New Trade CMI – Playing for a Selloff INTO Earnings

by Enis October 1, 2012 3:45 pm • Commentary

Cummins has been on my radar ever since I first wrote about Caterpillar and its ties to the China back in May.  In that post, I discussed the price signals being sent by FXI and copper, a key industrial commodity with financing implications for various Chinese businesses.  Cummins is not as tied to mining as Caterpillar, but its international exposure to the industrial business cycle is quite similar.  Around 60% of its revenues come from outside the U.S., with significant exposure to the BRIC infrastructure story.

Despite the recent party thrown by central banks, CMI has been a serious laggard, registering 2 month lows last week, and failing an attempted bounce again today.  Here is the 1 year chart that shows its roller coaster ride this year:



The huge volume from its July pre-announcement stands out as a capitulation event, but the stock is basically flat since the broader market’s June lows, significantly underperforming this summer.  The stock has rapidly given back its QE rally gains as well, and this weakness has a valid fundamental basis in my view.  The stream of negative manufacturing reports internationally will likely weigh on CMI’s Q3 results as well.    

CMI reports earnings on Oct. 25, and though estimates have come down since last quarter, 2013 estimates still look too high, pricing in 10% earnings growth in a weakening environment.  Analysts have not yet capitulated either, with CMI sporting 12 buys, 10 holds, and 0 sells, for a name that has sold off 30% from its highs earlier this year.  Valuation seems cheap at 10 times earnings, but it feels like a classic value trap at this point in the cycle.

More importantly, both CMI and CAT have had a tendency to sell off into earnings reports over the past 2 quarters, as investors have gotten more nervous about the fundamental backdrop.  That tendency, and the legitimacy of the fundamental concerns, got me interested in option plays.

Expectations seem likely to be quite low by the time CMI actually reports results.  You could get a JOY type scenario (JOY reported in late August, weak results, but guidance wasn’t as bad as expected, and expectations were so low, that the stock rallied by the close).  However, until the report actually comes out, I think traders will be nervous to buy this dog.  So I wanted a trade that doesn’t take the earnings risk, but plays for a selloff ahead of the report:


TRADE: CMI ($92.35) Sell October 90 / 95 call spread at $2.50
  • Sell 1 Oct 90 call at $3.85
  • Buy 1 Oct 95 call at $1.35

Break-Even on October Expiration:

  • Profits btwn 92.50 and 90.00, with max profit of $2.50 below $90.00
  • Losses btwn 92.50 and 95.00, with max loss of $2.50 above $95.00

I decided to sell a call spread rather than buy a put spread because there are no catalysts for CMI to sell off hard between now and October expiry, but I do think any gains will be capped as traders get nervous about the fundamental setup ahead of the earnings report.  Though risk/reward is only 1 to 1 here, my odds of winning are better than on trades where we’re buying premium.