Imagine you're the humble head of US equity trading at Morgan Stanley (MS), minding your own business and trying to dodge bullets while Europe implodes and JPMorgan (JPM) gets dragged down by its CIO scandal.
Now imagine you're sitting at your desk Friday morning and learn that the Facebook (FB) IPO pricing isn't going as well as underwriters, led by your colleagues in investment banking, thought. You're called by a Very Important Person and ordered to buy every share of stock offered at $38. It appears that this happened.
With 580 million shares trading hands on Friday, if you wound up buying just 5 million shares, that would be $190 million in risk on your books. How do you react?
You have two options:
It's my belief that the latter happened, which was the reason for the large decline in other social names, not a psychological letdown of Facebook pricing lower than some thought.
Hedging an IPO in its first day of trading is a nightmare. Correlation is a guess. Volatility is a guess. Calculating hedge ratios in the best of times is tricky. In a situation like this, it's much more art than science.
To hedge $100 of Facebook risk, how much LinkedIn (LNKD) should one sell? Or Zynga (ZNGA)?
Looking at closing prices on Friday, we see that Facebook-related names were pummeled. GSV Capital Corp (GSVC), which owns Facebook stock, fell over 18%. Zynga fell over 13% and was halted for an extended period because of the severity of its decline. Yelp (YELP) fell over 12%. Pandora (P) fell over 7%. The Global X Social Media Index Fund (SOCL) fell over 6%. So did Groupon (GRPN). LinkedIn fell over 5%. Those are the most liquid ways of hedging Facebook.
Here's a chart showing Friday intraday moves in Zynga, GSV Capital, and Facebook.
In addition to the catalyst of Morgan Stanley hedging its Facebook exposure, there were two more events – Friday being options expiration day, which often exacerbates large price moves, and continued jitters surrounding Europe leading to low liquidity, with the Volatility Index (^VIX) being at 25.
So what happens this week? Morgan Stanley is unlikely to support Facebook forever, and it will look to unwind its Facebook exposure and hedges as soon as possible. With markets oversold – the Dow Industrials (DIA) have fallen for 13 out of 15 trading days for the first time since 1982 – any bounce combined with Morgan Stanley covering its hedges could lead to an explosive rally in the names that fell so hard on Friday.
Zynga in particular looks compelling. It closed Friday with a market capitalization of $5.3 billion, of which $1.5 billion is cash. Consensus revenue estimates for this year, which tend to be a low bar so that companies can look good beating them, are $1.45 billion. So Zynga's trading at an enterprise value to sales (EV/sales) ratio for this year of 2.6x. Facebook, expected to do around $5 billion in revenues this year, is trading with an EV/sales ratio of more like 20x. Noted growth companies like Altria (MO), Coke (KO), and McDonald's (MCD) trade at EV/sales ratios of more like 3-4x. Something closer to Zynga's peer group, like OpenTable, trades at an EV/sales ratio of 5.4x.
Zynga underwriter Morgan Stanley projects Zynga will earn $623 million in adjusted EBITDA in 2013, giving Zynga an EV/EBITDA ratio of 5.9x 2013 projections, which would be cheap for Wal-Mart (WMT), let alone an Internet growth company.
Obviously, in the short-run, volatility in the new Internet names has become immense, but Zynga offers 50% to 100% upside with very reasonable downside here.
By Conor Sen
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