MorningWord 10/8/12: Free Options Aren’t Always Free in Vol Terms

by Dan October 8, 2012 8:52 am • Commentary

MorningWord 10/8/12:  It was probably hard to miss last week, but wireless telecom m&a is back, not exactly back like the early part of the last decade when Deutsche Telecom paid $50 billion for Voicestream in July 2000 to create what would ultimately be T-Mobile in the U.S., or the $35 billion acquisition announced by Spring for Nextel in Dec 2004.  Last week’s agreed upon reverse merger by Deutsche Telecom for Metro-PCS is a fairly inelegant reworking of DT’s U.S. wireless holdings, but at this point it seems very un-German of them to continue to compete so poorly with AT&T, VZ and even Sprint for that matter.

This morning, Sanford Bernstein analyst Craig Moffett upgraded shares of MetroPCS (PCS) from a Hold to a Buy and raising the price target from $9 to $16 as he feels the stock,

-Shares have settled into a range that suggests deep skepticism about the merger’s ability to deliver planned synergies

-We believe this presents an attractive opportunity. Investors are, in effect, getting two free options. First,there is a free option on a successful merger and the realization of merger synergies. And second, there is the free option that Sprint elects to make a counterbid for MetroPCS”

-We believe the market’s fears that T-Mobile/MetroPCS will be a repeat of the technology integration
morass of Sprint/Nextel reflect a fundamental misunderstanding.

-In fact, there is no technology integration. Instead, there is a very low risk run-off of PCS’s existing
CDMA customer base and a subsequent meshing to two nearly perfectly compatible spectrum portfolios.1

-The probability of successfully achieving synergies appears to us to be significantly higher than is
currently discounted in MetroPCS’s shares.

-The prospect that Sprint might launch a counterbid represents a second “free option.”

-Sprint has repeatedly hinted that a merger with T-Mobile itself was Sprint’s preferred scenario. That now appears off the table. However hard a combination of #3 Sprint and #4 T-Mobile might otherwise have been, a combination after either of the two merges with #5 MetroPCS is all but untenable.

-Sprint, in other words, has few attractive alternatives. They must either bid or stand pat… perhaps permanently.

Basically the analyst is suggesting that at Friday’s close, equity investors are placing a very low probability of a counter-bid by Sprint.  But Options traders see it a very different way, on Friday, Oct and Nov premium was being bought hand over fist, with front month implied volatility up nearly 20 points.


PCS 30 and 60 day atm Implied Vol from Bloomberg

SO when an equity analyst describes a stock as a “free option” it may make sense to take a closer look, especially when the activity in the options market is indicating something altogether different.  As usual, ignore the options market at your own risk.

Added Reading, the NYT Dealbook blog had a what I thought to be a very useful breakdown of the mechanics of the proposed DT/PCS deal here.