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Alphabet (GOOG, GOOGL) released mixed earnings yesterday to disappointed investors. GOOG and GOOGL stock have both taken hits. But the huge volume today in its calls signals some think the drop today is overdone.
The company said its revenue rose 11% year over year to $76.93 billion from $69.09 billion a year ago. But this was disappointing as the market had been forecasting revenue of $85.15 billion, according to Seeking Alpha.
Moreover, Q3 sales were only $2.09 billion higher than last quarter's $74.6 billion in sales. That represents a paltry 2.8% QoQ revenue growth rate.
In addition, Google Cloud sales rose just 4.7% from $8.0 billion in Q2 to $8.4 billion in Q3. Investors had been hoping to see much higher growth.
Free Cash Flow Still Strong
Nevertheless, the company's free cash flow (FCF) is strong. In Q3 it generated $22.6 billion in FCF. That was 3.77% higher than the Q2 FCF figure of $21.778 billion.
But even more importantly the FCF margin stayed elevated at 29.4% in Q3 vs. 31.5% in the prior quarter.
The bottom line is that Alphabet is still an incredibly strong and profitable company, although its growth rate seems to be slowing.
Heavy Call Option Volume Today
Today a large volume of calls with unusually high ratios of volume to open interest (Vol/OI) have traded in both GOOG and GOOGL stock. This can be seen in the Barchart Unusual Stock Options Activity Report table below.
It shows that most of the strike prices of these call options are out-of-the-money (OTM). That indicates that some of these trades may have been initiated by bullish investors who think that the roughly 9% downdraft in Alphabet stock today may have been overdone.
On the other hand, some of these trades offer good covered call opportunities for existing GOOG and GOOGL investors. For example, the $130 strike price calls due Nov. 3, which is 9 days from now, offer a premium of $1.27.
That represents a 1.0% yield on today's spot price of $127.33 per share with less than 2 weeks to go before expiration. So, on an annualized basis, assuming this trade could be repeated 26 times in a year, the expected return is 25.9%. That assumes, again, that this exact trade could be repeated each time.
The bottom line seems to be that some option investors are taking advantage of today's weakness in GOOG and GOOGL stock, based on its reset growth rate.
Contrarian Thinking
This is essentially how contrarians think. For example, is it really such a bad thing that this company has produced a 29% FCF margin and generated $22 billion in free cash flow? I don't think so.
For example, using a FCF yield metric we can estimate a value for GOOG stock. Let's assume that analyst estimates for $339.57 billion in sales next year come to pass. That implies that, using a 29.4% FCF margin its FCF could rise to about $100 billion (i.e., 0.294 x $339.57 = $99.8 billion).
So, what is a company that generates $100 billion in free cash flow worth? At a 3% FCF yield (i.e., 33.3x FCF) it is worth $3.33 trillion. Today's market cap is $1.589 trillion.
Moreover, even using a 5% yield (i.e., 20x FCF), it is worth $2 trillion. That is still 25.9% over today's market cap, implying huge upside in the stock. It could still be worth $160.30 per share (i.e., 1.259 x $127.33). That assumes Alphabet generates a consistent 29% to 30% FCF margin and its revenue growth stays on target with analyst estimates.
In fact, even at a 5.5% FCF yield (i.e., 18.2x FCF), the market cap should be worth $1.818 trillion, or 14.4% over today's price. That puts the minimum price target at $145.66 per share.
In other words, maybe this hit to Alphabet's market cap is temporary. No wonder there are large call buyers today in GOOG stock and GOOGL stock.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
