$PG Cresting?

by Dan June 17, 2016 1:57 pm • Commentary• Trade Ideas

Since the start of 2014, shares of Proctor & Gamble (PG) are essentially unchanged, up $2, or about 2.5%, vs the S&P 500 (SPX) up about 13% during the same period. The dividend yield on the SPX has been about 2% during that time period, while PG’s was about 3%. So on a total return basis the under-performance by PG has been meaningful.

In that time period, PG’s average price has been about $81, trading as highs as $93.50, and as low as $65 on August 24th 2015:

From Bloomberg
From Bloomberg

PG’s more than 50% revenue exposure outside the U.S. has made its earnings volatile since the end of QE in Q4 2014, which happens to be the year its earnings have peaked, with two consecutive annual earnings decline and sales expected to be $65 billion in fiscal 2016, down from their 2013 peak of $84 billion.  PG trades at about 21x expected fiscal 2017 eps growth of about 9%, vs the forward PE of the SPX of 16.4x.

So there is two ways I’m thinking about PG. If the dollar were to ease for the right reasons (ie the Fed remains accommodative, but global growth sees an uptick), then PG should see a bump in eps & sales overseas and the stock should break out above $85:

PG since Jan 2015 from Bloomberg
PG since Jan 2015 from Bloomberg

That seems like a fairly decent probability and to be frank, implied volatility, the price of options in PG are about as cheap as it gets for a mega cap stock, with 30 day at the money implied volatility at 13%, with 2 month at about 16%:

PG 1yr chart of 30 day at the money Implied Volatility from Bloomberg
PG 1yr chart of 30 day at the money Implied Volatility from Bloomberg

The other way I would think about the set up in PG is that it is a very crowded trade, with investors too focused on the defensive nature of the stock, leaving the door open to the sort of decline it had last August in the event of a broad market sell off or on disappointing results and outlook.

The next identifiable catalyst for PG will be their fiscal Q4 earnings scheduled for August 2nd.  I want to isolate that event and the potential for the market to get bit jittery into the July 27th FOMC meeting.

While the case for a breakout could easily be made on a technical standpoint, and it will most certainly happen if PG is able to guide up for the full fiscal year 2017, but I think that is unlikely given the volatility of the US dollar, and the continued softness in the global economy. Following PG’s fiscal Q3 earnings in late April, management highlighted the impact of FX first a headwind, and then a tailwind in PG’s fQ3 earnings presentation:

FY 2016 Guidance
Potential Headwinds Not Included in Guidance
Further foreign currency weakness
• Change in market growth rates
• Further unrest in the Middle East, Russia & the Ukraine
• Further deterioration in markets like Argentina and Brazil – with softened market conditions

FY 2016 Guidance
Potential Tailwinds Not Included in Guidance
Strengthening of foreign currencies
• Expansion of markets
• U.S. economic growth accelerates

I want to make a defined risk bearish bet that PG trades back in the mid $70s in the next couple months.

*PG ($83) Buy Aug 82.50 / 70 Put Spread for $2
  • Buy to open 1 Aug 82.50 put for 2.25
  • Sell to open 1 Aug 70 puts at 25 cents

Break-Even on Aug expiration:

Profits: up to 10.50 between 80.50 and 70 with max gain of 10.50 at 70 or below

Losses: up to 2 between 80.50 and 82.50 with max loss of 2 above 83

Rationale: This is essentially an at the money put purchase at a decent vol level that captures an earnings event. The sale of the 70 puts benefit from a great deal of downside skew. Even if the target of 70 seems aggressive those are a good sale against any higher put purchase. If the stock breaks out of its range to the upside this trade can be closed for not too bad of a loss and we’ll use that level of 85 as an upside stop. On the downside we can be patient on any breaks below 80.