MorningWord 5/17/16: Have to $P ?

by Dan May 17, 2016 10:00 am • Commentary

It sure seems like activist investing only works during a roaring bull market. Just a few years back, the announcement that a multi-billion dollar hedge fund took a stake, pushed for board seats, increased capital return, explored m&a or strategic alternatives was a sure fire way to at least halt a stock’s decline, if not reverse the stock’s fortunes. But over the last year and and half this strategy has gone very wrong in some high profile names like Valeant (VRX), Qualcomm (QCOM) and Yum Brands (YUM).  There have been plenty of scenarios that have worked out, but they might have occurred anyway. For instance, Family Doillar’s (FDO) sale to Dollar Tree (DLTR), in which Carl Icahn took a stake, urging m&a in the target before the deal. And of course there’s Herbalife (HLF), where an activist investor has lost big from the short side.

Of course a lot of this is anecdotal. There are plenty of examples on both sides of this argument. But my point is it’s alot easier to play follow the leader with famous activists when risk assets as a whole have an underlying bid to them. In that case having a loud mouth billionaire, or a savvy activist fund publicly put pressure on a management or a board is like pouring gasoline on a campfire.

The problem now for these activists (or those investors that would follow)is that we are no longer in a roaring bull market.  The 18 month chart (below) of the S&P 500 (SPX) shows the largest equity index in the world in just about the same spot now as it was back in November 2014. That suggests that at the very least, the path of least resistance is no longer higher. And the inability for the SPX to make new highs on two occasions since early November suggests to me that downward volatility shocks will continue until the SPX finally establishes a new range above the 2050 – 2134 range (shaded). Until then, buckle up:

SPX 18 month chart from Bloomberg
SPX 18 month chart from Bloomberg

This all informs my view when I see headlines like this from Bloomberg last night regarding online streaming music company Pandora (P):


I find it hard to believe that any company looking to be a player in streaming music has not already taken a look at Pandora over the years. The urging by a shareholder for the company to engage advisers to solicit bids is not exactly going to cause a bidding war. When Apple bought Beats nearly 2 years ago they probably took a peak at Pandora. I suspect Google and Amazon have also done so as they have continued to build out their Play and Prime offerings (respectively).  Would Pandora be a cheap asset with a mere $2.2 billion enterprise value, just 1.6x expected 2016 sales and nearly 80 million monthly active listeners? Sure. But if history is any guide, these behemoths prefer to build vs buy when it comes such services, remember Napster and Real Network’s Rhapsody. Then there is Microsoft (MSFT). Whoops. Remember Zune, Facebook, Netflix, Samsung, Sony etc etc.?

If Pandora couldn’t get a deal done in the Go Go times of the past few years, when the company was still growing their audience, I’d be surprised to see a deal now for any meaningful premium.

If you think Pandora is a cheap asset, then buy the stock. Don’t buy the stock because some hedge fund who owns $200 million worth thinks the company should put up a for sale sign. It’s not that I don’t agree with Corvex. But remember that for the firm to truly be activist, they would be encouraging and working with management and the board in the background. And while there have been recent reports that the company is exploring a sale, it appears they were at an impasse when Corvex went public with their thoughts.

Without an actual deal I don’t think Pandora can move on just the announcement of activism. But for those that think the company is valuable here and exploring a deal could lead to, you know, an actual deal, I’d consider bullish risk reversals looking out to Jan17 expiration. With the stock around $10.50, you can sell the Jan17 $8 put at about $1 and use the proceeds to buy the Jan17 14 call for about $1.  With this sort of trade structure I have defined a fairly wide range on Jan17 expiration where I have no gain or loss, the worst case is that I am put the stock at $8 down 24%, and have long exposure at $14, up 33%.  The main goal here for this medium conviction play is that offers leverage to a sharp move higher while not necessarily betting much on small moves lower or higher during that period.