Update W/ New Trade DELL: Q2 Preview, Term Structure Presents Trade Opportunity

by Dan August 21, 2012 2:48 pm • Commentary

See Update with New Trade below:

Event: Dell reports fiscal Q2 earnings tonight after the close.  The options market is implying about a 9% move which is inline with the average over the last 4 qtrs, but shy of the 8 quarter avg of about 7%.

Sentiment: Wall Street analysts fairly mixed on the name with 16 Buys, 18 Holds and 2 Sells and an avg 12 month price target of about $15.  Short interest sits at a surprisingly low 3% of the float.  

Balance Sheet: Dell has almost 65% of their market cap in cash, and 21% net of debt.  This seems fairly impenetrable, but over 75% of this cash balance sits outside the U.S., and aside from foreign acquisitions, the company would face serious tax implications if they were to repatriate under current tax laws.

In the Spring the company started to pay a dividend, with an indicated yield of about 2.5%, and the company has a fairly active share repurchase program which has been fairly effective at incinerating the companies hard earned cash over the last 5 years.  I read somewhere recently that DELL has bought back more than $40billion in shares over the last 10 years, that is nearly double the companies current market cap.

Valuation: As expected by almost every metric, the company trades near historical low levels.  Chart below shows on a PE, Price/Sales and Enterprise Value to Ebitda the stock trades at record low levels.

[caption id="attachment_15817" align="aligncenter" width="589" caption="DELL PE, Price/Sales & Ev/Ebitda from Bloomberg"][/caption]


Price Action:  DELL is down 15% ytd, and down about 32% from the 52 week and 3 year highs made in February, while only up about 9% from the 3 year lows made just last month.

Volatility: 30 day implied vol is through the roof at roughly 48, vs the 30 day realized vol of about 26 and the 90 day realized of about 40.

[caption id="attachment_15818" align="aligncenter" width="589" caption="DELL 30 Day Implied Vol vs 30 and 90 Day Realized from Bloomberg"][/caption]


My View: DELL basically checks all of the boxes for the classic “value trap” investment.  While the downside may be limited due to it’s strong cash balance, the company’s inability to grow sales and stem market share losses in their core business may cause investors to flee the name once and for all as we have recently witnessed in the handset space with RIMM and NOK.

Back in May when the company missed Q1 expectations they company did not give forward guidance citing poor visibility resulting from macro uncertainty.  I would suggest that the macro picture has gotten worse for PC makers and the trend towards tablets will only amplify these issues for company’s like DELL that appear to be very poorly positioned, especially as they now face competition from software partners such as MSFT and GOOG and electronics retailers like AMZN.  These guys are screwed!

The street fully expects the company to guide fiscal 2013 earnings down from the guidance of above $2.13 back in February to the current consensus of about 1.90.  SO a guide down is probably in the stock, but how much of a guide down?

We are currently evaluating a few different trades, but calendars probably make the most sense depending upon your directional bias.  Please look for an update email with trades by 3pm eastern.


Update Aug 21st, 2012 at 2:41pm:
The most noticeable discrepancy in the options market is the richness of September expiry. Looking for potential reasons why September options was so expensive relative to what would normally be expected, we saw that more than 30k contracts have traded in September today, with the majority lifting offers. As a result, we explored strategies that involved selling September options and buying October options.

We used our proprietary Implied Move Calculator tool to assess this strategy, entering in the following inputs:

First month implied volatility: 50
Second month implied volatility: 40.5
Trading days to first month expiry: 22
Trading days to second month expiry: 42

That yielded a forward vol calculation of 26, which implies that the market expects realized volatility between Sept and Oct to be around 26 based on current option prices between the 2 months. DELL has only registered such low volatility less than 20% of the time in the past 3 years, and given that it’s likely to be a month with plenty of macro headlines, short Sept / long Oct offers great risk/reward. Here is the trade:

TRADE: DELL (12.40) Bought the Sept / Oct 11 Put Calendar for .09

-Sold 1 Sept 11 Put at .26
-Bought 1 Oct 11 Put for .35

Break-Even 0n Sept Expiration:
-If the stock is 11 or above the Sept 11 Put will expire worthless and I essentially own the Oct 11 Put for .09, if the stock makes a move to 11 or below I will make or lose the difference btwn the options that I am long and the one that I am short. MY MAX RISK IS .09

Trade Rationale: As I said above, I don’t exactly want to press a name like this (see CSCO trade from earlier in the month), but if the company is unable to articulate the 50th iteration of their turnaround strategy, and gives guidance that’s worse than expected, than out of the money put calendars could be a low premium defined risk way to play for a move in line with the markets expectations to the downside.

If management were to somehow maintain forward guidance, and speak to improving sales trends with optimism heading into the supposed PC upgrade cycle associated with the introduction of Windows8, then the stock would likely fill in a bit to most of the gap from May, possibly to about $14. I am not willing to commit any real premium to make a bearish leaning bet, but this trade is certainly interesting for the reasons listed above.