A little over a month ago we initiated a structure in GOOGL that looked for a slight pullback in shares based both on technicals (declining momentum) and what we thought were some pretty unrealistic growth expectations. GOOGL has in fact been weak since (down about 5%) and is now banging around close to our sweet spot in the center of the put fly.
With the stock at 532 this morning the structure is worth about 3 times what we paid for it. That’s great but it’s getting close to decision time on how long to wait for the intrinsic value of this structure to come in.
If the stock is 532 and this structure is worth about 11, that means that there’s about 7 dollars of intrinsic value that has yet to decay (at 532 on expiration this trade would be worth 18). That 7 dollars represents the expected movement in the stock between now and expiration. The mark to market value of the trade will continue to converge with the intrinsic value as we get closer to expiration. It does that in a non linear way as that convergence accelerates the closer we get.
The problem with waiting around for that is that there’s still delta risk. The structure is short about 25 deltas this morning. Like the decay of the structure, those deltas also grow everyday the stock is below 550 and above 525 (below 525 the structure is long deltas). In a 500 dollar stock that’s significant because the stock could easily bounce 10-15 dollars, making waiting around for 7 dollars in decay look dumb.
Therefore we’re going to use this opportunity to close the trade for a healthy profit:
Action: GOOGL ($532) Sell to Close Dec 550/525/500 Put Fly at $11.25* for a $7.60 profit
* reminder when trading multi-leg options strategies that the bid /ask can be wide and we always use limit orders, to trade inside screens, never crossing full bid ask. It makes sense to take a couple attempts to execute inside the bid/ask.
There are few who would dispute that Google (GOOGL) has been, and on current estimates remains, one of the best large cap growth stories on a valuation basis. The stock trades at a PE/G (PE to Growth rate) of 1, trading at 18x next year’s expected EPS growth of 18%. For investors focused on growth over value, paying a market multiple for that sort of growth is a decent proposition. But it’s important to note that as GOOGL’s sales have climbed above $50 billion in 2014, the rate of ascent has declined, from 37% in 2012, to 19% last year, to an expected 11% this year. Yep you know the drill, harder to grow a larger base.
But Wall Street analysts expect a massive re-acceleration in 2015, back to 19% sales growth, which would make an almost 100% increase year over year in sales growth (from about $5 billion to $10 billion). I am not exactly sure what would cause that sort of dollar increase. The price action of the stock since its all time highs made in late February, and the stock’s relative under-performance to the broad market suggest that investors have become a tad skeptical of this sort of potential sales growth after such a meaningful deceleration.
But it’s not the estimates that have caught my eye, it’s the price action and the technicals. The inability of GOOGL to keep pace with the broad market is the key, with the stock sitting flat on the year and 9% off of the 52 week highs that were made more than 8 months ago. Additionally, the declining momentum is about to manifest itself with what some technicians call the “Death Cross” where the shorter moving average, in this case the 50 day (purple below), is about to cross to the downside of a longer term moving average, in this case the 200 day (yellow below):
There’s not much scientific data as to the significance of the “Death Cross” so I don’t want to put too much emphasis on it (good recent discussion here from SeeItMarket.com), but it indicates a loss of momentum and there was an example in the last couple months that got a lot of attention as small caps, measured by the IWM, saw a nearly 10% decline following the cross:
While it’s hard to draw a connection between the pattern of one of the largest companies in the world and that of the index of 2000 of the smallest publicly traded companies in the U.S., there is one comparison that is worth noting – the relative under-performance prior to the cross of IWM and now that of GOOGL.
In the last couple months, there is no doubt that the strength of Facebook and Alibaba has taken its toll on GOOGL, as money has rotated out of the internet stalwart. It’s also important to note that despite GOOGL’s massive cash hoard of $65 billion, they do NOT buyback their shares as other large cap tech leaders in 2014 do and will continue to do in a big way (See AAPL, MSFT, INTC, up 35%, 32% and 26% respectively).
To sum up… GOOGL’s under-performance is likely to lead to a few potential outcomes. First, it could attract an activist like Carl Icahn to lever up and buyback shares. Why Not? It worked with larger target AAPL. Or possibly the company is forced to make a sort of transformative acquisition to diversify away from their dependance on search revenue. Regular readers know that I think GOOGL should buy Twitter in an effort to add a meaningful social media property that would be very synergistic (Real-Time Search) with their current properties . At the same time, TWTR could solve what is becoming a growing gap in their social media strategy as YouTube is largely seen as the only real social-ish property given that Google+ appears to be an all out failure. Anyway you slice it, GOOGL is likely to have to do something with that cash in an effort to reinvigorate investors.
But here is a third potential corporate action that could cause investor interest. As I wrote about on June 30th, “MorningWord 6/30/14: Should YouTube Try Googling Itself?”, highlighting the potential value of YouTube, a spinout is something that could also be of interest to activists:
YouTube is the second largest “social network” by revenues (some analysts expect $4 billion in sales in 2014, which has been growing and expected to continue at about 40% a year) only second to Facebook, which had nearly $8b billion in sales last year with expected growth of 50% to nearly $12 billion in 2014. While many market pundits (including myself) dismiss Google’s social efforts largely because of Google Plus’s inability to make a dent into Facebook’s dominance, Google through YouTube is sitting on one of the largest social properties on the web.
So when you add together the stock’s under-performance, the relative under-leverage of the balance sheet that could lead to added earnings growth, the potential for unlocking shareholder value by monetizing YouTube or the potential for a transformative acquisition, options prices seem fair if not low. The 30 day at the money implied vol in GOOGL looks fair if not cheap, once again approaching multi-year lows.
So weak price action, potential for activists, no shortage of potential catalysts with low options prices does not exactly mean buy straddles or strangles, but it does suggest that defined risk directional plays could be an attractive way to express a view.
SO WHATS THE TRADE?? In the near term the long term underperformance, and the short term techncial set up lead me to a bearish trade. If the stock were to pull back to where I think it can into the year end then I would look to enter a long biased trade for the new year that could catch some of the potenital catalysts that I outlinedabove:
TRADE: GOOGL ($561.40) Bought Dec 550/525/500 Put Fly for 3.70
-Bought 1 Dec 550 put for 10.40
-Sold 2 Dec 525 puts at 4.25 each or 8.50 total
-Bought 1 Dec 500 put for 1.80
Break-Even on Dec Expiration:
Profits: between 546.30 and 503.70 make up to 21.30, with max gain of 21.30 at $525, down about 6.5%
Losses: between 546.30 and 550 lose up to 3.70, between 500 and 503.70 lose up to 3.70, max loss of 3.70 below 500 and above 550. Max risk of less than 1% of the underlying stock price.
Rationale: This is a dollar cheap way to play for a realistic pulback in GOOGL shares. We target near the recent lows and the trade could easily be a double or even a triple on a pullback. If the stock breaks out from here we’d look to take the trade off for a small loss as it should hold value decently if the stock only goes slightly higher.