Chimin Sang's  Instablog

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 carving out PALM in March 2000, when 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