7/17/14

Quick thought piece to the few followers who own LO with me. This is a short term arbitrage play (3-4 week trade) that I wouldn't recommend unless you currently own the stock, given its speculative nature.

LO Sept 20 $60 Call ($1.50)

The Reynolds American (RAI) and Lorillard (LO) merger was announced two days ago. Following the release, RAI fell 6.9% and LO fell 10.5%. This unusual drop resulted from expectations of a higher purchase price

and LO divesting one of its crown jewels, Blu e-cigs. The market likely overreacted in this case. If the merger

goes through, LO shareholders will receive $67.42 based on 7/16 closing prices. RAI would have to fall to $33

to breakeven based on today's prices, given the $50.5 cash floor.

The other scenario is the merger is not approved. This could result in a number of outcomes. It could potentially stay in its current range since it would retain the Blu line. More likely, it would fall towards the mid 50's where it would be without the merger rumors. Probability  50%         Scenario #1 - Merger in current form ($67.42)                              RAI offer:                  Closing Price (7/16)      Proceeds / Share                  Cash: $50.5                 RAI: 58.14                     Cash:  $50.5                  Stock: .291 / Share      LO: 60.06                      Stock: $16.92                                                                                                      $67.42 50%         Scenario #2 - Merger does not advance. Assuming midpoint of base case ($58) & low case ($55). Expected Return: (50%*67.42) + (50%*$56.5) = $61.96 With the assumptions above, our expected return would yield an arbitrage opportunity of almost $2. While this helps our conviction, the main case for the trade in my opinion is the natural "drift" that acquisition candidates typically have during the quiet period of closing the deal and gaining regulatory approval. With little news, LO should drift towards the buyout price. Assuming a 60 day close, the Sep 20 $60 calls are probably the best way to play this. If LO pops up to $63 in a few weeks, that should yield a nice return and exit opportunity without the risk of waiting. Also, if RAI modifies the deal and offers to divest Camel, the merger approval rate would increase substantially and help our trade in the process.

7/11/14 Picks

Back with a quick pick today. Hopefully everyone got in on the last two picks. LULU is up 7% and OUTR is down 23% (July puts up 573%).

The pick today is a highly unprofitable internet-related company that took advantage of frothy IPO markets to go public. It feels like the year 2000 all over again with flawed internet businesses and their owners cashing in on exuberant markets.

Short CHGG ($6.5)

• Chegg is a website focused on college students which offers textbook rentals, tutoring support, and other ancillary services.
• Chegg went public in November at $11 and has since been nearly cut in half. In the process, they have also burned through much of the cash raised via the offering. 
• Flawed Business Model: 80% of the company's revenue comes from textbook rentals. This was a great business idea in the past, competing against college bookstores, but since 2012, they go head to head against Amazon (#1 online retailer), Half.com (Ebay), and Staples (#2 online retailer). Amazon has a history of aggressively cutting prices to gain market share, which they began doing this summer. Books are a commodity product, budget-conscious students are going to search google for their title and choose the lowest price. Amazon's resources assure their title will pop up first, their pricing will be the lowest, and their shipping times will be minimal (35 distribution centers vs. 1 for CHGG). 
• Unprofitability: The company has averaged a 22% net loss in each of the past three years. In 2013, they posted revenue of $255 MM with losses of $56 MM. The more they grow, which they are doing at a progressively slower pace, the larger the losses grow.
• Industry Headwinds: College enrollment has shrunk the past two years. Less unemployment and higher wages, coupled with student debt regulations equates to less students. This trend will likely continue.
• Cash Burn: At the their current cash burn rate, they will need additional capital soon. Any follow-on equity raises will dilute the stock and debt will be expensive and covenant-heavy. This problem becomes exacerbated considering the capital intensive nature of CHGG's business: they own each book. Cash is essential to their business model and one season of poor planning would be painful, if not catastrophic.
• Expectations: Analysts expect CHGG to miraculously buck their current trend and become profitable by next year. With those expectations baked into the price, there is significant value betting on their current spiral to continue. 
• Conclusion: The current IPO lockup has expired. The CTO sold 25% of his shares a few weeks ago and I would bet more executives will follow. The IPO will allow for them to cash in their chips while they still have value. The textbook environment has transformed in the past two two years and I see this David (Chegg) vs. Goliath (Amazon, Ebay, Staples) matchup ending differently than the traditional story.
• If you can't short, OCT 7.5 puts are an alternative.