ERTS Trade Update

Update: ERTS report their fiscal Q1 tonight after the close.  The options market is implying about a 5.5% move following earnings vs the average over the last 4 qtrs of about 9%.  I took this short put off soon after the results back in May and now today before earnings think it makes sense to sell out of the long call.   The Sept 22 call can be sold at about 2.45. A couple weeks back the company used half of their cash balance to buy a company called Popcap for $1.3 billion, some analyst/investors wondered if this was a good use of their cash to push into mobile and social gaming.  What does this mean for their near-term results? are they being reactionary?  Who knows, but with the stock’s 60% run off this years low it may make sense to look for a better entry point to play longer term.

If you still think there is more upside you may want to roll a call spread up and out.  At this point with the way stocks are moving around following earnings, I don’t want to be complacent here, if you can’t put your finger on the exact reason why you are long or short than you may want to cut the position.   In times of uncertainty, which we are definitely in now (or at-least this week), don’t be afraid to be defensive or in cash.

ORIGINAL POST MAY6, 2011:

Wednesday evening ERTS reported an earnings beat, and while guidance was a bit light the company gave color regarding the release of the much anticipated Star Wars multi player online game which gives analysts and investors some comfort with the pipeline and the digital strategy.

-Stock is up 10% in 2 days outpacing the implied move……

-If you put on the suggested trade from Wed (below),  the ERTS Sept 17/22 Risk Reversal for ~.45 (now worth ~1.50) as stock replacement or preferred to buying the stock then you have this thing right where you want it and may want to consider some trade management.

CONSIDER:

1. covering the Sept 17 Put for ~.25 as it is a 10 delta option and it is kind of like being short a tale at this point…..Once you do that then you are only risking the value of the call that you are long.

2.Additionally you may want to consider locking in some gains by selling a further upside call against the call the Sept 22 call that you are long.  You could sell the Sept 25 Call at ~.70…THEN YOU OWN THE SEPT 22/25 CALL SPREAD FOR ESSENTIALLY NOTHING.

-You originally spent .45 for the risk reversal, now worth 1.50.  So if you cover the Sept 17 Put for .25, then you have reduced the potential profit by .25, but you have also reduced your risk.

-If you sell the Sept 25 call against the Sept 22 call that you own then you now have spent .70 (.45 for the RR and then .25 to buy back the Sept 17 Put=.70) and now you have guaranteed, that you can not lose on the trade and could make a max gain of 3.00 (the difference btwn the Sept 22 call that you own and the Sept 25 call that you are short.)

-want to make one last point, when I wrote this up on Wednesday i deliberately didn’t want to cap gains by selling a call against the one that i owned just in case of take over chatter or an actual deal…..If you are apprehensive of doing that, but want to lock in gains consider selling a call spread against the Sept 22 call……For instance you are long the Sept 22 call and you sell the Sept 25 call but then also buy a higher strike call in case the stock ramps and you would start to participate again on the long side.  Problem is that there are not options listed above 25 strike at the moment.

ORIGINAL POST May 4, 2011:

EVENT: ERTS (20.16) reports fiscal q4 2011 earnings tonight after the close.

-Options market is implying ~7.25% move vs the 8 qtr average of ~7.5%.

PRICE ACTION / SENTIMENT / FUNDAMENTALS:

-stock is up 22% ytd, outperforming the Nasdaq up 7%.  Since the stocks ramp from the lows earlier in the year, short interest has picked up meaningfully from ~2% in February to ~7.5% of the float in April.

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-In the latest 13f data available for Q4 2010, 14 of the top 20 largest holders added to positions, while only 4 sold some.

-analyst community fairly mixed on the name with 13 Buys, 12 Holds and 2 Sells….avg 12 month price target ~21.00.

-In February, the stock rallied off of near multi-year lows on a tepid earnings beat (they have been hard to come by in the name for sometime) and the announcement of a $600 million stock buy back.  Chart below shows ERTS’s massive out-performance to the Nasdaq 100 over the last few months.

-Stock has held the gains from February and has benefited from positive sentiment and raised guidance by GME in late March…..Since GME offered upside revenue guidance on March 24th the stock has rallied a little over 20%.

-ERTS investors expect a beat for fiscal Q4, but the stock will likely trade on the guidance issued for FY2012.  There are a few potential uncertainties that could weigh on the company’s ability to offer upside guidance for fy 2012….1. NFL lockout could hurt sales of the Madden franchise, 2. ERTS has high reliance on package product sales, even though the company has shown good growth in digital they will need to continue to make big strides to diversify a bit in path to margin expansion….3. title slate for fy 2012 also very important as pipeline and calendar often drive stock price……

-Valuation is in-line with peers with mid to high teens PE…..ERTS has a strong balance sheet with almost $6 in cash and no debt…..

MY VIEW: With the stock at multi-year highs, it will clearly need a beat and raise quarter to break out to the mid twenties, which at the moment I would be hard pressed to see the company offering overly aggressive guidance in the face of the NFL situation.

-The company has long been rumored as a take-over candidate, either by a large media company or a tech titan like MSFT.  The problem here is that there is no sales growth.  Company has massive brand value with franchises like EA Sports, but has not of late been able to make any new breakout titles.  While the stock is not particularly cheap on most valuation metrics, excluding its almost $2billion in cash, the company could be easily acquired.  But per usual that is not a great reason to buy the stock.   Even with volatility elevated, I want to resist the desire to overwrite longs or offer structures that would cap gains in this healthy m&a environment.

WITH A LOT OF GOOD NEWS IN THE STOCK, LONG HOLDERS, OR THOSE CONSIDERING NEW LONG POSITIONS MAY CONSIDER STOCK REPLACEMENT/REPLICATION STRATEGIES AS THE COMPANY’S VISABILIY AS A RESULT OF NFL/MADDEN SITUATION MAY HURT THEIR ABILITY TO OFFER UPSIDE GUIDANCE FOR FY2012 EVEN IN THE FACE OF COST REDUCTIONS AND GROWTH OF DIGITAL.

TRADE; ERTS (stock 20.16)   BUY THE SEPT 17 /22 Risk Reversal for ~.45

-Sell Sept 17 Put at .50 (~20 delta option at 36.41 vol)

-Buy Sept 22 Call for .95 (~37 delta option at 32.74 vol)

Break-Even on Sept Expiration:

Upside: above 22.45 ( up 11%) you make money, btwn 22 and 22.45 lose up to .45

Downside: bwtn 22 and 17 lose .45, below 17, you are put the stock and lose the .45 premium that you paid, so you have effectively paid 17.45 for the stock, down 13%.

TRADE RATIONALE: Stock has rallied to the high end of the multi-year range on news/guidance that has yet to be validated, this is still a wait and see story……Uncertainty regarding product cycles and the company’s ability to grow sales will be major focus……option market reflects this as Vols are elevated in the name, current implied vol around 37 is trading rich to its 60 day realized vol of ~22 and its 90 day realized of ~32.    This structure offers a band in which you can get long on Sept expiration without making the commitment to buying the stock at current levels in front of what will be 2 key earnings events.  I chose the 17 strike Put as that is the approximate level of the 200 day moving average.  The 22 strike call was chosen as a level that would confirm the break-out above the multi-year range.  If the company beats Q4 and offers guidance less than street expectations, but not a disaster calling into question their credibility the stock will likely see a sell off within the implied move……Flip side is if they are able to show digital results that give some clarity to the their longer term goals then could casue shorts to cover and large holders to add sending the stock near term to 22-23.