Seeing Three Scenarios for GeoEye

I’ll spare everyone a re-hashing of the various pros and cons associated with a long or short position in GeoEye (GEOY) – it has been extensively covered both here at Seeking Alpha and in many other places.

What everyone seems to agree on is this: the launch and successful provisioning of GeoEye-1 will have a monumental impact on both how lucrative and even how viable the business will be.

High volatility scenarios such as this provide great training grounds for derivative-based trading strategies.

There are three likely scenarios for GEOY that will play out over the next few months.

Scenario #1

GeoEye-1 is launched approximately on time and is successfully provisioned once in orbit

While this is by no means a guarantee, as the launch date was quite recently pushed back due to unfavorable weather conditions, most agree that this is the likely outcome. Without getting into a valuation debate, for the purposes of this exercise let’s assume this leads to a stock price of $30 within three months and $35 within six months.

Summary: Dec 19 price = $30 Mar 20 price = $35

Scenario #2

GeoEye-1 launch is materially delayed, but eventually launches successfully

Though things appear to (finally) be going swimmingly on this front, let’s remember that this launch was supposed to happen quite a while ago. In this case, assume that the stock trades down to $20 by December before recovering to $30 by March (after a successful launch between 12/08 and 3/09).

Summary: Dec 19 price = $20 Mar 20 price = $30

Scenario #3

GeoEye-1 launch is a failure

This scorched earth scenario could very well signal the end of life-as-we-know-it for GEOY – with 2 aging satellites and the next launch scheduled for 2011, the company’s viability would certainly be in question. With launch success rates of 98%+, this is easily the least likely scenario. Yet, if this were to happen, GEOY would easily trade down to $10.

Summary: Dec 19 price = $10 Mar 20 price = $10

So, we have three possible outcomes, each with drastically different payouts. As a risk-averse investor, capital loss is my primary concern, so I would look for a way to generate meaningful profits while limiting downside.

Ever the pessimist, I assign the following probabilities to scenarios #1, #2 and #3, above: 65%, 30%, and 5%. Feel free to substitute different numbers if you’d like, depending on your particular feelings about GEOY. Given my beliefs, I suggest the following trade:

• Buy Mar 25 call – cost of $620
• Sell Mar 35 call – income of $200
• Buy Dec 20 put – cost of $250
• Sell Dec 15 put – income of $145
• Total capital outlay: $525

So, the profit (loss) in each scenario would look like this:

1. Scenario #1: + $475
2. Scenario #2: - $25
3. Scenario #3: - $25

Applying the above probabilities, the expected value is + $300, with a 65% chance of meaningful profit and 35% chance of essentially breaking even. This yields a 57.1% return on capital within 6 months – not bad, but not great, considering the risk and the potential deviation in returns. Note that I seek to maximize profits on what I believe to be, by far, the most likely scenario while minimizing losses in all other scenarios.

And what is the major risk? Simply put, stagnation. We are “buying volatility” in this basket, so if the stock price remains range-bound, the trade will be a loser. Moreover, the range is pretty darn wide.

We make money and/or preserve capital if the stock price is lower than $14.75 or higher than $30.25, representing a decrease of 43.1% and an increase of 16.6%, respectively, and lose money in all other scenarios. A tall order, indeed, but remember – we wouldn’t consider this type of trade in any but the most clearly volatile situations – situations exactly like the one facing GeoEye.

Disclosure: No positions

Comments

[NOWHEREMAN:]

Dual Degrees, PHD in either?

Track record?...

It either works or it doesn't, what sort of straddle creates a win regardless of the position taken from the Scenarios you have envisioned. I'd really like to know so I can apply it to everything and never, ever lose another dime.

What are your worst case scenarios?

2008 Sep 07 09:52 AM

[mikejw:]

You article is out of date. The launch was successful yesterday (6 September) and GeoEye-1 successfully deployed and responded to ground station commanding. The only other step is the calibration/ certification phase which is expected to be complete by mid to late October.

2008 Sep 07 10:43 AM

[Square Circle:]

Sorry guys, I submitted this on Thursday - not sure why it wasn't published until today.

For what it's worth, I looked at this as much as a discussion of options strategy as a specific treatise on GEOY. Also, a successful launch does not necessarily mean that the satellite will function as planned.

2008 Sep 08 11:52 AM

[Square Circle:]

Just checked - looks like this was up on Sep 5, the day before the satellite launched.

2008 Sep 08 12:50 PM