I laid out the fundamental and technical factors for EBAY earnings in the Q3 Preview yesterday. My main takeaway was that I think EBAY beats earnings, but valuation might be full. EBAY could also be vulnerable to selling simply from mutual funds selling winners (like we’ve seen in AAPL or AMZN this month).
I expect EBAY to beat. And I expect a tepid reaction to a beat. BUT, in the unlikely case that EBAY misses and/or guides below the street, the stock could be down big. In a heated RiskReversal debate today, we asked ourselves, what’s a structure that makes money in all potential scenarios, except a big spike higher?
Today’s trade is a complicated trade structure that we haven’t really done on the site before. I’m doing it in small size, and want to use it as a teaching moment, too. Let me lay out the trade first, then please read the Trade Rationale that follows where I explain the reasoning:
TRADE: EBAY ($48.00) Bought the Jan 13 47 / Nov 45 put diagonal for $1.70
-Bought 1 Jan13 47 put for $2.62
-Sold 1 Nov 45 put at $0.92
TRADE RATIONALE: At first, it looks nonsensical to buy a 2-dollar wide put spread for $1.70. But hear me out. This is similar to the put calendar trades we do on the site (where you pay premium for a 0-dollar wide put spread), but I’ve staggered the strikes. The ideal scenario is that EBAY ends November expiry at $45, at which point I will own the Jan13 47 strike, which will be worth much more than $1.70, since there will still be 2 months of time value.
Why this structure? Here are 5 potential scenarios for the stock tomorrow after earnings:
- Stock up 5% or more: In this scenario, my trade is a loser tomorrow. But my Jan13 put will take a long time to lose value, so it does give me more hope than if I did a pure Oct / Nov put calendar.
- Stock up small (around 2%): My trade is flat in this scenario. So if EBAY is $49 tomorrow, my spread should be worth around the same. That is because the Nov options will lose a lot more on implied volatility than the Jan13 options, giving me some protection on an up move.
- Stock unchanged: My trade should be up small (10-20 cents) in this scenario. Again, it benefits from Nov options losing value more quickly than Jan13 options.
- Stock down small (around 2%): This is an even better scenario, as I make more money on the Jan13 options directionally than I lose on the Nov options (Jan13 is a 41 delta, Nov is a 25 delta). I should be up around 20-40 cents.
- Stock down 5% or more: The best scenario is if the stock goes to around 45 tomorrow (at which point the trade should be up 60-80 cents). But even if the stock had a huge down move, my structure would be profitable, as I own a $2 wide put spread for $1.70.
In other words, the trade structure makes money in 3 of 5 scenarios, is flat in one scenario, and only loses on a big up move. That’s the reason I chose the put diagonal.
Q3 Preview Post Oct. 16th, 2012, 12:27 pm
Event: EBAY reports Q3 earnings Wednesday afternoon after the market close. The options market is implying about a 6% move, which is below the 4 quarter average of 7.5%, but slightly above the 8 quarter average of 5.5%. EBAY has rallied on 7 of the last 9 earnings reports.
Sentiment: Wall Street analysts are generally bullish, with 28 buys, 15 holds, and no sells. Traders are also generally bullish, as EBAY has only a short interest at 1% of float.
Balance Sheet / Fundamentals: EBAY has a very clean balance sheet, with little long-term debt. Its business is split up into 3 parts: the Marketplace business (classic eBay, as well as add-ons like StubHub), the Payments business (primarily Paypal), and GSI (an e-commerce and marketing business). Marketplace makes up 55% of revenues, Payments about 40%, and GSI about 5%. International is a big portion of the business, around 60% of revenues coming from outside the U.S.
The clear growth story that has been the driver of the stock in the past couple years is Paypal. The Marketplace business has been a 10% grower, but Paypal is growing 25-30%, and margins have actually been improving in the process (job cut announcement last week at Paypal might be another indication of management intending to keep margins high).
One last positive that makes me think eBay might report a beat this quarter. Given their international revenues, they took a hit on dollar strength in Q2. The dollar’s broad-based weakness in Q3 should give them a bit of a boost, in addition to the secular trends that have helped their earnings growth overall.
Valuation: I think this is where the debate will take place on whether the stock goes higher or lower. If earnings and guidance are positive, which I expect, the real question is whether valuation here is too rich or not. Here is the chart of the P/E ratio over the last 3 years:
The P/E is at 3 year highs as the stock is up almost 60% year-to-date. What’s interesting is that the projected growth rates from analyst estimates for 2013 and 2014 are the same as the earnings growth rate in 2011 and 2012. Clearly, investors and traders think analyst estimates are too low.
Price Action: My main fear on a bullish bet in eBay is that we could see mutual funds take profits on the names since it’s up 60% this year. Recent price action in tech winners is concerning for a name like eBay. But it’s held up better than most of its peers.
The 3 year weekly chart shows that the stock broke out above the $35 resistance level that contained the stock throughout 2011, and has not looked back:
On a technical basis, the recent high at 50.65 is resistance, and the June high around 44 should act as support.
Volatility: EBAY implied volatility displays the natural tendency to rally into the earnings report. It is particularly pronounced for EBAY relative to other names because its realized volatility is relatively low outside of earnings periods (in the absence of large macro moves). Here is the 2 year chart of 30 day implied vol, with the earnings dates highlighted with an E:
Vol in November is around 35 and will likely come in around 10 points following earnings. The weekly vol is in the 80′s which means calendars utilizing a short Oct weekly and long outer month is using relative vols in your favor.
My View: EBAY has been a huge winner this year. The fundamental story seems to be in good shape, and well diversified, both by business type and geography. But this year’s strong run has caused valuation to reach more concerning levels, and the stock’s strong performance this year could make it vulnerable to some profit taking in October and November. Since I expect the stock to beat, I don’t expect a big down move, but also think the valuation and profit-taking concerns likely cap the stock’s move on the upside. So all in all, I think the move is priced a bit cheap for a reason.