Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

Good News for Omega Protein

A quick update to my Omega Protein ("OME") write up from a few months ago.

1. On 6/28/2016, shareholders elected Wynnefield Capital's nominees for the board. The activist investor now has 2 out of 8 board seats.

2. The latest NOAA Menhaden fishing season status came out 7/5/2016 and it looks like OME is off to a strong fishing season.

These good news should lead to an upbeat 2Q'16 earning call and drive stock price upward.

Sterling Construction Will Enjoy Higher Margins For Years to Come

Sterling Construction Company (STRL) works on transportation and water infrastructure projects (more of the former, particularly highways). It’s a microcap that few analysts cover. The stock trades at $5/share and I think it could be worth $8.

The company has all sorts of not-so-obvious positives: turnaround play with operating momentum, low margin legacy contracts fading away, big net operating losses (NOLs) to monetize, understated book value due to off-balance sheet asset. On top of all that, management incentives are aligned with shareholders.

The political/economic climate also favors Sterling. Monetary policy is running out of bullets and politicians have to start pulling fiscal levers. Highway construction is one area that enjoys bipartisan support – even Republican candidate Trump talks about using constructions to provide jobs.

The next few paragraphs will give a brief industry background before getting into company specifics.

Cyclical business, But Right Part of the Cycle

Coming out of the Great Recession, federal and state governments tightened their construction budgets. For the past few years, companies competed intensely for limited work and margins fell as a result.

That picture is reversing. At the federal level, Obama signed a $300+bn Fixing America’s Surface Transportation Act (“FAST Act”) in December 2015, which provides certainty over the next 5 years. At the state and local government level, politicians have also been working to boost construction budgets.

Texas and California are Sterling’s two biggest markets. Texas is already seeing a spike in highway construction budget. Not only that, the recently passed Proposition 7 will provide billions more in funding starting late 2017. California is also in the works - although transportation needs were not addressed in the June budget, it remains high on the agenda. Multiple stakeholders are united in their push for increased funding. Here’s a taste of what's happening from Granite Construction’s latest transcript.

"We are helping lead the charge in California where construction industry and labor leaders are working shoulder to shoulder to build legislative support for a long-term incremental commitment for transportation investment of at least an additional $40 billion over the next 10 years."

In the coming years, I expect even better legislative support for infrastructure projects as politicians turn to fiscal stimulus. With a bigger and more visible budget, competition will be more rational and that should lead to better margins.

Gross Margin Turnaround and Other Good Stuff

In fact, Sterling Construction is already seeing improving margins. Gross margin is by far the largest driver of net income and cash flows, and here’s how that’s looking:

The momentum is clear. Gross margin troughed during 2013-2014 and has been going up since. Also note that margins have plenty of upside before returning to historical norm of 10%+.

Backlog margins are improving as well. Gross margins in the backlog for the past 4 quarters (starting 1Q’15) are 6.0%, 6.5%, 7.0%, 7.7%. Management expects 8.5%-9% by year end.

Part of the margin improvement will come from better mix. Sterling has been held back by legacy low margin projects from 2013, but it is quickly working them down. Here’s what CEO Paul Varello have to say:

“…we have to complete approximately $70 million worth of legacy jobs that will finish over the next couple of quarters and will generate small to zero margins. We believe that we will start to see the higher margin projects generate stronger earnings in Q3 and beyond…In addition, by year-end we anticipate that our overall backlog margin will be in the range of 8.5% to 9%.”

Those higher margins come at a great time as Sterling had accumulated a big NOL. With the cycle turning, it will basically pay no taxes the next few years.

There are more goodies and I will quickly outline them here:

• Sterling bought $40mm of life insurance policies. The policies are to cover Sterling’s commitment to buy out minority interests upon death of key executives. That commitment is booked as a liability on balance sheet, but the insurance policies are off balance sheet. So book value is understated by a material amount. 
• The company just did an equity raise to deleverage the balance sheet. 
• CEO Varello took an $1 salary and restricted stock when he took over last year. 

Put it all together

Backlogs have been increasing and will likely increase over the next five years. Margins have gone up with lots of room to go. But at $5/share the stock is trading like a normal cyclical. It certainly does not reflect the extended growth runway I described above.

2017 P/E is a modest ~9x. The real question is how does 2018+ look? I think the answer is higher revenue, higher margin, and no taxes will translate to explosive free cash flows growth and multiples expansion.



Note: Competitor Primoris was also bullish about Texas in its 1Q’16 call.

“We continue to expect substantial growth in the Texas heavy civil market, especially once Prop 7 money starts to flow. Which should be sometime late next year.”

Teekay Tankers Will Be Owned By Creditors for a While

• TNK stock has been down more ~50% year to date. It trades at less than 3x earnings and this has shareholders calling for buybacks.
• However, management is paying down debt instead. They have to do because of lower cash flows in 2016 and 2017, as well as demanding debt maturity schedule.

Back in December 2015, Teekay Tankers (TNK) announced a $900 million refinancing, including a term loan and a revolver that are both due in 2021. I thought the deal was bullish for the stock, since it cleared out near term maturities and allows TNK to buy back stocks.

This is not the case. That deal did push out a lot of near term maturities, but a substantial amount remains. In addition, the new term loan actually has an onerous principal payment schedule.

The $525 million term loan matures in 2021 but demands principal amortization of $31.94 million per quarter for the first few quarter and $24.845 million per quarter thereafter. This amounts to $99-106 million of principal payment per year.

What’s more, a sizeable chunk from old loans remains. The annual report has a maturity schedule pro forma for the refinance. Backing out the January 2016 loans, and assuming the debt payment made during 1Q16 was toward near term maturities, the current debt schedule would look like the below.

The big question is the $215 million due 2017. To put that in context, TNK only generated $167 million of cash flows from operations for the entire 2015, and that’s with peak tanker rates! So far in 2016 we are already seeing lower tanker rates and lower cash flows.

More headwinds are coming in 2017. Tanker supplies will come on line second half of 2016 and through 2017. So rates in 2017 will likely be lower. In-charters will expire so TNK will be operating with a lower number of vessels.

So forget about TNK paying off the entire $215 million out of cash flow from operations. It will struggle to even pay the ~$106 million term loan scheduled principal in a weaker market. It will certainly have to refinance the rest of 2017 maturities; failure to do so means another round of equity raise, or even bankruptcy.

To entice lenders for the 2017 refinancing, TNK will need to demonstrate credit worthiness and deleverage in the near term. This explains management’s focus on deleveraging, why the company has not repurchased any shares despite the ostensibly low P/E ratio, and why an equity offering is still on the table.

So creditors will get most of the cash flows for now. This is not to say avoid the stock, but investors should recognize the credit situation, and be willing to hang on for a couple years for their big pay day.

Advice for Investors

In this situation, demanding share buybacks is to demand a short term boost in the stock price while risking equity dilution or even bankruptcy down the line.

Instead of pushing for buybacks, big boy activist investors can provide the refinancing themselves. Just to toss some ideas around, with $250 million of 10% senior notes, weighted average cost of debt would still be under 5%.

Even after the 2017 maturity is addressed, TNK will still face a demanding term loan amortization. But by late 2017, it should have shown progress in deleveraging and tanker rates should have stabilized. Management can then refinance the January 2016 loan into another with easier principal payment schedule, and finally release free cash flows to shareholders.

There is also a lesson here. P/E ratios and free cash flow yield (free cash flow divided by market capitalization) are meaningless measures for companies loaded with debt. “Free cash flow” is not really “free” in terms of using it to reward shareholder, especially if there are near term maturities/obligations that can’t be funded from operation.

Beijing Enterprises Holdings - A Stub Trade

I first wrote about Beijing Enterprises Holdings (“BEHL”, 392.HK) last year here when the stock was trading around HKD$60. The stock is now at ~$39 HKD/share, a 36% drop. This is all despite very strong fundamentals. 2015 revenue and EPS were up 25% and 18%, respectively. 2016 results are also expected to be up double digits.

So why did the stock go down? First, it’s just a bad timing for a stock like BEHL. It’s China. It’s energy. Combine the two most hated features in this market and of course you get a lower multiple. The second reason is more concerning. There’s a risk of a tariff cut in the pipelines segment, perhaps coming in second half of 2016.

The stock is now ridiculously cheap. If you hedge out publicly traded subsidiaries Beijing Enterprises Water (371.HK) and China Gas (384.HK), that would leave you with the stub of natural gas segment, Yanjing Beer, and corporate (including waste treatment). This stub is trading at around 5x LTM earnings. Even in if you assume pipeline profits goes to 0, an extreme proposition, the stub is trading at <17x 2015 earnings.

Keep in mind natural gas usage is still set to grow in China over the next decade. LNG supplies coming online will push prices down, encourage adoption, and benefit distributors like BEHL. So I have gradually added to my positions in the past year. I suspect a tariff cut will actually be good for the stock, and that the stock will make a run after the bad news is flushed through.

Select Harvests and the Almond Boom and Bust

SHV is the second largest almond producer in Australia, behind the well diversified Olam. SHV is the only pure play almond stock I know of. The company is vertically integrated - it owns almond orchards, not just processing plants - and sells both domestically as well as export.

Almond prices have crashed over the past few months and SHV’s stock price went the same direction. Earnings will probably be way down this year.

A bullish story for Australian producers emerges once you look past the recent boom and bust of almond prices. Global demand for almonds continues to increase over time, driven by health trends. California supplies the majority of the world’s almonds, but it faces structural difficulties from drought and water shortage. Australia is the second largest producer and is in position to take more market share. Australian producers also have geographic advantage in terms of being closer to key growth markets of India and China.

I think almond prices are probably at or near a trough. The current price of $2.3/lb in California is already near break even. According to this presentation (see slide 43), growers need $2.15/lb to break even and $2.5/lb to insure a minimal profit. Longer term, stabilizing California supplies should put a floor on global prices.

Select Harvest will enjoy a natural production ramp in a few years (think like ~2019) as trees age and reach production sweet spots. Between higher normalized price and higher production, I can see earnings stabilizing.

The risk is California productivity. Yield per acre have consistently went up over the past decade. It is conceivable that Californian farmers can find a way to cut down water usage while keeping up production, so supply may actually not be constrained for years.

To be conservative I assume prices of USD 2.25-2.75/lb and fully ramped production of 19,000 tons. This would correspond to earnings of A$0.2 to 0.5 per share for SHV. The stock had a nice run during my research and it is now at A$5.4-5.5/share. I’m waiting for a pull back toward $5 or below to pull the trigger.

Virtus Health

Business and Industry Overview

Virtus Health Ltd (“Virtus”, “VRT”) is a steady dividend grower I found while scanning through Australian stocks.

Virtus operates In Vitro Fertilization (IVF) clinics. Fertility specialists contract with Virtus to use the clinics for IVF and related operations and get a split of the revenue. When a couple gets an IVF at Virtus, they pay the bill initially but gets heavy reimbursement from the federal government (Medicare and EMSN) as well as Private insurance if they have it. As a result, Virtus’ revenue is AUD 10,000-14,000 per IVF cycle but typical out-of-pocket costs for each patient is 1/3-1/2 of the total price.

The Australian assisted reproductive services (ARS) industry is concentrated. The top 3 players Virtus, Monash IVF, and Genea owns over 70% market share and are all privately owned. ARS are mostly provided by private clinics as there are virtually no public sector fertility clinics in Australia. Virtus is the biggest of the three with ~1/3 market share. At the local level VRT is even stronger since it is number one or number two in its geographies.

Why I Like It

There's lots to like about the industry and specifically Virtus. You have a product that is naturally price inelastic (we’re talking about babies here), good market structure, and very long growth runway due to demographics.

The industry structure is a big attraction for me as new entrants will have difficulty recruiting fertility specialists. This is the key to market share gains. But there are only some 300 odds fertility specialists in Australia and they are typically under contract with the big three.

Australia’s low birth rates provide Virtus a long growth runway. Those data were cited extensively in IPO prospectuses so I won’t recite them here.

Acquisitions have been sensible and generally at below 10x earnings. As a result return on incremental capital is solid low-mid teens. Management has been good about returning excess cash in the form of dividends.

My plan to make money with this stock is buy and hold, let the company accrete value over time and receive dividends in the interim. That should give 5-15% IRR over the next few years, maybe even decades.

Risks and Mitigants

What might change my mind? If the key risks turn out worse than expected: government funding risk, lower price competition, and alternative technologies.

By “funding risk” I mean risk that government will reduce reimbursement for IVF, or reduce subsidies for private insurance. Despite the chaos in Australian politics I have actually gotten comfortable here. First, unlike other benefits that add to expenses for the government, an IVF actually creates a future tax payer. 

Second, in the extreme and unlikely case where funding is removed and patients pay 100% out of pocket you're talking about AUD 10,000-14,000 per IVF cycle, a lot of couples would still pay. Keep in mind Australia is one of the wealthiest countries on Earth and typical clients are women in their late 30’s, who tend to be well educated and have sound financial positions (which is often why they delayed starting a family in the first place)

Competition is a bigger worry. Primary Health is in the market with low end $500 or even $0 out of pocket services. There has been some impact on Virtus' lower price, less service clinic but management indicates their full service IVF is still going strong. Industry IVF cycle growth have been higher than normal since Primary Health’s entry, so it would seem that they enlarged the pie by drawing in new customer segments. 

Primary only has two IVF clinics so far and I think scaling up and signing up doctors will be tough. I don’t see why doctors would leave a high priced practice for a low end one.

Longer term tail risks is that an alternative technology emerging to replace IVF. Also if IVF success rates (currently ~25-30% for women in late 30's) improve then people would need less service.

Why Virtus and Not Monash IVF; Catalysts

I prefer Virtus because Monash has business concentration risk with 1/3 of IVF cycle from 5 doctors. It also hasn't really been exposed to competition from Primary Health, which only recently opened a clinic in Melbourne. Yes, Monash IVF does have higher margins mostly due lower employee benefits, but Virtus is not a provider of low cost commodity services and in fact there's something positive to be said about paying your employees well.

“Self-help” earning opportunities are available in the next year or so. The company’s Singapore operations can swing from loss to profit (management indicated this can happen in a couple quarters). One of the Ireland Clinics had some temporary staffing issues in FY1H16 which has been addressed. VRT can also benefit from general ramp up of new facilities and younger doctors as they grow their reputation and attract new clients.

Australian budget comes out in May and we will have more color on the government funding risk then. The technicals are not great - the stock is coming upon a resistance zone at $7.0-7.25. But I’m inclined to ignore that and hold even if it gets there.

I have a 2-3% position right now with average cost basis of $6.56. Virtus trades at 15-16x forward earnings. Accounting earnings tracks cash flows well and leverage is moderate at 2-2.5x EBITDA.