Dollar General has been all over the headlines the past month, including a shocker on Friday that its CEO, Rick Dreiling, intends to retire. Mr. Dreiling was viewed as a titan of the retail industry, and his departure also raises doubts about the possibility of the merger between DG and FDO, pushed by Carl Icahn who owns 10% of Family Dollar as of his filing in early June.
Analysts and market participants were quite surprised by the announcement. GS Research had the following take:
The announcement and timing came as a surprise to us. Per our note It will take more than weather to take this “General” down published on March 27th, 2014 following management meetings, Mr. Dreiling had expressed commitment to performance targets underscoring outstanding options. Given Mr. Dreiling’s impressive track record and impact on DG over the past few years, the stock has come under pressure. Our estimates and price target are unchanged.
While the GS analyst did not mention the reduced probability of a DG/FDO merger as a result of the news, that was also a major factor in Friday’s selling.
However, some options traders remain bullish, as illustrated by the unusual activity in the stock yesterday, which I laid out in this morning’s TMO post:
DG – Trader sold 72k of the Aug 57.5 calls at 2.10 and bought 62k of the Nov 62.5 calls for 2.35, rolling the position up and out after Friday’s 7% decline in DG after the CEO’s resignation (and likely delay in the DG/FDO deal). Implied volatility declined over 2 points in August and rose over 1 point in November as options traders adjusted pricing to reflect the new potential timing of a deal.
This was a huge trade, as the trader essentially moved around $15 million in premium from August expiration to November expiration, but had to move the long call strike up to the 62.50 level in exchange for the added time.
On a shorter-term basis, the technical situation suggests important support around $55:
[caption id="attachment_42400" align="alignnone" width="600"]
DG daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]
First resistance is around $60, while the all-time high above $65 was briefly touched on June 9th, though sellers were quite aggressive there.
I would be surprised to see DG trade outside of the $55 to $65 range in the coming months, as the $55 level on the downside is technical support, in addition to the fact that activist involvement in FDO is likely to provide some downside support to DG as well (given potential consolidation). In addition, the stock’s valuation seems reasonable at 18x P/E for a company that is expected to grow EPS at 10-20% per year over the next few years.
On the upside, the large volume that traded between $60 and $65 on the potential for a deal likely means ready sellers in that area on the next move higher. In other words, DG looks ripe for a range trade. Meanwhile, implied volatility has remained elevated, despite no earnings event for a couple of months, as a result of the increased speculation in the stock:
[caption id="attachment_42401" align="alignnone" width="600"]
30 day implied volatility in DG, Courtesy of Bloomberg[/caption]
While 25 implied vol is hardly high for DG, it is relatively elevated versus the rest of the market, where most stocks have implied volatility at multiyear lows. Relatively elevated implied volatility and the likelihood for rangebound price action means an in-the-money fly looks like a decent structure here:
Hypothetical Trade: Buy the DG ($57.60) Aug16th 55/60/65 Call Butterfly for $1.85
-Buy 1 Aug16th 55 call for 3.65
-Sell 2 Aug16th 60 calls at 1.10 each
-Buy 1 Aug16th 65 call for 0.40
Break-even on Aug16th expiration:
Profits: btwn 56.85 and 63.15 make up to 3.15 with max gain of 3.15 at $60
Losses: btwn 55 & 56.85 lose up to 1.85, btwn 63.15 & 65 lose up to 1.85, below 55 and above 65 lose full 1.85.
Rationale: This trade structure is profitable between 56.85 and 63.15, targeting a wide range where DG is likely to trade barring any major headlines between now and August expiration. Options markets are wide, so a limit order and patience are likely necessary for a decent fill.