On Tuesday, Tesla (TSLA - Free Report) CEO Elon Musk announced plans to take the company private. It started with this mid-day tweet that left the market guessing:
That missive was followed by several more tweets that elaborated somewhat on the possibility of an imminent deal to buyout current shareholders and the choices current shareholders might have if the plan were to come to fruition.
Finally, after trading in the shares was halted due to news pending, an internal email from Musk to Tesla employees was released in which he laid out the reasons why he would seek to take the company private and stated that in the deal he is proposing, current shareholders would have the choice to receive $420/share in cash to tender their shares or could choose to remain stakeholders in the resulting private entity through a separate trust structure.
When trading resumed, the shares continued the day's rally, finishing up 11% - just shy of $380/share.
Many details remain unknown – most notably, the source of the funding that Musk claims to have “secured.” If the deal involves debt financing, it would be the biggest leveredged buyout in history with a total value of between $70 and $80 billion.
While the investing community speculates on whether and how a buyout might occur, the options markets can give us some information about how traders are pricing the probability that it will actually happen.
If the deal were actually to be executed the way Musk laid out - which would require a shareholder vote - shares of Tesla would trade higher, eventually converging on $420/share on the date of the official tender. If you knew with certainty that this was going to occur, you could sell any call option at or above the 420 strike, safe in the knowledge that the shares couldn’t be higher than that at expiration and that you’d keep the entire premium. You could also buy any call below that strike for less than the difference between the strike and the deal price and be assured a profit.
This is basically the same thing that occurs when one company acquires another for cash. Once the deal is announced, calls on the company being acquired that have a strike price above the acquisition price go progressively toward zero. Any residual value on those calls is due to market uncertainty about the deal happening, or the possibility of a higher competing bid. In-the-money calls go to parity with the deal price and again, any premium represents uncertainty.
So what do current options prices tell us about the probability of the Tesla buyout happening? The markets seem to think it’s a little less than 50/50.
Tesla is currently trading just above $370/share. Let’s look at the price of options that expire in January of 2019 and January of 2020.
(Because details on the Tesla deal remain sparse, including with regard to timing, let’s consider another instance in which a large public company was taken private – the $25B buyout of Dell computer by founder Michael Dell with significant financing from Silver Lake Partners. From the time the deal was announced until it closed was about 8 months – from February until November of 2013. Dell also had to contend with the objections of billionaire activist investor Carl Icahn, which slowed his progress. Assuming that Musk does in fact have financing already locked down and doesn't encounter shareholder resistance, it’s conceivable he could complete the deal faster than that, so we’ll look at options that expire in both 5 months and 17 months.)
If the deal was certain to occur at exactly $420/share, the value of the 370-420 vertical call spread would be exactly $50 on the day of the deal – the 370 call would be worth $50 and the 420 call would be worth zero.
Currently the markets for those options is:
Jan19 370 call 38.00 39.80
Jan19 420 call 15.40 16.40
Jan20 370 call 62.00 67.00
Jan20 420 call 39.00 43.00
Because those markets are so wide, we’ll use the midpoint of the bid/ask as a proxy for what the market considers “fair value” for the options.
The fair value of the Jan 19 370-420 call spread is $23. This suggests a 46% probability that the deal will occur at $420 or higher.
The fair value of the Jan 20 370-420 call spread is also $23, suggesting the same probability.
The market is basically calling it a little bit less likely than “heads” on a coin flip.
So much about the proposed deal is uncertain that I wouldn’t recommend buying or selling either of these spreads, but if you watch how these prices change over the next weeks and months as more details emerge, you can get an idea of what the markets are predicting about the chances the buyout will happen.