploitable by speculators who try to make a quick buck off the indexers by, in essence, front-running their predictable market-on-close orders. The indexers and the brokers who take execution risk for them aren’t stupid — so be careful if you go up against them in this highly liquid name in this highly publicized transaction.


The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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