GOOG reports after the close, and I laid out my broad thoughts in the 4Q preview (below). I am relatively neutral on direction, but ended up settling on a good risk/reward options trade nonetheless.
Importantly, GOOG has sold off more than 5% since its high on Jan 10th, and expectations are low after the bad 3Q miss. I do think overall sales trends were likely strong at GOOG, but the margin story continues to be the main concern. Along those lines though, I think investors are more likely to give the company a pass on margins as long as the company shows that there is light at the end of the tunnel, particularly with the broader bullish market backdrop. So I chose a trade with a slight bullish bias:
TRADE: GOOG (~$704) Bought the Jan25th / Feb16th 725 Call Calendar for $3.60
-Sold 1 Jan25th 725 call at 9.30
-Bought 1 Feb16th 725 call for 12.90
Break-Even on Jan25th Expiration:
-My expectation is that this call calendar will be profitable if GOOG is trading between 700 and 750 tomorrow (though that expectation depends on where Feb implied vol settles). The ideal scenario is that GOOG trades to just below 725 by Friday expiry, and I can then decide what to do with my Feb16th 725 call position.
Trade Rationale: My main reason for choosing this trade is that the relative cheapness of the call calendar. The max I can lose is the premium that I paid, or $3.60, against which I could have a nice winner on my hands (around a double) if GOOG does have a move higher in line with its implied move tomorrow. I don’t have a very strong view on GOOG’s direction, but the favorable risk/reward of the calendar made me pull the trigger here.
Q4 Earnings Preview:
Event: GOOG reports Q3 earnings tonight after the close. The options market is implying about a 5.5% move, vs the trailing 4 qtr avg move of ~6% and the 8 qtr avg of ~7%.
Sentiment / Price Action: GOOG is actually down on the year, as it closed 2012 at $707.38, one of the few large cap stocks currently down in 2013. The consensus 12 month price target is around 802, and analysts have 33 buys and 11 holds, no sells.
Fundamentals/Valuation: In its Q3 earnings report from October, GOOG had the first year-over-year quarterly earnings decline since the stock went public in 2004. Not surprisingly, the stock declined 8% on the news, and has had trouble rallying ever since. As much as GOOG has tried to diversify away from its online advertising business, it still gets 95% of its revenues in one form or another from that source.
In the process of trying to diversify into other businesses, GOOG management has hurt its gross margins as expenses have grown faster than revenues in the past year. Sales actually grew more than 40% from 2011 to 2012 (the best performance in the past 5 years), but earnings only grew 11% (the worst performance in the past 5 years). Here is a chart of gross margins for GOOG over the last 10 years, courtesy of Bloomberg:
GOOG Gross Margins as Percentage, courtesy of Bloomberg
For 2013, analysts are projecting 22% sales growth and 16% earnings growth, so a stabilization in the margin compression story.
In addition to the trend in margins, I will be watching for the overall trend in online ad pricing, which was declining last year. Mobile ad trends will be important as well, but that’s still a small part of the business.
At a P/E of 21x, GOOG does not look cheap, but its sales growth expectations are still 20+%. As a result, if earnings can actually grow 15-20% over the next 2 years as expected, then the current valuation is understandable. But the move in margins over the past year is concerning, as it’s becoming harder to translate sales growth into earnings growth for this behemoth.
Technicals: The 5 year chart of GOOG shows the 2 important levels where the stock is bounded. Obvious support is around $650, from where the stock broke out last year after years of testing that resistance level, while current resistance now lies around the previous high from last year around the $780 level.
GOOG 5 yr chart courtesy of Bloomberg
My first impression is that this set up lends itself to a longer-term range trade based simply on the technical setup, playing for GOOG between 650 and 750.
Volatility: GOOG’s current implied vol is lower than usual heading into earnings vs. the past 8 quarters (as seen by the peaks on the red line marked by an E). Of course, like the broader market, GOOG realized volatility is at 2 year lows. Here’s the 2 year chart of 30 day implied vol (red) vs. 30 day realized vol (blue):
GOOG IV vs. HV courtesy of LiveVol
Options are cheap, but for good reason, given the lack of volatility in the past month.
My View: GOOG’s strong sales growth has been a bright spot, but its declining margins and overall pricing weakness in the online ad business raise red flags. The stock’s inability to rally in a strong market is also not encouraging price action. My hunch is that online ad pricing has not recovered just yet, but expectations into this quarter are lower than in the past after last quarter’s miss.
In addition, GOOG does have many levels for cost control, so any signs that they’re reducing expenses to address the margin issue could be a significant positive.
Put it all together, and I see a mixed picture, particularly with the broader technical picture indicating a range trade. If I do a trade, it will likely be along the lines of a range bet.