Despite GoDaddy (NYSE: GDDY) being known to virtually anyone who has ever registered a domain name, the title remains relatively unknown to most investors. This is generally good for profit trading, as studies have shown that low profile stocks such as these tend to move more than expected during earnings releases. GDDY reports in early May. Timing the Market subscribers received this trade alert earlier:
An appraisal of $100 or more
In terms of valuations, GDDY is extremely cheap, at least from a cash flow perspective. Analysts expect free cash flow to exceed $1 billion by the end of the year. This trend is set to continue.
If you apply discounted cash flow analysis to GDDY, we’re talking about a $100+ stock.
In other words, the discounted cash flow valuation places the stock almost 50% undervalued. Obviously the market valuation and discounted cash flow valuation are not aligned, but I still believe that GDDY’s cash flow is highly discounted, even with the company’s issues. And on that note, let’s talk a bit about the company’s issues, as they’re likely contributing to investor wariness here.
I see GoDaddy having some major issues. The first is simply financial: the debt ratio is close to 5,000%.
You can see how even investors interested in cash flow would get their feet wet here. Also, equity was negative until recently. The silver lining here is that operating cash flow covers debt by 20% and EBIT covers interest payments by 340%. So, although the debt is heavy, GoDaddy is not at risk of becoming insolvent anytime soon, thanks to its cash flow.
The second problem is much less financial and more reputational. GoDaddy recently suffered several serious security breaches. In the past six months alone, the company has had two: one in March and one in November. While the average individual GoDaddy customer is likely unaware of this fact, those who run many sites will be more likely to choose a competitor over GoDaddy, the more frequent and severe these breaches of security will be. Technology news tends to spread quickly, and if GoDaddy doesn’t take its security concerns seriously, it could see a significant migration of customers. Notably, GoDaddy also provides security services and has seen growth in this category. More flops in this category could stifle such growth.
And growth is the name of the game here. Gross margin has been on a steady slope since its IPO.
As research has shown, earnings reports tend to move stocks as new financial data forces investors to reapply their valuations. And as my own research has revealed, Q1 earnings tend to be the perfect time to go long-side for GDDY. The combination of a high probability of Q1 earnings surprises and low analyst expectations leads to an alpha-generating trade for anyone who regularly takes long positions in GDDY during the first quarter.
The probability of GDDY increasing relative to this quarter’s earnings is 71%. Unfortunately, the risk/reward ratio favors the bears, with the Q1 earnings sell-off being 54% larger than the earnings increases. However, the expected value still makes it a winning play for the bulls.
Holding GDDY just above Q1 earnings yields a 6% annual return. The period containing Q1 explains 13% of GDDY’s overall growth, 5% more than expected. For this reason, I suggest going long on GDDY for its next profit period.
The options market is pricing an $8.70 move from GDDY to earnings. I think it’s too high, because the average move is more like around $5. This means the options are probably too expensive.
In this situation, I would normally recommend running a long call ladder. But GDDY’s option bid-ask spreads are a bit too wide to sell out-of-the-money calls here. Instead, I recommend just buying the stock or using long-term parity calls with tight bid-ask spreads if you can find them.
At the time of writing (April 22), the January 20 $82.50 has tight spreads, with only 50 cents between bid and ask. They’re currently trading at $1175 each, and I’d use those default calls if you’re not sure what to buy.
Let me know what you think.