Weekend Update – July 28, 2013

Stocks need leadership, but it’s hard to be critical of a stock market that seems to hit new highs on a daily basis and that resists all logical reasons to do otherwise.

That’s especially true if you’ve been convinced for the past 3 months that a correction was coming. If anything, the criticism should be directed a bit more internally.

What’s really difficult is deciding which is less rational. Sticking to failed beliefs despite the facts or the facts themselves.

In hindsight those who have called for a correction have instead stated that the market has been in a constant state of rotation so that correction has indeed come, but sector by sector, rather than in the market as a while.

Whatever. By which I don’t mean in an adolescent “whatever” sense, but rather “whatever it takes to convince others that you haven’t been wrong.”

Sometimes you’re just wrong or terribly out of synchrony with events. Even me.

What is somewhat striking, though, is that this incredible climb since 2009 has really only had a single market leader, but these days Apple (AAPL) can no longer lay claim to that honor. This most recent climb higher since November 2012 has often been referred to as the “least respected rally” ever, probably due to the fact that no one can point a finger at a catalyst other than the Federal Reserve. Besides, very few self-respecting capitalists would want to credit government intervention for all the good that has come their way in recent years, particularly as it was much of the unbridled pursuit of capitalism that left many bereft.

At some point it gets ridiculous as people seriously ask whether it can really be considered a rally of defensive stocks are leading the way higher. As if going higher on the basis of stocks like Proctor & Gamble (PG) was in some way analogous to a wad of hundred dollar bills with lots of white powder over it.

There have been other times when single stocks led entire markets. Hard to believe, but at one time it was Microsoft (MSFT) that led a market forward. In other eras the stocks were different. IBM (IBM), General Motors (GM) and others, but they were able to create confidence and optimism.

What you can say with some certainty is that it’s not going to be Amazon (AMZN), for example, as you could have made greater profit by shorting and covering 100 shares of Amazon as earnings were announced. than Amazon itself generated for the quarter. It won’t be Facebook (FB) either. despite perhaps having found the equivalent of the alchemist’s dream, by discovering a means to monetize mobile platforms.

Sure Visa (V) has had a remarkable run over the past few years but it creates nothing. It only facilitates what can end up being destructive consumer behavior.

As we sit at lofty market levels you do have to wonder what will maintain or better yet, propel us to even greater heights? It’s not likely to be the Federal Reserve and if we’re looking to earnings, we may be in for a disappointment, as the most recent round of reports have been revenue challenged.

I don’t know where that leadership will come from. If I knew, I wouldn’t continue looking for weekly opportunities. Perhaps those espousing the sector theory are on the right track, but for an individual investor married to a buy and hold portfolio that kind of sector rotational leadership won’t be very satisfying, especially if in the wrong sectors or not taking profits when it’s your sector’s turn to shine.

Teamwork is great, but what really inspires is leadership. We are at that point that we have come a long way without clear leadership and have a lot to lose.

So while awaiting someone to step up to the plate, maybe you can identify a potential leader from among this week’s list. As usual, the week’s potential stock selections are classified as being in Traditional, Double Dip Dividend, Momentum or “PEE” categories (see details).

ALthough last week marked the high point of earnings season, I was a little dismayed to see that a number of this week’s prospects still have earnings ahead of them.

While I have liked the stock, I haven’t always been a fan of Howard Schultz. Starbucks (SBUX) had an outstanding quarter and its share price responded. Unfortunately, I’ve missed the last 20 or so points. What did catch my interest, however, was the effusive manner in which Schultz described the Starbucks relationship with Green Mountain Coffee Roasters (GMCR). In the past shares of Green Mountain have suffered at the ambivalence of Schultz’s comments about that relationship. This time, however, he was glowing, calling it a “Fantastic relationship with Green Mountain and Brian Kelly (the new CEO)… and will only get stronger.”

Green Mountain reports earnings during the August 2013 option cycle. It is always a volatile trade and fraught with risk. Having in the past been on the long side during a 30% price decline after earnings and having the opportunity to discuss that on Bloomberg, makes it difficult to hide that fact. In considering potential earnings related trades, Green Mountain offers extended weekly options, so there are numerous possibilities with regard to finding a mix of premium and risk. Just be prepared to own shares if you opt to sell put options, which is the route that I would be most likely to pursue.

Deere (DE) has languished a bit lately and hasn’t fared well as it routinely is considered to have the same risk factors as other heavy machinery manufacturers, such as Caterpillar and Joy Global. Whether that’s warranted or not, it is their lot. Deere, lie the others, trades in a fairly narrow range and is approaching the low end of that range. It does report earnings prior to the end of the monthly option cycle, so those purchasing shares and counting on assignment of weekly options should be prepared for the possibility of holding shares through a period of increased risk.

Heading into this past Friday morning, I thought that there was a chance that I would be recommending all three of my “Evil Troika,” of Halliburton (HAL), British Petroleum (BP) and Transocean (RIG). Then came word that Halliburton had admitted destroying evidence in association with the Deepwater disaster, so obviously, in return shares went about 4% higher. WHat else would anyone have expected?

With that eliminated for now, as I prefer shares in the $43-44 range, I also eliminated British Petroleum which announces earnings this week. That was done mostly because I already have two lots of shares. But Transocean, which reports earnings the following week has had some very recent price weakness and is beginning to look like it’s at an appropriate price to add shares, at a time that Halliburton’s good share price fortunes didn’t extend to its evil partners.

Pfizer (PFE) offers another example of situations I don’t particularly care for. That is the juxtaposition of earnings and ex-dividend date on the same or consecutive days. In the past, it’s precluded me from considering Men’s Warehouse (MW) and just last week Tyco (TYC). However, in this situation, I don’t have some of the concerns about share price being dramatically adversely influenced by earnings. Additionally, with the ex-dividend date coming the day after earnings, the more cautious investor can wait, particularly if anticipating a price drop. Pfizer’s pipeline is deep and its recent spin-off of its Zoetis (ZTS) division will reap benefits in the form of a de-facto massive share buyback.

My JC Penney (JCP) shares were assigned this past week, but as it clings to the $16 level it continues to offer an attractive premium for the perceived risk. In this case, earnings are reported August 16, 2013 and I believe that there will be significant upside surprise. Late on Friday afternoon came news that David Einhorn closed his JC Penney short position and that news sent shares higher, but still not too high to consider for a long position in advance of earnings.

Another consistently on my radar screen, but certainly requiring a great tolerance for risk is Abercrombie and Fitch (ANF). It was relatively stable this past week and it would have been a good time to have purchased shares and covered the position as done the previous week. While I always like to consider doing so, I would like to see some price deterioration prior to purchasing the next round of shares, especially as earning’s release looms in just two weeks.

Sticking to the fashion retail theme, L Brands (LTD) may be a new corporate name, but it retains all of the consistency that has been its hallmark for so long. It’s share price has been going higher of late, diminishing some of the appeal, but any small correction in advance of earnings coming during the current option cycle would put it back on my purchase list, particularly if approaching $52.50, but especially $50. Unfortunately, the path that the market has been taking has made those kind of retracements relatively uncommon.

In advance of earnings I sold Dow Chemical (DOW) puts last week. I was a little surprised that it didn’t go up as much as it’s cousin DuPont (DD), but finishing the week anywhere above $34 would have been a victory. Now, with earnings out of the way, it may simply be time to take ownership of shares. A good dividend, good option premiums and a fairly tight trading range have caused it to consistently be on my radar screen and a frequent purchase decision. It has been a great example of how a stock needn’t move very much in order to derive outsized profits.

MetLife (MET) is another of a long list of companies reporting earnings this week, but the options market isn’t anticipating a substantive move in either direction. Although it is near its 52 week high, which is always a precarious place to be, especially before earnings, while it may not lead entire markets higher, it certainly can follow them.

Finally, it’s Riverbed Technology (RVBD) time again. While I do already own shares and have done so very consistently for years, it soon reports earnings. Shares are currently trading at a near term high, although there is room to the upside. Riverbed Technology has had great leadership and employed a very rational strategy for expansion. For some reason they seem to have a hard time communicating that message, especially when giving their guidance in post-earnings conference calls. I very often expect significant price drops even though they have been very consistent in living up to analyst’s expectations. With shares at a near term high there is certainly room for a drop ahead if they play true to form. I’m very comfortable with ownership in the $15-16 range and may consider selling puts, perhaps even for a forward month.

Traditional Stocks: Deere, Dow Chemical, L Brands, MetLife, Transocean

Momentum Stocks: Abercrombie and Fitch, JC Penney

Double Dip Dividend: Pfizer (ex-div 7/31)

Premiums Enhanced by Earnings: Green Mountain Coffee Roasters (8/7 PM), Riverbed Technology (7/30 PM)

Remember, these are just guidelines for the coming week. Some of the above selections may be sent to Option to Profit subscribers as actionable Trading Alerts, most often coupling a share purchase with call option sales or the sale of covered put contracts. Alerts are sent in adjustment to and consideration of market movements, in an attempt to create a healthy income stream for the week with reduction of trading risk.

 

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A Final Thought About the Pfizer Tender Offer

In the weeks since Pfizer’s (PFE) announcement that it was offering the remainder of its 400+ million holding in Zoetis (ZTS) in exchange for Pfizer shares many opinions have been offered regarding the relative merits of the tender offer.

My own opinion, previously cast some skepticism regarding what appeared to be a very favorable offer that might provide as much as a 7.52% premium for individuals offering their shares of Pfizer in exchange for Zoetis shares.

I did not offer my shares for tender, with the deadline for having done so, passing on Monday, June 17, 2013.

However, Pfizer has announced that its tender offer for exchange of its shares for Zoetis shares has been over-subscribed and that the offer has been automatically extended, as provided by the terms of the tender offer.

“The final exchange ratio is 0.9898 because the upper limit is in effect. Accordingly, the exchange offer has been automatically extended by its terms until 12:00 midnight, New York City time, on June 21, 2013”

That simple phrase means one very important thing for those that had believed a quick pay day by selling their new shares of Zoetis..

As explained in the prospectus, plainly in sight on the cover page, although the exchange premium was 7.52%, it was subject to an “upper limit” of 0.9898 shares of Zoetis for each share of Pfizer exchanged. The prospectus warned that the actual amount of in-kind value received could end up being substantially less if the “upper limit” was reached.

And it was.

At the conclusion of the initial phase of the tender offer, more than 800 million shares of Pfizer had been tendered for about 400 million shares of Zoetis.

That means that on a pro-rated basis an individual will have less than half of their tendered Pfizer shares accepted for exchange. The potential impact and costs associated with small share lots was discussed in my previous article that included the impact of transaction administrative fees that could wipe out any potential profit for those seeking to immediately sell shares in order to capitalize on any exchange premium.

While the final exchange rate is known, 0.9898 shares of Zoetis for each share of Pfizer tendered and accepted, it isn’t yet known what the pro-rated figure will be. In other words, what proportion of each 100 shares of Pfizer tendered will be accepted. It will likely be less than the current ratio. The greater the additional number of shares tendered the greater the adverse impact on small share holders.

For those still considering tendering shares, you have until midnight, Friday, June 22, 2013 to do so.

The following may be helpful:

At Zoetis’ current price of $30.19 after the close of trading on Thursday, June 20, 2013, each share of Pfizer that is accepted for tender will be worth $29.88, as compared to the Pfizer actual closing price of $28.64 on Thursday. That represents a 4.32% premium, which is substantially below the initial 7.52% premium.

Since the tender offer was made public Zoetis shares have subsequently fallen more on a percentage basis than have Pfizer shares and the premium has contracted. The Zoetis share price may or may not be maintained at that level when trading begins, so even that reduced premium may or may not be realized for those seeking to sell their new Zoetis shares.

For those that decide to accept the extended offer and had sold June 22, 2013 call options on their shares, you must be certain that your shares were not assigned. Strictly speaking, option contracts that expire at the end of a monthly cycle, do not expire until Saturday, which is after the extended deadline to tender shares.

If you accept the tender offer and your Pfizer shares were subsequently discovered to have been assigned you would still be obligated to deliver Pfizer shares in exchange for Zoetis shares and could do so by purchasing them in the after-market. That has additional risk if the price of Pfizer shares increase while the price of Zoetis shares decrease.

What to do?

Stick with Pfizer. If and when there is a time to own Zoetis shares you can always do so based on its own merits and without a clock ticking away in the background.

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Picking a Winner in the Pfizer-Zoetis Divorce

Strictly speaking, Pfizer’s (PFE) decision to separate from Zoetis (ZTS) is called a spin-off.

It did so initially on February 1, 2013 and there was much excitement about the prospects of being able to invest in the pets and livestock healthcare business, which was being touted as that portion of Pfizer that had the greater growth potential and by inference the greatest likelihood of out-performing the market and certainly out-performing stodgy old Pfizer, itself.

Certainly, if you are able to remember back to the heady days of Pfizer when Viagra was brought to an eager consumer demographic, there isn’t much reason to believe that sort of growth is in Pfizer’s future. From every logical point of view the best way to unlock shareholder value was to unleash hidden gems that were buried inside of a behemoth.

Additionally, if you look at the recent experience of the spin off by Conoco Phillips (COP) of its refiner arm, Phillips 66 (PSX) you might be of the belief that such spin-offs are akin to a license to print money.

By now Pfizer shareholders may have received the offer to exchange shares of Pfizer for Zoetis. With consummation of this offer, the separation of the two entities will be complete.

Pfizer refers to it as an “exchange offer to separate the Zoetis animal health business from Pfizer’s bio-pharmaceutical businesses in a tax-efficient manner, thereby enhancing stockholder value and better positioning Pfizer to focus on its core bio-pharmaceutical business.”I call that a divorce.

In some situations, I suppose that the children of divorce could see themselves as winners, particularly if they are able to leverage their parents against one another, but that sort of thing may be more common in situational comedies than in real life.

Perhaps shareholders of Pfizer see themselves as winners, as well, although, Zoetis shareholders may have a very different view of melding families.

On the surface, the offer looks very attractive. In a nutshell Pfizer shareholders are being given the opportunity to exchange $100 worth of their Pfizer shares for approximately $107.52 of Zoetis shares.

When in a red hot stock market, that kind of exchange is actually more than just appealing. Where else can you get a 7.52% return from one minute to the next?

For me, the decision isn’t quite so straightforward, as I have sold Pfizer calls with an expiration of June 22, 2013, while the deadline to respond to the offer is on June 17, 2013. There is no mechanism in the option market, particularly for contracts that may be exercised to identify those Pfizer shares that have been offered for tender.

There may, in fact, be some liability if, having sold calls and accepted the tender offer, the shares are subsequently assigned as a result of option exercise. That would be potentially onerous, especially if Zoetis shares were to go on a run higher, but I’m not overly concerned about that occurring.

But forget about me and my problems, or the problems of an option buyer. For the ordinary buy and hold investor the decision should be a fairly easy one to make.

Right?

Well not so fast.

For starters, the likelihood of being able to exchange all of your shares is small. There are over 7 billion shares of Pfizer and only about 400 million shares of Zoetis being offered. That’s good enough reason to inform shareholders that the exchange may be made on a pro-rata basis. Unlike a Facebook (FB) IPO offering you’re not likely to get more shares than you imagined.

Incidentally, about 75% of Pfizer’s shares are institutionally owned. The greatest likelihood is that those holdings are in excess of 100 shares per institution, but more on that later.

Assuming that everyone in the world salivates at the prospect of that 7.52% premium and the ability to cash in by selling shares of Zoetis, there are a number of considerations before counting your profits.

Among those considerations is that institutions, which currently only own approximately 18% of Zoetis shares, would be more facile in being able to unload shares quickly, as they are freely transferable upon exchange. That 7.52% premium may not be destined to withstand a lack of buyers, even if some discipline existed and there was an attempt to create orderly selling.

With the differential in the number of shares between the two companies, assuming that all shares were tendered, each shareholder would receive an allocation of about 6% of their request.

Before you get exposed to too much math, you should also know that there is a $30 fee to exchange shares. As with all investing transactions, there is an economy achieved in volume, especially when there’s a fixed price involved.

In the event that someone holds 100 shares of Pfizer, approximately 6 of those would be eligible for exchange, based on the assumption that all outstanding Pfizer shares would be offered for tender. The final number of shares of Zoetis received in exchange for Pfizer shares will be based upon an exchange rate as determined by the 3 day weighted closing price as announced on June 19, 2013, or after, if the deadline is extended by Pfizer.

For illustrative purposes, let’s assume the final Pfizer share price was $29. That would entitle the shareholder to $31.18 worth of Zoetis shares.

Your 6 share allocation would mean a profit on the exchange of $13.08, less the $30 transaction fee, leaving you with a loss of nearly $17.

That is an example of snatching defeat from the jaws of victory.

Of course if less than all shares are tendered the 100 share stock owner would fare better. If only 3 billion shares are offered for exchange he would break even.

Or would he?

The next part of the equation is what happens to Zoetis. At the moment the float is approximately 500 million shares, which will increase from one moment to the next to 900 million shares.

Then comes the real fun as there will certainly be those looking to quickly capitalize on that 7.52% differential before the opportunity disappears.

One can only imagine that would put some downward pressure on share price, which incidentally hasn’t fared terribly well since the initial spin-off.

Zoetis became a publicly traded company in a successful IPO, having been priced above expectations and closing up 19% on its first day of trading, from an IPO price of $26. Unlike Phillips 66, however, it hasn’t left its parent in the dust.

In fact, despite an early positive showing, Zoetis has lagged Pfizer in its performance, while both have trailed the S&P 500.

As with many stocks that hold the promise of growth, Zoetis doesn’t offer a terribly appealing dividend, although that could change as it has already been increased for Phillips 66. Currently the Zoetis yield is 0.8%. Compare that to the stodgy Pfizer that is yielding 3.4%

Ultimately. in terms of the offer itself, the fewer that express an interest, the far better the offer would likely be as allocations would be increased and pricing pressure on Zoetis would be decreased.

A classic battle of greed versus common sense.

As an inveterate option seller, I have an additional consideration. Zoetis does offer option contracts, but unlike Pfizer it does not offer weekly contracts, nor does it have a multitude of unit denominated strike prices, making the prospects of holding shares less attractive for me.

With a bit more than two weeks until a decision is required my initial reaction to the offer has undergone quite a transformation, but I’ll still end up following the numbers and determining whether some additional return can be squeezed out of the transaction owing to the size of my Pfizer position

While I now anticipate the possibility of continuing to hold onto my Pfizer shares, I do hope that perhaps someone who hasn’t given the subject too much thought may end up exercising their $29 option early, at a price below the strike, as they may perceive Pfizer priced at anything greater than $27 to be the equivalent of Zoetis priced at $29 and hope to make a killing in what they believe to be an arbitrage opportunity.

Maybe divorce isn’t that bad? At least if you don’t think about it too much.

 

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