Angie's List: 7.7% 2-Year Bankruptcy Risk Due To Litigation

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After two weeks of wild trading including a short squeeze that lifted Angie's List (NASDAQ:ANGI) to $15 from $12 followed by a critique in the New York Times and a fall back to $14, Angie's List has been beset by a flurry of new class-action lawsuits against the company and its executives. The following firms have filed class action lawsuits, with press releases in the attached links:

These lawsuits make roughly the same allegations. This succinct summary is offered by Kahn Swick & Foti:

Angie's List and certain of its executives are charged with issuing a series of materially false and misleading statements during the Class Period, violating federal securities laws.

These false statements and omissions included, in part, that Angie's List: (1) had increased its reliance on providing free memberships in order to artificially boost its subscriber figures; (2) was consistently deriving a majority of its revenues from the service provider side of its business, where it collected fees for listing paid service providers more prominently, contrary to its statements that it did not permit service providers to buy ratings on its website; and (3) did not vet the service providers listed and recommended on its website, causing consumers to question the value of its recommendations.

The full complaint from Robbins Geller Rudman & Dowd can be found here. Interestingly, Robbins Geller Rudman & Dowd cite Seeking Alpha author J Mintzmyer's analysis (p. 18 of the complaint):

52. On October 24, 2013, stock blog published a report entitled "Angie's List -- a Deferred Revenue Train Wreck," which stated, in pertinent part, that Angie's List had been receiving cash, booking it as "deferred revenue," then rapidly spending it at a rate that, unless the Company suddenly became profitable, it would be unable to fulfill its commitments and faced insolvency. The report also stated that all of the analysts that had been serving as cheerleaders to support the stock price -- rather than providing critical analysis --had conflicts of interest in that they had served as underwriters in the Company's IPO and follow-on offerings and were unlikely to be critical as they sought additional investment banking work from Angie's List in the future.

Instead of addressing the validity of the lawsuit claims, which is well beyond my scope, I performed a small amount of research to find out how large a liability Angie's List might face from these lawsuits in the context of other securities-releated class action litigation. Of note, this analysis does not address a prior class action lawsuit, Fritzinger v. Angie's List, which was filed in 2012 alleging that Angie's List improperly charged customers' credit cards.

The maximum possible size of the damages appears to be relatively easy to estimate. To my understanding, investor damages consist of losses incurred due to the alleged misconduct plus the expected return that would have been gained by investing in the overall market. In the class period from 2/14/13 to 10/23/13 submitted by Robbins Geller Rudman & Dowd, ANGI stock reached a peak of $28.32 and bottomed out at $14.63. During the same period, the S&P 500 increased 14.94%. Using a share count of 58.4 million, the maximum shareholder loss would amount to (58.4 x 11.69 + 0.1494 x 58.4 x 28.32), or $1.017 billion. The company reported $88 million in current assets and -$23 million in negative equity in the third quarter. Clearly, a verdict or settlement for the entire maximum possible value of investor damages would result in instantaneous bankruptcy. However, most securities-related class action lawsuits settle for a tiny fraction of the theoretical maximum investor damages.

Detailed statistics on securities litigation are published annually by National Economic Research Associates. Their report for 2012 can be found here. These statistics are based on all of the securities-related class-action lawsuits in a given year and are an accurate description of outcomes rather than a sampled subset. NERA's data allow us to make quantitative estimates of the risk to Angie's List due to the new class-action litigation.

There is essentially zero possibility that the full $1.017 billion could be assessed against Angie's List. In the past 10 years, the 10 largest settlements have ranged from $1.043 billion (McKesson) to $7.242 billion (Enron). These cases with massive settlements involved fairly egregious charges ranging from allegations of manipulating the prices of drugs in the case of McKesson to running a fraudulent company and grossly misrepresenting the accounts in the case of Enron. In my opinion, it would be difficult to argue that Angie's List has committed sins (if any) of anywhere near the gravity of the other members of the billion-dollar-settlement club. With ANGI's negative equity, however, a settlement for substantially less money could still result in significant financial problems.

According to NERA, the median case takes about 2.5 years from filing to settlement. Only 0.5% of shareholder class-action lawsuits go to trial. Of all cases filed, nearly 50% are settled and 50% are dismissed in the 6 years following the date of filing. When outlier cases with settlements greater than $1 billion are excluded, the average settlement is $36 million and the median is approximately $12 million. There is a monotonic relationship between investor damages and median settlement, with cases resulting in $1 billion in investor damages having a median settlement of $11-$16 million. The large difference between the median and average settlement is probably due to the presence of a few very large settlements and the large number of frivolous nuisance lawsuits that are settled for a pittance to avoid court costs.

Assuming that the possible merits of the lawsuits are irrelevant and that lawsuits are purely probabilistic events (not an entirely true assumption, but definitely not entirely false either), Angie's List has a 50% likelihood of dismissing the case and paying only attorney's fees or some fraction thereof depending on its insurance. Of the remaining 50% of cases that settle instead of being dismissed, 50% settle for the median or less, which would be a maximum liability of $16 million. Neither of these outcomes would be fatal for Angie's List. The remaining 25% of cases that settle for more than the median settlement, however, could prove to be highly dangerous to Angie's List. How large a financial hit could Angie's List survive? How much of that liability would be covered by liability insurance? How much will the threat of litigation distract the executives? Ultimately, the market will provide an assessment of these risks.

As of 12/26/13, $2.50 puts expiring January 2016 traded at $0.30, yielding an estimate of cumulative bankruptcy risk of roughly 12% over the next two years. On 12/27/13 current bid and ask are 0.05 and 0.30; using the mid-point, this yields an cumulative bankruptcy risk of 9%. The Kamakura default probability, which is based exclusively on financial metrics rather than event risk, estimates the cumulative default risk of Angie's List at 1.27% over the next two years. Total bankruptcy risk is the sum of credit risk and event risk, so the event risk is roughly 9-1.27 = 7.7%, most of which is presumably due to litigation. I estimate that the 92nd percentile of settlements in the setting of $1 billion investor damages would fall in the range of around $50-$100 million, roughly the size needed to trigger a bankruptcy at Angie's List. The concordance of put pricing and settlement probabilities as a function of size per the NERA statistics suggests that 7.7% is a reasonable risk estimate.

If there is any justice in the legal system, the true likelihood of significant liability accruing to Angie's List from these lawsuits will be related to the merits of the charges. Those with legal expertise may have an opportunity to profit in this situation if their assessments differ from the probabilities priced in by the market.

Disclosure: I am short ANGI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article, including the estimate of 2-year bankruptcy risk, represents my opinions only. I am not a legal or financial professional and my opinions should not be construed as legal or investment advice. In addition, please note that the allegations in the lawsuits filed against Angie's List are allegations, not statements of fact. Legal complaints are inherently one-sided versions of events. Readers are urged to seek balanced viewpoints (including perspectives from Angie's List) on the validity, if any, of the complaints filed in the lawsuits discussed in this article. I personally am not insinuating that the claims made by the plaintiffs in these lawsuits are correct or incorrect. Instead, the purpose of this article is to estimate the risk of bankruptcy relating to shareholder lawsuits based on prior outcomes involving other companies. Please rely on your own due diligence for all of your investment decisions.