Name That Trade – $GE Wiz

by Dan April 16, 2015 12:52 pm • Commentary

A day after GE announced its plans to sell off parts of its finance and retail units, and the stock’s subsequent 11% one day gains, Barron’s ran the following story Time to Sell General Electric.  The bottom line of the story is that while the cash received for the assets will be used for up to $50 billion in share buybacks (on top of the dividend that currently yields 3.35%) the company’s business that it is left is devoid of growth with the stock trading at a market multiple:

which could shift as analysts come to grips with the changes. That is a rich multiple for a company putting all of its chips into industrial businesses that have boosted operating earnings at an average of 1.4% a year for the past four years.

The article goes on to state that the reduction in GE Capital’s earnings contribution will be a messy process:

GE Capital accounted for 57% of the company’s operating earnings in 2007, shrinking to 42% last year. If the company’s plans go as expected, GE Capital will account for just 10% of earnings in 2018.

The company has already agreed to sell $26.5 billion in real estate assets to Blackstone (BX), Wells Fargo (WFC), and others. In the short term, the moves will wreak havoc on GE’s income statement, leading to $16 billion in write-downs in the first quarter alone.  

It is my sense that the company will need to counter a bit of the noise from quarter to quarter of decreased earnings contribution by accelerating a portion of their increased buyback.  This should keep the stock buoyed in the mid to high $20s.

On Monday on Fast Money on CNBC I highlighted a bullish risk reversal where a trader sold the Dec 26 put at 85 cents and bought the Dec 30 call for 65 cents (when the stock was just below $28), resulting in a 20 cent credit.

This trade, the Dec 26/30 Risk Reversal, creates a situation where the trader receives the 20 cents if the stock is between 26 and 30 on Dec expiration (highest probability), is put the stock at 26 if the stock is 26 or below (less the 20 cents premium received) or is long above 26.   I like this trade for those who are comfortable short puts, as it gives a wide range where nothing happens but considerable leverage to a breakout to new multi-year highs.

Taking a quick look at the technical set up, the breakout on Friday above the prior highs on massive volume was nothing short of impressive.  But in the near term, a hold of $27 is imperative, and a gap fill to about $26 would be downright disappointing:

[caption id="attachment_52838" align="aligncenter" width="600"]GE 1yr chart from Bloomberg GE 1yr chart from Bloomberg[/caption]

As for option prices, they saw a steady ramp into what was likely the worst kept secret on Wall Street last week, as call open interest had been expanding for months (we highlighted a large long dated call spread in late Feb here) and this weeks re-tracement might just be profit taking.  Implied vol in GE has moved close to 20%, this is a combination of the company’s earnings do out before the open tomorrow, but is likely to settle as the the scale of the buyback should be vol dampening in the months to come.

[caption id="attachment_52839" align="aligncenter" width="600"]GE 1yr chart of 30 day at the money IV from Bloomberg GE 1yr chart of 30 day at the money IV from Bloomberg[/caption]

Event: Q1 earnings  – the implied move in the options market for GE Is about 2.7%, the April 17th (tomorrow expiration) 27.50 straddle (the call and the put premium) is offered at 65 cents, if you bought the move, and thus the straddle, you would need a rally above $28.15, or below $26.85 to break-even.  The average move over the last 4 qtrs has been about 1.5%.

We’re going to wait out the upcoming earnings and see if it presents us with an entry a little lower. If that does occur we may look to buy the stock (capturing the dividend) and possibly overlay the stock with an upside 1×2 calls spread that takes advantage of the elevated volatility and adds leverage to the position to the upside.