Yesterday shares of Dell jumped 13% on reports that the company was in talks with several private equity firms about going private. This morning Jefferies raised their price target on the stock to $13 “to reflect the possibility of” a leveraged buyout. Option trading on the stock was decidedly bullish with 3.8 calls trading for every put on nearly twice the average daily volume. One of the biggest trades of the day was the purchase of 2500 January 2014 15 calls for $0.50 with the stock at 12.36. This is a bullish bet that the stock will reach at least 15.50 by this time next year.
As option traders scrambled to buy out of the money options on the buyout rumors implied volatility in the stock skyrocketed. 30-day implied volatility closed at 52.97%, up 65% on the day. This means that options are quite a bit more expensive now as a result of the heightened uncertainty surrounding the stock. While this did not dissuade this trader from buying long dated deep out of the money calls, I believe traders need to take a step back and analyze the situation before joining the call buying frenzy.
A key metric private equity firms look at when analyzing a deal is enterprise value. Enterprise value is basically the market cap of the stock plus outstanding debt minus cash and investments. Private equity firms like to buy companies below enterprise value unless they believe they can unlock major synergies through the acquisition to create new value the market is not pricing in now. Dell’s current enterprise value is $12.54 per share which is below yesterday’s high. This doesn‘t mean that someone wont buy Dell above enterprise value, but it does make it less likely that a private equity firm will pay a big premium over yesterday’s closing price.
Another headwind facing a buyout of the stock is Michael Dell’s personal stake in the stock. Currently he is the company’s largest shareholder with a roughly $4.5 billion position. It is unlikely that a private equity firm would want to be a minority shareholder in the stock, and yet there are few firms likely to put up over $4.5 billion to become the largest shareholder. Again, this doesn’t mean that a deal cannot be done, but it means that a deal will require serious financing and will not appear overnight.
The key to playing this stock will be to keep risk small and reward high. Buying out of the money calls that expire in a year like this trader did is probably a good way to go if you want to step into the stock today. Long dated options are less sensitive to initial spikes in volatility which means that they will have more reasonable premiums than the short dated options. They also have less time decay and give the trade time to work. After such a big one day run on nothing but a rumor I would think the stock is due for a pullback sooner rather than later as traders take some profit off the table. If you want t buy calls on the stock I would wait to do it on a dip after the initial frenzy has abated.