A Unique Arbitrage Situation + Results From Options Strategy (3rd Month)
June was a really tough month work wise, so updates have been few in between. I’ve only just realized how busy I was, when my lunch buddy noted that I’ve only had 2 weekday lunches the entire month, and had to work through all the other lunches.
Anyway, busy is good. I love busy. Time passes quickly when one is busy.
Speaking of which, I’ve also been busy on the options front. Busy fighting fires that is.
Over the past month, Valeant’s share price shot up rapidly.
Unfortunately, I sold a bunch of call options just prior to the rapid increase, and those got exercised. The good news part is that I took quick remedy actions, and sold several put options, and since the share price has continued rising unabated, all of the options have expired or are expiring, while I’m keeping the fat premiums (Fat because the volatility has been just cazy here!)
As a continuation of previous results (Geo Vs GEAR! + Options Update), here’s the most recent month’s activities:
Total cashflow received from 16/06/2017 – 14/07/2017: US$13,404.41
wow. I never expected it to be so consistent thus far. It’s curious, because every contract is different, with different premiums and stuff. Yet on a monthly basis, the total CFs attained has been rather consistent:
Total cashflow received from 12/04/2017 – 12/05/2017: US$13,657.25
Total cashflow received from 13/05/2017 – 13/06/2017: US$13,911.82
Total cashflow received from 16/06/2017 – 14/07/2017: US$13,404.41
Anyway, what’s significant in the past month, is divestments in my positions in WFC and EWZ.
Both positions were built up in prior months mostly via the exercising of sold put options, and partially by direct purchases. I would classify both as deep value, opportunistic purchases.
The WFC stake was bought after the WFC accounts scandal, which claimed its CEO John Stumpf’s job. Having had prior experience with WFC, I was fairly comfortable building up a sizable stake in the midst of all the controversy. Anyway, I’d be happy selling options on both sides, both puts and calls. As it turned out, the share price has recovered much faster than I expected.
EWZ was also bought on the back of the Brazilian political scandal. I sought an ETF in this case, as I didn’t have the time to analyze any specific Brazilian company. In any case, I figured that’d be the safest. Since then, the share price has rallied somewhat, and I’ve pocketed both the premiums, as well as the capital appreciation.
I’d add that the total divestment gains of approximately $6.8k USD are NOT part of the CFs tabulation above. The CFs specifically only includes nett premiums from options activities.
The total CFs received is still a tad below that of last month’s, but I’m definitely pleased.
What’s important is a repeatable, successful process. As long as it’s fairly repeatable, I can see how it’d work out to be very favorable in the long run. It’d also give me confidence to increase my allocation.
I’ve also been building up positions in an arbitrage situation:
CenturyLink’s acquisition of Level 3 Communications.
Some background here: CenturyLink is a telecommunications company in the US, probably similar to Singtel. It is the 3rd largest in the US, behind AT&T as well as Verizon.
CenturyLink has a presence throughout US, but is strongest in the west coast, as well as the states in the middle. It also operates data centres in Europe and Asia Pacific markets.
Late last year, CenturyLink announced their intention to acquire Level 3 Communications. Well, although it’s an acquisition, in essence, it’s actually a merger of sorts, since equity of CenturyLink will feature in the purchase of Level 3.
Recently, the acquisition has achieved approval from all remaining states, so the deal is definitely going through.
There are 2 major, clear benefits to this merger:
- Synergies. The 2 companies clearly are quite different and have complementary businesses. Level 3 has an extensive fibre network that’s currently underutilized. CenturyLink on the other hand, would suddenly have access to an additional 200,000 miles of fibre optic networks, and can cross sell services to their much larger customer base, with better connectivity and better access. Level 3 Communications also have a much larger global presence that CenturyLink can tap upon. Particularly so in Latin America and EMEA.
- Tax! Having spent the cash in prior years to build the extensive network, Level 3 Communications have a gigantic amount of tax losses that the combined enterprise can utilize to offset future taxes. How significant is this tax benefit? Very significant apparantly! Level 3 has nearly $10bil worth of net operating losses in it’s books, waiting to be utilized to offset future taxes. To put things in perspective, CenturyLink’s net operating income in the 3 years prior are between $2.3bil to $2.6bil
This also means that post-merger, the future CFs for the company will be significantly increased (since they have tax credits for the next few years) The company has already indicated that they’d use less than $2bil worth of operating losses as tax credits, so the combined entity will likely pay next to nothing on taxes for the next 5 years.
Seeing that the tax expense for 2016 was $394mil… this means that the company will have at least $400mil extra cold hard cash than prior years, since it wouldn’t have to pay this amount as taxes.
So where’s the arbitrage in this?
The deal is fairly complex. (It has to be, otherwise it’d be priced 100% correctly all the time)
CenturyLink will buy Level 3 Communications for $26.50 per share, and give 1.4286 CenturyLink shares for each Level 3 Communications share.
The deal is expected to close fairly soon, before the end of the year.
Now, at the time of writing this, Level 3 Communications share price is now $58.12
CenturyLink’s share price is around $23.
For each Level 3 Communications share, shareholders stand to receive the equivalent of $59.36 worth of “value”
Whereas Level 3’s share price has been fairly constant, CenturyLink’s has fluctuated fairly significantly of late, hence there has been arbitrage opportunities to acquire Level 3 shares at a discount to what the deal would entail.
Of course, it all depends on the ultimate share price of the combined entity.
So, how am I building my long position?
I currently have sold multiple in the money put options on both Level 3 Communications, as well as CenturyLink. These are likely to be exercised. Simultaneously, I have also sold far out of the money call options on all positions that I’ve built, as well as those that would likely be built upon assignment of the put options.
This, IMO, is the best way with the lowest risk and highest chances of success. The premiums I’ve received on both call and put options are significant, and if everything goes as planned, I’d have significantly reduced my purchase price of the combined entity CenturyLink.
As an added sweetener, CenturyLink pays a hefty dividend. The company has already committed to maintaining their dividend of $2.16.
That works out to be a yield of 9.4%!
And since dividends are paid quarterly, technically it’s slightly higher since I can utilize the cash. With my options strategies, time is of an essence. I’ve only allocated a relatively small portion of my portfolio, and yet I’m already seeing the effects of time whilst using such a strategy.
In the long run, this difference may well work out to be worth several tens of thousands of dollars every month!
Now, seeing that CenturyLink’s CF will not only be maintained, but IMPROVED significantly post-merger, there’s no reason why the dividends cannot be maintained. At 9.4% yield…. I think that’s a significant buffer.
Long time readers of SG TTI would also understand how much emphasis I place on CFs. That is a true barometer of the success of the business in the long run. (In the short run though, earnings is what makes headline news)
I am keeping an eye on the other operating metrics of the company though. As of FY17Q1, financials deteriorated slightly, with earnings coming in at $163mil, vs $236mil for FY16Q1.
Core revenue also dropped, offset only partially by a corresponding drop in operating expenses.
In short, it’s not all rosy, as the operating metrics seem to have gotten weaker.
Post-merger, I’ll be monitoring to see that the management team executes on their state synergistic goals. I’ll probably continue selling call options on my positions, although I haven’t quite decided on the exact strategy i.e. what strike price options do I sell and how close, relative to the share price.
Since the dividends are significant, ex-dates will also play a significant role in determining the premiums of the option contracts.
Alright, that’s it for this post.
As always, good luck hunting!
Filed under: CenturyLink Communications, Companies, General