The tech world is abuzz with rumors that Apple is preparing to make their largest acquisition to date by paying a reported $3.2 billion for Beats by Dr. Dre, a headphone company that has a nascent streaming music service with 512,000 paying subs. Initially, investors took this as a potentially adverse situation for Pandora (P), who has 76 million streaming users, with expected annual revenue of $900 million this year, largely from advertising, but the stock has since gone positive on the day.
To be frank, I am not a fan of most streaming music products (having tried both Pandora, Apple’s iRadio and Spotify) as I find them to be spotty on mobile devices that rely on cellular networks, which is when I would be most apt to use them. That being said, the kids today seem very unlikely to buy music outright, and it seems obvious that Apple is worried about this potential trend against their long standing belief of own vs rent. For years after iTunes launch it was rumored that Apple would or should buy Sirius, Rhapsody or Napster, and most recently Spotify, Pandora or Rdio, which makes the potential Beats acquisition fairly curious given their small scale. Obviously, Beats for the most part is a hardware company selling very expensive headphones that aside from their “cool” factor don’t particularly rate that high (here are customers reviews from Apple.com: http://store.apple.com/us/search/beats#!).
Regardless, whether or not this is an acquisition to get Beats co-founder Jimmy Iovine or for the headphone business or the small streaming service, It’s obviously not a particularly big deal from a financial standpoint for Apple. But I think there are likely to be reverberations in the market, causing Apple competitors to do some silly things.
Pandora is the obvious next derivative trade given their leadership position in the music streaming business. Despite being cut nearly in half since the all time highs in early March, the stock is still not particularly cheap, trading at a price to sales of about 5x. That being said, there are internet based companies with similar market caps like YELP that make Pandora look like WMT compared to AMZN. So, on a relative basis, if you thought there were catalysts or that there should be more of takeover premium for Pandora given the price tag for Beats, one could easily make the case why Amazon, Microsoft, Facebook, or Google to name a few could make a $6-7 billion bid or roughly a 50% premium for the company which would take it back up towards its prior highs.
As regular readers know I think the price action of the last year in many of these web services and social media stocks has been close to a mania, while not reaching nearly the heights of the internet bubble of the late 90s, there have been clear similarities on a smaller scale. We will continue to be defined risk short sellers of most of these names, and we have a few on now (here NFLX & Z), but those that we can identify a secular trend or a catalyst that could outweigh sentiment or valuation we will be sure too look. It is my belief that most of these stocks will overshoot on the downside, just as they have on the upside, and a stock like Pandora, without take-over spec will likely round-trip the entire move since last May.
The one year chart below of Pandora shows the stock pausing at support (yellow line, gap level from last Sept), and a break below would likely mean high teens coming to a theater near you. That being said, if a deal were to happen the stock would likely move back to the mid to high $20s prior, making a mid to high $30s deal possible, back towards the prior highs near $40.
This is all real pie in the sky stuff, which is why I would NOT BUY the STOCK for the reasons I laid out above, but I will decide how much I am willing to lose that this low probability event will happen in the period I am willing target with defined risk.
The set up with Pandora from a long premium perspective isn’t great as the implied vol remains very high despite the recent 27% decline of 30 day at the money IV, as the one year chart below shows it should level out down another 10-15% over the coming weeks.
So as I will be routinely shorting rallies in many of Pandora’s peers, I like the idea of dedicating a specified amount of premium to a bullish trade in Pandora that would benefit from a frenzy of takeover spec. Again I want to look up and out and recognize what may be a low probability of success.
TRADE: P ($22.50) Bought to open Sept 28/35 Call Spread for .95
-Bought Sept 28 Call for 1.45
-Sold Sept 35 Call at .50
Break-Even on Sept Expiration:
Profits: btwn 28.95 and 35 make up to 6.05 with max gain of 6.05 above 35
Losses: btwn 28 and 28.95 lose up to 95 cents, with max loss of .95 below 28
Rationale: Pandora, like most high valuation/high growth stocks has had a big move from its highs, and further movement down is likely dependent on the broad market at these levels. If the broad market plays catch up to the downside, I would expect the round-tripping to take place, but if large caps continue to hold, smaller cap more speculative names will likely put in a short term bottom soon. Playing for a bounce from here and any potential rumors of it becoming an acquisition target should only be done through defined risk structures. This structure plays for that potential while defining risk to $1 in case these momentum stocks have more risk to the downside here.