Shanda: Mispricing Persists

As mentioned in my previous post on this topic, using the "Sum of the Part" method, we should arrive at $63 per ADR for Shanda Interactive (SNDA) based on the current price of Shanda Games (GAME), a newly carved-out company. If the market is perfectly efficient, the SNDA price should be positively correlated to the GAME price with SNDA having 67% of the volatility of GAME, knowing that the share value of GAME held by SNDA is about $2.2 billion, and the rest of the company is worth $1.0 billion ($3.2 billion market cap minus $2.2 billion GAME holding).

In plain English, if GAME appreciates 1%, SNDA should improve 0.67%. Nevertheless, today the two stocks keep diverging: GAME rose 2.4% to $11.01 per ADR but SNDA fell 3.6% to $48.22. The stub of SNDA excluding GAME shares, which includes $1.4 billion cash and a profitable game platform business, is selling at $1.0 billion, discounted by about 50%.

Is it puzzling? Well certainly it is, but it is not that surprising. This happened before, is happening now, and will happen in the future due to the lack of perfect hedging means.

The most famous example came from 3COM (COMS) carving out PALM in March 2000, when the Nasdaq was at its historical high. Lamont and Thaler from the Chicago Booth (Chicago GSB at that time) had a famous paper questioning if the market can add and subtract.

Also known as a partial public offering, an equity carve-out is defined as an IPO for shares (typically a minority stake) in a subsidiary company. A spin-off occurs when the parent firm gives remaining shares in the subsidiary to the parent's shareholders.

The most prominent example of mispricing in this study is the case of Palm and 3Com. Palm, which makes hand-held computers, was owned by 3Com, a profitable company selling computer network systems and services. On March 2, 2000, 3Com sold 5 percent of its stake in Palm to the public through an IPO for Palm. Pending IRS approval, 3Com planned to spin off its remaining shares of Palm to 3Com's shareholders before the end of the year. 3Com shareholders would receive about 1.5 shares of Palm for every share of 3Com that they owned, thus the price of 3Com should have been 1.5 times that of Palm. Investors could therefore buy shares of Palm directly or by buying shares embedded within shares of 3Com. Given 3Com's other profitable business assets, it was expected that 3Com's price would also be well above 1.5 times that of Palm.

The day before the Palm IPO, the price of 3Com closed at $104.13 per share. After the first day of trading, Palm closed at $95.06 per share, implying that the price of 3Com should have jumped to at least $145. Instead, 3Com fell to $81.81.

What happened afterwards?

The day after the IPO, the mispricing of Palm was noted by the Wall Street Journal and the New York Times. The nature of the mispricing was easy to see, yet it persisted for months.

John Cochrane of Chicago Booth argued in his paper "Stock as Money" that liquidity caused the mispricing.

What caused the rise and fall of tech stocks? I argue that a mechanism much like the transactions demand for money drove many stock prices above the 'fundamental value' they would have had in a frictionless market. I start with the Palm/3Com microcosm and then look at tech stocks in general. High prices are associated with high volume, high volatility, low supply of shares, wide dispersion of opinion, and restrictions on long-term short selling. I review competing theories, and only the convenience yield view makes all these connections.

What is the market thinking? Suppose the market is rational, which is a big question mark itself, we can come up with the following possibilities:

1. The market expects that GAME will drop in its value, and SNDA is simply leading in depreciation.
2. The market expects that SNDA will waste cash in its war coffer, and reduce the future value of SNDA.

In any case, due to the lack of direct means to hedge (finding GAME shares to short), the mispricing could go away tomorrow, or could persist for months. One tool that SNDA can utilize to fix the mispricing is to do a complete spin-off: Give 3 shares of GAME to each SNDA share so that the rest of SNDA value can be completely unlocked.

SNDA and GAME keep being on my radar screen to be monitored.

Disclosure: Long SNDA, no position in GAME

Comments

[Paul Harper:]

could it not be a case of a lot of SNDA holders either exiting or selling part position to pick up GAME stock ?
the other scenario I think is likely, plenty of people missed the boat on CYOU earlier in the year & any Chinese IPO / ADR issue, will get a lot of attention from China watchers in the investor retail space, especially with the GAME price point compared to some stronger plays.

Sep 29 06:22 AM

[ginger78:]

Looking at GAME's stock price, expected sales growth, and balance sheet, I think it's a buy. I think its bashers sold when the stock jumped to $13 and have been buying back in on the drop--which is why this stock had huge buys on Friday and Monday. The big boys wouldn't be buying GAME if it were overvalued.

Sep 29 08:25 AM

[traderfox1:]

It COULD be a buy long term if hedge-fund managers and prime shareholders decide that it's holding up in the gaming market and adding to the already- positive revenue stream. But, it could take months for that to happen. Either way a little bit of sell off was to be expected and this one looks like a 'Hold'. It has all the markers of a stock that will most likely break out within a quarter ---or two.

Sep 29 09:30 AM

[mr clark:]

i think SNDA is worth more like $20 nad GAME maybe $4, dont be fooled market is near a top also...

Sep 29 10:32 AM

[ginger78:]

LOL. Another basher. SNDA has $11.70 cash per share, net profit of 35%, forward P/E of 13.2, outstanding shares less than 70 million . . . GAME's figures aren't quite as good (e.g., net profit is only 31% and debt is zero), but I like the CEO and prospectus.

Sep 29 11:26 AM