By: Steve Smith
Legendary investor Mario Gabelli often describes Merger & Acquisition activity as a form of corporate “lovemaking” in which the union of two produces the value of three or more whether it be through cost cutting, synergies or simply gain of market share.
And if even if companies are not feeling particularly amorous they will continue to be compelled into forced marriages as the cheap money combined with the lack of global demand has corporations turning to mergers and acquisitions activity to drive top line growth.
Last week I discussed the dynamics driving this urge to merge. This week I want to look at an options strategy that lets you reap the rewards of a speculative bet without incurring much risk.
The recent spate of the M&A activity covers all industries, from energy, to tech to healthcare to media and entertainment. Yesterday’s deal in which Expedia (EXPE) purchased Homeaway (AWAY) for a handsome 20% premium as just the latest example. Each deal comes various specifics from the form of payment cash/stock, the premium offered, to regulatory hurdles that can impact the time frame to closing. Trying to capitalize on a broad trend of M&A by simply buying call options is basically throwing darts. You may hit a bull’s eye but unless you are an expert, or have some special knowledge, it will usually take a lot of throws. Let’s look how options can be used to take a more conservative approach to capturing value if a merger does occur and minimize the losses if it doesn’t.
This options strategy will let you speculate on takeovers while minimizing the risk.
Selling the Calendar Spread
The approach I’m taking is an atypical use of a calendar, or time spread. Some quick definitions:
-A calendar spread consists of buying and selling calls (or puts) with different expiration dates.
-If the near term option is sold and the longer dated purchased, usually for a debit, this is considered being long the spread. It is mostly employed on the expectation of a gradual move higher or lower in stock price. The notion being that the sale of the near term option helps finances the cost of the longer dated option.
– A diagonal calendar spread refers to using two different strike prices to gain a more directional bias. Typically this would involve buying a longer dated closer to the money options and selling the near term further out of the money option. This approach cost money or is done for a debit and its profitability is dependent on clearing that cost basis.
For a potential takeover play we are going to turn these typical approaches on their head. That is; buy a lower strike call and sell a longer dated higher strike call. This strategy will be done for a credit and will profit if a takeover is reached regardless of the price.
The reasoning is that once a deal is announced and agreed upon all options will approach their intrinsic value. The concept is that once a deal occurs all options across all expirations will drop in implied volatility essentially losing their time premium, and be valued at intrinsic value.
Meaning the time premium of the longer dated calls will evaporate given the upside potential of the stock has been eliminated. Let’s look at an example that will allow us to focus on the numbers and reasoning for using such an approach.
Pandora in Play
Pandora (P), the streaming music company, hit a very sour note following its third quarter earnings report on October 22 as shares sank over 30% in a single day and are now down some 45% for the year.
The actual numbers weren’t too bad as total revenue came in at $311.6 million, a 30% year-over-year increase. Advertising income grew 31% to $254.7 million and subscription fees increased 25% to but remains at a paltry $56.9 million.
The big concern was total listening hours grew by only 2% year-over-year increase and experienced a 1.6% sequential decline. Given Pandora is dependent on ad revenue the decline is hours was disconcerting and highlighted the challenge posed from deep pocketed competitors such as Apple, which had launched its Apple Play in June with its three-month free trial, as well as significant category spending and trial offers across multiple players which probably grabbed listener market share. It seems subscription based models such as Spotify and SiriusXM are becoming more attractive to consumers that are willing to pay to listen to what they want when they want.
But given Pandora’s sizable 75 million registered users and now diminished $2.5 billion market cap I think it makes an attractive take-over candidate. If not by Apple, which spent $3 billion to buy Beats which had just 20 million users, then one of the other big internet/media companies such as Google (GOOGL) which is looking to ramp up its YouTube division with more channels and different levels of advertising and subscription packages. Amazon Facebook and Netflix are also potential purchasers. Any of these companies, which have multiple revenue streams and deep reach could easily absorb Pandora use their broader platform to help it scale to the next level.
In fact if Pandora doesn’t get taken over, or at least rumored to, think shares could continue to fall by another 20%-30% over the next six months.
With this in mind I’m implementing the above described calendar spread strategy that would profit handsomely if the company gets a bid but would still break even if the stock continues to tumble. The specifics are:
-Buy March $14 Calls
-Sell January 2017 $18 Calls
For a $0.50 Net Credit
This is what the order and risk graph looks like:
As you can see by the narrow line profit would be realized I shares move above $14 prior to the March 2016 expiration. What it doesn’t show is that if the price move came due to a takeover bid which would collapse the value of the short January LEAP $18 calls as the time premium would be removed. Again, this would be the result of once a firm takeover deal is announced there would be no additional potential upside.
In such a scenario if shares climbed above $18 the value of the spread would approach the intrinsic value of $4; meaning the profit would be $4.50 as we initially collected $0.50 of net credit premium. Based on the initial margin requirement that would translate into a 400% return.
On the other hand if no deal comes I think shares would come under continued pressure and in this case that $0.50 of premium we collected would go to offset any potential losses as the of the decline in value of the March calls.
The worst scenario would be if share price merely meandered between $11 and $14 leading into the March expiration. For this reason I would exit the position by the end of February no matter what.
By selling a diagonal calendar spread for a credit one can take advantage of a takeover or merger without having to predict the exact price or timing.