Telus: Which Side Of This Arbitrage Trade Should You Be On?

A quick summary of what is going on at Telus (TU):

1. There are two classes of shares, one non-voting class (TU traded on the NYSE) and one voting class (T.TO traded on the Toronto Stock Exchange). They exist because of foreign ownership restrictions.

2. The voting shares have traditionally traded at a 5% premium to the non-voting shares.

3. Telus management announced a vote to collapse the voting and non-voting shares together into one class, with a one for one conversion of non-voting to voting. This exchange requires 2/3s of both classes to vote positively to be passed. The vote will be settled in a shareholder meeting on May 9th and can be voted on online until May 7th. (If you bought stock now, you can't vote because the record date was April 3rd, and only people possessing stock then could vote.)

4. Initially, the spread* between the two shares collapsed as arbitrageurs bought the non-voting shares and shorted the voting shares in order to profit when they were exchanged one for one.

(The spread is the difference in value between the two shares, in this case, it was originally 5%.)

The story gets more interesting as...

5. Another band of arbitrageurs, most prominent of which Mason Capital, started making the exact opposite trade, betting the spread will reestablish itself. Mason Capital disclosed ownership of 18.7% of the voting class, already enough to block the vote himself if less than 56% of the class participates. Other arbitrageurs seemed to have joined him as well, and last month Telus had to file this report that shows that foreign pending purchases of T.TO combined with current ownership of T.TO might exceed the 33.3% limited.

6. Both Mason and Telus Management began lobbying for their side of the vote.

The two sides of the argument are:

Pro-exchange: Listing on NYSE of voting shares, increased liquidity, larger share pool, and removal of the complicated structure that brings uncertainty to investors.

Pro-exchange advocates also claim that Mason is "empty-voting" because although he owns 18.7% of the voting class, the position is offset by about an equal value short of the non-voting class.

Anti-exchange: Mason's argument is that the market has historically placed a premium on the voting shares because of the extra security and influence commanded by these shares. By effecting a one for one exchange, voting shareholders are treated unfairly, and a premium of 4-5% should be given to the voting shares in the exchange.

So the most recent events in this story are that the influential independent proxy organization Institutional Shareholder Services has confirmed its recommendation that shareholders should vote for the 1 for 1 exchange. They mainly cite the increase in the value of both classes of shares since the exchange has been announced - which they say would be lost if the exchange is shot down.

Glass Lewis has also just reaffirmed a pro-exchange opinion against Mason.

However, the odds are in Mason's favor.

This vote is structured in such a way that each group of arbitrageurs get to vote in one class of the stock. Arbitrageurs who want the spread to collapse are long the non-voting and short the voting - i.e.. there is little doubt they will win the non-voting 2/3rds super-majority. None of these pro-exchange arbitrageurs gets to vote in the voting class vote as they have to be net short to profit from the spread collapsing.

Anti-exchange Arbitrageurs who want the spread to reinstate are long the voting and short the non-voting. They only need 1/3rd of the voting shares of which they are long to block the entire thing (assuming 100% participation, which is unlikely, so less than 1/3rd are needed as non-participating shares are excluded from the total), and Mason alone controls 18.7% of the vote. Despite all this talk of "empty voting," there is no injunction being sought on his right to vote.

In fact, each arbitrageur camp enables the other side to acquire more shares of their respective classes. By borrowing shares to sell, arbitrageurs make a large supply of shares available to be bought by the other side. It is likely that both arbitrageur camps churned the shares so that many voting shares are held by anti-exchange arbitrageur camp right now.

Since both classes have to have a super-majority supporting the 1 for 1 conversion to happen, the game is rigged for the anti-exchange arbitrageurs lead by Mason. Mason Capital is the only publicly announced one, but there are likely other smaller players contributing to his voting bloc.

Telus does has cards up its sleeve, though. Remember this report that foreign ownership might exceed 33.3%? It seems Telus was using this restriction to prevent certain foreigners (Mason-like foreigners?) from acquiring voting shares before the record date. However, Canadian investors would not have this limitation.

Telus is also offering a 10 cent "dealer solicitation fee" to any shares who vote for the exchange.

Also, Telus management and Board own a large portion of voting and non-voting stock (mostly non-voting stock, hence their incentive for the 1 for 1 exchange). They will be the large block voting for the exchange in the voting class.

Despite this, Telus management is fighting an uphill battle. If foreign arbitrageurs acquired even 25% of the vote, then Telus would have to rally up a voter participation of at least 75% and all of the non-arbitrageurs would have to vote for the exchange. This is assuming there were no Canadian arbitrageurs - who would also block the vote.

How can you profit from this?

TU is currently trading at 58.82 USD, T.TO at 60.1144 USD (converted from 58.96 CAD). This is a spread of ~2.2% If the exchange happens, this spread will collapse. If the exchange is blocked, the spread will increase to 4-5%.

Now say you go long the voting class and short the non-voting class. Since you have offsetting positions, you don't really care where the stock prices go, just what happens to the spread.

Say you buy 100K long voting and 100K short non-voting. The maximum you can lose is 2.2% * 100K = $2,200 if the spread collapses. If the spread increases back to 4 to 5%, you stand to gain around 2.5% * 100K = $2,500.

Here is a summary of the hypothetical trade:

(click to enlarge)

IMPORTANT NOTE: This chart does not include transaction costs, see chart below in next section as well.

So basically it's a 1 for 1 payoff. The amount of capital you are putting at risk is about equal to the amount that you can receive. The 10K isn't what you are putting at risk, but you will need this amount to do this trade (which you can achieve using leverage or not).

However, since this is a 1 for 1 payoff, the odds should be 50%. I cite the reasons I mentioned earlier for the odds favoring Mason's side of the trade. Therefore, the expected value on this trade would be positive.

However, only people with low transaction costs can effectively do this trade.

For this trade to make economic sense, an investor would need:

1. Cheap conversion between Canadian dollars and USD (or already have both currencies in your brokerage)

2. The ability to leverage up effectively

Both of these killed me. (2) is not such a big deal, because even without leverage a 2% return on capital tied up for a week (result occurs on May 9) is a greater than a 100% annualized return on capital, but (1) made it impossible for me to make this trade. My conversion from US to CAD and back to US costs 3% of the amount I'm converting, which is greater than the 2% gain I would get if the trade went my way.

It is important to note that the transaction costs are key in this trade. Every .1% paid on commission or conversion reduces the pay off to be less than 1 for 1 pay-off.

There is still a chance the trade will go against the investor and the spread collapses. The smaller the payoff, the lower the expected value of the trade. Anything better than a 1 to 2 pay-off is worth it in my mind (translates to 66% chance Mason prevails, 33% chance Telus prevails), and you'll have to do the math based on your personal transaction costs.

Transaction costs will include your interest paid for trading on margin, foreign exchange commission, and trading commission. Here is the earlier table assuming you personally have a 1% transaction cost (which is $1000 of the hypothetical $100,000).

(click to enlarge)

As with any investment advice, there are risks involved. This analysis is based on publicly available information and my interpretation of this information.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in TU over the next 72 hours, paired with a long position in T.TO, if I can find a way to get around my transaction costs.