A Beaten Down Blue Chip Might Be Worth More Than Its Stock Price
General Electric Company (NYSE: GE) has been in the news quite a bit recently. The latest news is that the company will fire 12,000 workers in its power business. This amounts to nearly 20% of its workers- in that division. The hope is that the cuts will lower costs and turn around the struggling business.
While the company has been struggling, at least one analyst is concerned the cuts won’t be enough to put GE on the right path. CFRA Research’s Jim Corridore writes that he is “not certain these efforts will be enough” to turn around its power business, or the company. Specifically, he noted:
“GE will cut 12,000 jobs (roughly 18% of staff) from its Power Business, as part of an effort to cut $1 billion in structural costs out of Power. We see this move as part of GE’s overall strategy to cut costs and refocus on areas of strength.
However, we are not certain these efforts will be enough to turn around Power, which has struggled with poor execution and demand shifts. We still feel GE has great assets and great technology, but we think that the company faces a long drawn out restructuring, and think it’s best to wait for signs of improvement before adding to positions.”
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This isn’t the first step the company has taken to restore investor’s confidence. Last month, GE cut its dividend in half, from $0.96 a year to $0.48. This will save the company $4.1 billion a year. According to CNBC, that is the eighth-largest dividend cut in the history of the S&P 500 by dollar value.
This cut is the largest dividend reduction of all time on a dollar basis outside the financial crisis. Not surprisingly, the stock price has been in a down trend for some time. The chart below shows the daily trend since last spring has been nearly straight down.
The selling has left the stock at what investors believe is a bargain level.
Insider Buying Could Tip a Bottom
In the last several weeks, some General Electric directors have made major purchases of the company’s stock. Several large acquisitions were made at prices below $18 a share. The company also has been a buyer, acquiring 142,000 shares during the quarter that ended September 30.
Insiders are the individuals that know the most about a company. Buying by insiders, especially buying by several different individuals at around the same time, is often a bullish signal in the stock.
Insiders, a group that includes management and independent directors of a company, can always delay buying if they believe the stock is overvalued. By buying, they demonstrate with their own money that they believe the stock offers value.
At least one analyst agrees with the insiders. Melius Research’s Scott Davis believes the stock could potentially gain more than 50% from its current level as investors realize the value of the company’s individual businesses.
Davis noted that the company’s stock is worth about $27 per share based on the value of its individual divisions. The analyst called GE “an asset play,” noting that General Electric’s aviation and health care units “are probably worth the entire value of the company.”
He values the health care unit at about $7.34 per share which represents a price to earnings (P/E) ratio of 19 for the division. The aviation unit could be worth $13.49 a share using a P/E ratio of 21. These are the P/E ratios of competitors in the industries.
This adds up to more than $20 a share and values several other components, including GE Power, GE Capital, GE Lighting and Baker Hughes, at nothing. Davis concludes that “[Investors] just have to get comfortable that the rest of the assets more than offset liabilities—and we think they do.”
Bad News Carries Good News for Traders
All of this news has at least one bit of good news for traders. The stock has become more volatile.
Higher volatility is generally associated with higher options prices. This is because options prices reflect a number of factors. The price of a call or put option is affected by the price of the underlying stock, the current level of interest rates, the time left to expiration and the volatility of the underlying stock among other factors.
Increased volatility, when it leads to increased options prices, sets up a number of potential trading opportunities for options traders.
A Strategy to Trade General Electric
GE is likely to remain in a relatively narrow trading range while investors wait for news on how the steep discounts are affecting the company’s bottom line. This indicates a significant move in the stock price is unlikely.
When a stock is expected to remain in a narrow range for some time, it is possible to generate income from the stock. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which recently saw increased volatility and is likely to remain in a narrow range.
Source: The Options Industry Council
This options trading strategies involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
For General Electric, a bull put spread could be opened with the January 5 put options. This trade can be opened by selling the January 5 $17.50 put option for about $0.30 and buying the January 5 $16.50 put for about $0.10.
This trade would result in a credit of $0.20, or $20 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $1.00 ($17.50 – $16.50). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $80 ($100 – $20).
The potential gain is about 25% of the amount of capital risked. This trade will be for about one month and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors.
These are the type of strategies that are explained and used in Trading Tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.