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A Big Deal Could Benefit Small Traders

A Big Deal Could Benefit Small Traders

Some deals lead to questions about what the companies were thinking. This is especially true as cash is building up on company balance sheets. Management teams are using that cash to make acquisitions, in some cases, at premium valuations.

When a company pays top dollar for an acquisition, it can take time for the deal to pay off. This is because almost all deals involve integrating two companies. Cultures are different in the companies, as are information technology systems and operational and administrative processes.

Integration comes with risks and the higher the price paid in the deal, the greater those risks can be for investors.

A Recent Deal Could Benefit Shareholders Immediately

On Monday, Genuine Parts Company (NYSE: GPC) announced the acquisition of Alliance Automotive Group (AAG), a leading European distributor of vehicle parts, tools and workshop equipment. Genuine Parts Company will buy AAG from private equity funds managed by Blackstone and AAG’s co-founders.

The acquisition is valued at a total purchase price of approximately $2 billion, including the repayment of AAG’s outstanding debt upon closing. The transaction has been approved by the Board of Directors of both companies and is expected to close in the fourth quarter of 2017.

Genuine Parts intends to finance the transaction, including the pay-off of AAG’s existing debt arrangements, with approximately $2 billion of debt financing. This will include a combination of new term loan agreements, new multi-currency debt and an upsized revolving credit facility.

Genuine Parts is one of the leading car parts distributors in the US. The deal marks its entry into the European market. AAG is the second largest parts distribution platform in Europe, with a focus on light vehicle and commercial vehicle replacement parts.

AAG is expected to generate gross revenue of approximately $1.7 billion under US accounting rules in 2017. This deal is expected to immediately add to Genuine Parts’ earnings in the first year after closing.

For 2018, incremental diluted earnings per share is estimated at $0.45 to $0.50 and adjusted earnings per share is estimated at $0.65 to $0.70, which excludes the amortization of acquisition-related intangibles. The company expects to incur one-time transaction costs in the fourth quarter of 2017.

Paul Donahue, Genuine Parts Company’s President and Chief Executive Officer, stated, “We are excited to combine with AAG and enter the European markets with critical scale and a leading market position in the automotive aftermarket.”

With the move, Genuine Parts will compete directly with LKQ Corp, the No.1 automotive parts distributor by gross billings in the 68-billion-euro ($80.8 billion) European light vehicle aftermarket.

This is important because the US is a mature market, as is Europe. It is difficult for any company to expand in a mature market and it is also difficult to enter a mature market without an acquisition. Genuine Parts now has significant growth potential.

The CEO also noted that, “AAG has a strong management team and a deep bench of talent, and our similar cultures and histories make this acquisition an excellent strategic fit. We are confident this business investment will create significant value for our shareholders…”

Analysts agree with management’s assessment. “At the distributor level, AAG’s markets represent approximately 47 percent of the total European light vehicle aftermarket,” providing Genuine Parts an “attractive” entry into Europe, Jefferies analyst Bret Jordan said.

The deal, expected to close in the fourth quarter of 2017, will add 65 to 70 cents per share to Genuine Parts’ adjusted earnings in 2018, the company said.

A Catalyst for the Stock

The deal sparked buying in GPC and quickly pushed the stock price to a resistance level. Resistance is an area where technical analysts expect a trend to stall as sellers enter the market. Selling could be motivated by previous disappointment in the stock. The chart below shows GPC is near resistance.

Although GPC jumped on the news, the stock might not deliver additional, quick gains. However, it’s also unlikely the stock will sell off quickly. The price is most likely to remain near the current level as traders continue to assess the news and await updates from analysts and the company.

Sell A Put and Limit Risk

There is a readily apparent options strategy for this stock. Selling a put is a strategy to benefit from a potential up move. A spread can then be created to limit the risk of the strategy. The potential risk and reward are illustrated in the chart below. There are limited risks and limited potential gains to the trade.

Source: The Options Industry Council

For GPC, options expiring on October 20 offer low risk exposure to the stock. The October 20 $87.50 put is trading at about $0.50. This put could be sold to generate immediate income of $50 since each contract covers 100 shares. This example ignores commissions since trading costs should be relatively small at a deep discount broker.

To limit the potential loss, an October 20 $82.50 put could be bought for about $0.15. This will cost $15 to open. The net credit on the trade, considering the sale of the $87.50 put and the purchase of the $82.50 put, will be $35 or $350 per contract.

The maximum risk on the trade is equal to the difference in the option exercise prices less the premium received when the trade was opened. In this case, the risk would be equal to $500 (the difference between $87.50 and $82.50 exercise price contracts) minus $35 or $465. Most brokers will require a margin deposit equal to the amount of risk on the trade.

The potential gain of $35 represents a return of more than 7.5% on the required trading capital of $465. This is an excellent rate of return on a trade that will be open for less than a month. Additional bull put spreads could be opened after this trade expires, compounding gains in the stock over time.

This position has a high probability of success, about 88% based on the delta of the put option being sold. Delta is one the options Greeks, a group of values that describe the individual risk factors that affect the price of an options contract. Delta can be with free calculators at the exchange web site.

Delta measures how much an option’s price should change if the value of the underlying security changes by $1.00. The values of delta will range from 0 to 1 for calls and it will always be between 0 and -1 for puts. The absolute value of delta shows the probability of an option expiring in the money.

Absolute value is the value of the number ignoring the sign. So, the absolute value of 0.52 is equal to 0.52. The absolute value of -0.52 is also equal to 0.52 since the negative sign is ignored.

A put option with a delta of -0.12 would also have a 12% probability of expiring in the money. The lower the delta, the greater the probability of an option expiring worthless. This is a valuable insight for selling options. On this trade, there is a 88% probability of a 7.5% gain in the next month.

Spreads are a strategy all smaller investors should consider. They can generate immediate income or be opened for a small capital outlay, depending on the specific trade circumstances. Risks for a spread can be defined and limited in advance, ensuring only limited amounts of capital are risked.

Spreads are often featured in in the TradingTips.com service, Options Cash Cow. This service frequently identifies trades that generate immediate income and strictly limit risk. It could be ideal for small investors with limited capital. To learn more about this service, click here.