Monday, April 28, 2014

Management's attempt to inflate a bubble in Apple stock

By expanding its share buyback program, management is influencing investors expectations of an asymmetric payoff.  Using market price to project the business fundamentals is purely manipulating the investors expectations. In addition, by doing a 7 for 1 stock split, management is attempting to capitalize on investor psychology by attracting retail investors towards another potential gain opportunity in the stock. Strength of the company's fundamentals, massive shareholder capital return program, mutual interaction between the underlying trend and investor's bias will lead to divergence of reality from actual fundamentals

My fair value estimate for Apple hasn't changed after the recent earnings release. Recent price movement in the stock has converged the gap between price and value. However, above mentioned management actions and their consequences can possibly mark the beginning of a bull run in Apple, but I don't think it will end in a pretty way.

Saturday, April 19, 2014

Netflix : Options market understating the upside risk into earnings on Apr 21

Is the skew representing true risk associated with Netflix into the earnings. I agree in its current form , skew aligns well with broad market sentiment towards momo- stocks but what if  Netflix reports an improvement in subscriber growth or any other widely followed operating metric. 

Stock which has a history of wild movements after the release of earnings ( good & bad) , this time options market seems not worried about the upside. That indeed got me worried

Wednesday, April 16, 2014

Is Options market pricing the risk correctly in Google earnings

Google is scheduled to report 1Q-2014 earnings after the close of trading on Wednesday, April 16th. For the March Quarter, analysts are expecting earnings per share of $6.41 (Range: $6.00 -$6.83). For FY 2014, analysts are expecting revenue of $66.47 billion dollars implying 11.10 percent year over year growth.
For the last 14 quarters, Google's stock has on an average moved 6 percent, next day after the earnings release. Table below presents how the options market has historically priced at-the-money straddle for Google before earnings (in percent terms, standard deviation terms, and the implied volatility levels). Also included in the table is volatility crush that happens in the options after the earnings are released.

Heading into the earnings this week, the risk reflected by the options market (30 and 60 day implied volatility levels) is marginally lower than the all time highs levels seen last week. For the earnings event , options market is expecting a 5.85 percent move, which is close to the average move in the stock for the last 14 quarters. From an implied volatility perspective- ATM straddle seems overpriced, but appears to be priced fairly on an absolute move basis.
Despite missing the consensus sales estimates in seven of the last nine quarterly reports, market has rewarded Google on the hopes of its multiple revenue streams in future. Besides, the strong growth reported by the Internet software and services industry lifted the growth expectations for Google as well. Decomposing Google Price/ Earning ratio reveals the growth premium built in its stock price. Google stock has lost 13 percent after making an all time highs earlier this year. Even at current market price levels future growth accounts for approximately 50 percent of Google's price.
Implied volatility for long-term dated contracts in Google started to rise before the stock became a victim of momentum reversal in the technology sector. Implied through this divergence in volatility regime from the broader market is the magnification of risk in Google' stock beyond an earnings event.

Earnings Trade
I am quiet intrigued by the fact that Google straddle is pricing only average move heading into the earnings this quarter especially when the momentum stocks have taken a sharp beating. In fact market participants have continued to sell the volatility premium in Google's options since the beginning of this week. Even though I tend to view Google as overvalued at current levels but traders need to be cognizant of the irrational price movement which a growth stock can experience - by elevation of expectations only. 
For the above mentioned reasons and current market sentiments , long volatility offers favorable risk reward . Traders should factor in the volatility crush which the options will undergo after the release of earnings. 
I expect a volatility crush of 3.5 points for June options - exposing 515/575 strangle to a $530 dollars risk if Google does not move.  For September options, I expect a volatility crush of 1.5 points - exposing position to a risk of $250 dollars.  Both these positions have asymmetric payout if moves sharp and fast and these time left to expiry also enables to recover the losses as well. 

Sunday, January 5, 2014

INFY - Setting up Earnings Trade

Infosys historically has shown volatile movements after the earnings release.  Stock has moved close to 8.2% on an average after earnings release for last 12 quarters.  Table 1 below presents the implied volatility levels for first two months before earnings, expected volatility crush after earnings release, stock and at the money straddle performance. 

Implied volatility levels, straddle pricing, stock and straddle performance

Currently, at the money straddle for options expiring on January 18 is pricing a move of 8.4 % in the stock (Close to 12 quarter average move).  30 day and 60 day implied volatility levels shown in figure 4, present fair pricing of options. After converting straddle prices into standard deviation terms, these options seem to be fairly priced as we approach earnings on Friday.  

Monday, December 23, 2013

Monster Beverage- Quantifying Price of Growth

Monster Beverage Corporation (MNST) develops, markets, sells and distributes alternative beverage, such as non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, single-serve juices and fruit beverages, ready-to-drink dairy and coffee drinks, energy drinks, sports drinks, and single-serve still water (flavored and unflavored) with beverages, including sodas that are considered natural, sparkling juices and flavored sparkling beverages. Company markets its products through retail chains, club stores and specialty stores using exclusive distributor network. 

Energy drinks and shots represent small portion of non-alcoholic beverage market, this industry has seen tremendous growth since 2008, with total sales in United States close to $13.0 billion dollar presently. This growth has been attained on the backdrop of increased consumer penetration and drop in sales for traditional carbonated soft drinks due to health concerns related with cola products. According to “Energy Drinks and Shots: Market trends in US”, sales for energy drinks & shots is expected grow to $ 21.7 billion dollar supported by improvements in distribution channels and sustained economic growth. Energy drinks market is currently in its infancy and is expected to grow significantly as energy drink usage increases among its target consumers (Source: Presently energy drinks account for 78% market share followed by 18% for energy shots and 4% for energy drink mixes.

For the last twelve months, company reported revenues of $2.2 billion, operating income of $552.0 million and net income of $331.0 million or $1.98 earnings per share.  Company has realized huge growth in the past 9 years with revenue growth of 12.7%, operating income & net income growth of 16.8% annually, capturing a market share of 35%. Figure 1 highlights y-o-y growth Monster Beverage has realized since 2004.

Year over Year Growth in Revenues, Operating Income & Net Income for Monster Energy

Monster Beverage has been able to maintain its operating margins and net margins for past several years with only exception of compression in margins during 2008. This supports the fact that company is not growing revenues by compromising on margins.  It competes directly with other energy drink manufacturers such as Red Bull and with big stalwarts like Coca Cola (KO) and Pepsi (PEP) to gain the shelf space at convenience stores. Increased health concerns among consumers with the usage of carbonated soft drinks have worked favorably for Monster’s favor but recent allegations related to safety of its products seems to offset the tail wind it had. Figure 2 compares the operating & the net margins for Monster Beverage against Coca- Cola (KO) and Pepsi (PEP).

As business has grown over the last several years so have the reinvestment requirements – enabling the company to grow its revenues.  Management has been very effective in analyzing industry trends, growth opportunities and making decisions to reinvest. Figure 4 highlights relationship that exists between revenue growth and reinvestment rate (Part of Operating Income after taxes which gets invested back into the business)

Monster Beverage has created a huge brand in the marketplace and is aggressively marketing its products to attract youth to switch from coffee & carbonated soft drinks to energy drinks and turn them into loyal customers of the brand.  Additionally it is expanding internationally with sales growing in Europe, Japan, Middle East, Africa and partnering with industry peers to develop a strong distribution network.  

Valuation of Monster Energy

Growth story for Monster energy moving forward is international expansion but the firm also faces strong competition from Red Bull which already has an established international distribution network. Even though the firm currently enjoys strong brand loyalty, maintaining pricing power at the current margin levels will be a challenge, as reinvestment requirements for expansion of business starts to grow.  Growth in future for this company is where the investors need to realize the risks are and factor them in their valuation methodologies. From a valuation perspective, value generated by growth can be categorized in three categories

  1. Growth Rate
Revenue Growth Rate expected for next 5 year is 15.6 %, operating income is expected to grow 16.3% per year for next 5 years.

  1. Sustainability of growth
Developing a globally recognized brand and establishing partnerships for scaling up their distribution network provides a strong competitive edge for Monster.

  1. Return on capital
Brand loyalty, product mix and appealing marketing campaign has helped the company earn higher returns on capital invested. Median ROIC for Monster Energy since 2004 is 47.9% against cost of capital of 8%. Returns generated over and above the cost of capital reflect quality growth generated and value creation for share holders.   

As an investor we should know how much we are paying for growth in business and should be cautious about paying any premium for lower quality growth. Separating value of assets currently in place from market price helps in determining how much price for growth is built in the stock price. Using a cost of capital of 8% (Beverage Industry –US Average), we can see the value of assets in place, value that growth will add and price we are paying for growth.

As illustrated in the table above, assuming Monster Beverage will only be able to earn its cost of capital; price of growth comes at 3.7 times the value which growth assets will generate. At current price level, market is implying a growth rate of 23% in the operating income for the next 5 years. This level of implied growth rate seems higher than our expectations of growth in operating income but Monster’s ability to generate returns far higher than its cost of capital add value for share holders which needs to be factored in company’s valuation. Price investors pay for growth is a variable that investors should pay close attention to. Using the median ROIC which Monster Beverage since 2004, we come up with value of assets currently in place, value added by future growth, price we are paying for future growth, intrinsic equity & enterprise value of the business. For growth oriented investors, entry price lower than the sum of value of assets & price paid for growth ($62.87) – offers growth at a reasonable price and provides margin of safety as well.

I will publish a follow up article highlighting in detail the inherent business risk for Monster Beverage,  quantify stock price risk with ±1% growth variation , risks reflected in options markets and relationship which exists between business risk, growth risk and options market perceived risk 

Sunday, November 17, 2013

Trading Volatility Spread between S&P and Gold Options

There are only predominantly two main topics of discussion floating around financial markets these days- Are we in a bubble ( with S&P at its all time highs) and has the gold  bottomed out at these levels. Arguments can be made to the both sides for both asset classes, but we as traders have to deal with situations we are handed in present and exploit mis-pricing in market place to generate profits. 

I wrote few days back about what I believe drives gold prices from a macro perspective, and what we should be focusing on  moving forward.  If interested you can read the article by clicking the link below

As I dug deeper into analysis of gold and equity markets, one thing which struck me quiet interesting was the relationship between implied vol for both asset classes. Interestingly , implied vols for both have historically tracked each other very closely until this relationship got whacked in April this year. Gold volatility (normally  priced cheaper than S&P 500 )exploded to the upside due to sharp moves we saw in gold earlier this year. Currently spread between gold and S&P implied volatility is 5.57 points which is quiet high from a historical perspective. 

Red -30 day Gold Implied Volatility, Blue- 30 day SPX Implied Volatility
Based on realized volatility in both asset classes, I expect realized volatility in Gold to continue the declining trend and expect SPX realized vol to spike up in future. Having said that, this spread can also converge to historical levels with  volatility in gold declining lower than SPX. I want to create a trade structure which takes advantage of this convergence. 

Starting up with Gold,  below is my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  18.3%   
Expected IV 120 day :  18.6%  

Using above stated numbers , I calculated  one standard deviation  of $8,  selected 133 & 115 as price levels  which gold prices should stay with in.  Instead of selling them naked and exposing the position to significant losses, I add hedges to both upside & down side- there by creating a structure similar to iron condors. ( Essentially short gamma, short vega,slightly short delta and positive theta)

Moving to SPX, my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  14.6 %   
Expected IV 120 day :  15.0 %  

Presently  IV 90 & IV 120 for SPX is at 12.65 % & 13.57 % with budget talks and debt deal discussions scheduled to resurface back again in Feb , I expect IV for Feb & March to pick up significantly . Combine this with QE taper you should be strong upside move in volatility

Now putting some perspective of bubble talks we are faced with on a daily basis these days. Well, when every body is talking about a bubble - they last longer than everybody thinks. Secondly if everybody thinks equity markets are in bubble - one would expect smart participants to position themselves accordingly. There is no bidding up of Skew for SPX - which leads me to believe , this market will keep grinding higher until it doesn't. Supporting this bias of mine, I use a prop indicator which I had developed earlier to analyze current momentum of equity prices and understand where we stand 

Clearly it seems that we are not yet in ridiculously expensive state.  With this in mind, I want to create a trade structure which will let me enjoy the grind higher and offer me downside protection. In addition , I want to take advantage of theta decay from holidays. Based on  this, I used OTM Feb/March 182 calendars with March  173 puts in ratio. Position is essentially short delta, short gamma , long vega and slightly negative theta . 

How do you manage the risk for this trade. Risk for trade in gold is to the upside move in gold which based on my analysis will come from pick up in inflation  or drop in value of dollar. Both these factors are positive with S&P till the time they de-couple. If rise in gold is  due to liquidity risk in markets, we have sufficient downside protection in  S&P which will help.  Ability to ride the S&P's upside move limits our upside risk in gold. 

Saturday, November 16, 2013

Being Yum'mmed !!!

Tracking the order flow in YUM brands

We all are aware of YUM brands, the company which own & operates 3 major fast food chains KFC, Pizza Hut & Taco Bell.  If you want to dig more about this company you should check out the link below

Lately this company has been in news due to slumping sales in China, which contributes almost 40 % to its operating income. Slowing sales can potentially be the result of increased health concerns regarding poultry supply in China and outbreak of Avian flu.

It’s not any analyst report which sparked my attention on YUM, rather a very huge of option trade which went through yesterday (Nov 15th, 2013) got my attention and made me dig further into it. Part of my home work before trading this name, involves investigating how much growth market is expecting in this company’s stock price. Reverse engineering a DCF model revealed, market is expecting 34.70% growth in operating income over the next 5 years.  Price of current assets in place is only $20.90 and future growth should add $36.50, which puts the enterprise value close to $57.39. Last closing price I checked up was $73.98 – 29% more than enterprise value.   This seems to align well with discussion related to expensive multiple for markets which everybody is discussing these days!!  We‘ll see that later

Second leg of my analysis involves technical review of YUM to understand how it has been behaving lately.

Chart from Think or Swim Platform
Stock has been range bound since April 2012, with 75 ish being the upper bound and 60’ ish level – lower bound.  Long term trend from March 09 lows has been broken and stock is consolidating and even short term trend from earlier this year seem to following the same path as well.

Third leg of my analysis (most crucial to me) - How the implied vol and realized vol have been doing lately. No surprise that with the stock close to all time highs, implied vol currently is at 22th percentile. 30 day historical vol has ranged between 10.9% & 44.4% for the last 4 years and currently is at 28.5%.  I believe current 30 day realized vol still has the movement from earnings release captured and should decline shortly as earning move of 7.25% is priced out of it.

Chart from LiveVol Pro

Here’s a snap shot from order flow from Nov 15th

Someone structured a big bearish position on this name or is trying to hedge an existing stock position by locking in the gains below 65.  Order flow raised IV for Dec 65’s by 5 points and Jan 65 ‘by 2 points – creating vol difference between the two expiries.  Dec/ Jan Calendar makes perfect sense if you feel  this stock has seen it s high for now and is due for a trip south.