New Trade – $ADBE: Chose the Acrobatic Structure

by Enis December 13, 2012 2:59 pm • Commentary

Update with New Trade Dec 13th,2012 at 2:58pm:

Dan laid out his thoughts in ADBE this morning heading into tonight’s earnings,  He concluded:

My sense would be that the macro headwinds in the quarter, and the generally weak trends in their media and advertising end markets that a beat and raise is probably unlikely, but if so, and just modest, the news is probably in the stock at 2 yr highs .

I agree with Dan, and the stock’s recent run to the high end of its 3 year range on multiple expansion rather than growing earnings is reason for a pullback.  In other words, risk/reward seems skewed to the downside for earning.  However, Dec implied vol is near 50, and Jan13 implied vol moved 2 points higher today, making Dec / Jan13 calendars less attractive.  But I noticed that Apr implied volatility around 29 was quite low, so I wanted to look for structures where I could buy Apr options and sell Dec or Jan13.

Here is a scenario analysis I did for 3 different potential trades on ADBE:  

I considered buying the Dec / Jan13 34 put calendar, the Apr 34 / Jan13 33 put diagonal, or the Apr 34 / Jan13 32 put diagonal:



I’ve included the current approximate cost of the trade at the top, and then based on stock prices for ADBE tomorrow between 31 and 39, I’ve shown where I expect the different structures to trade midday tomorrow.  My assumptions for implied vol are that Dec will be down around 18 vol points, Jan13 will be down around 2 vol points, and Apr will be down around 0.5 point.

The Apr 34 / Jan13 32 put diagonal is the home run trade.  It does the best on a 5%+ move to the downside, and the worst on a 5%+ move to the upside.  The Dec / Jan13 34 calendar does best on moves of less than 5% in either direction.  The Apr 34 / Jan13 33 diagonal is a mix of the 2 trades.

I chose the Apr 34 / Jan13 33 put diagonal for a couple reasons:

  1. It behaves almost as well as the Dec / Jan13 34 calendar in the small move scenarios (up or down a similar amount if stock is at 34, 35, 36, or 37 tomorrow).  It performs better than the calendar on the downside, and offers me more flexibility on the upside if the stock does move higher, since I am long a 4 month option.
  2. It risks less premium than the Apr / Jan13 32 put diagonal, and behaves better on the way up.  It performs as well as the wider diagonal down to $34.
Based on ADBE’s last 8 earnings reports, I don’t think the stock moves more than 6% tomorrow.  In that case, I like the risk/reward of the Apr 34 / Jan13 33 put diagonal, as well as the future flexibility in managing the trade after earnings.
NEW TRADE:  ADBE ($35.55) Bought the Apr 34 / Jan13 33 put diagonal for $1.15

-Bought 1 Apr 34 put for 1.70

-Sold 1 Jan13 33 put at 0.55






Original Post Dec 13th, 2012 at 11:01am:  Q4 Preview $ADBE 

Event: ADBE reports fiscal Q4 earnings tonight after the close, the options market is implying about a 5.5% move post earnings which is rich to the 3 qtr avg move of about 4.5%.

Sentiment:  Wall Street analysts are fairly mixed on the stock with 11 Buys, 12 Holds and 2 Sells, with an avg 12 month price target of about $35 (below where stock is currently trading).    Short interest sits at 3.5% of the float.

Price Action / Technicals: While the stock is up about 28% ytd, enjoying its best performance since 2009, almost half of these gains have come in the last month as the stock is now making new 52 week highs and approaching a break-out at 2 year highs.

[caption id="attachment_20536" align="aligncenter" width="490" caption="ADBE 2 yr chart from Bloomberg"][/caption]


The lack of volume on the recent run is a bit of cause for concern, but price action always matters most.  The entirety of the rise in the stock this year has been due to an expanding multiple, as earnings is flat in 2012 vs. 2011, and projected to grow 2% next year.  Here is the 5 year chart of the P/E ratio:



The P/E around 22 is not high historically, but it might be high given current growth prospects.

Volatility:  ADBE implied vol is relatively low compared to its average implied vol heading into an earnings event in the recent past.  Here is a 2 year chart of 30 day implied vol (red) vs. 30 day realized vol (blue):



Previous earnings dates are marked with a blue “E” box, which show that the current 30 day implied volatility is relatively low.  But a large reason for that is the low recent realized volatility, shown by the blue line.  Despite that low realized volatility and low 30 day implied volatility though, the market is implying a larger than average earnings move (5.5% vs. 4.5% average).  As a result, selling the earnings move seems to make a lot of sense.

Expectations:  Here is the table of Q4 consensus expectations, along with expectations for Q1 2013 (to compare to guidance) and 2013 as a whole.

eps sales op marg
Q4 0.56          1.1b 35.4
Q1 0.57        1.07b 36.2
FY13 2.36        4.48b 35.5

For Q4 the company guided on their last earnings call in Sept, EPS from .53 to .58, and Sales from$1.075b to $1.125b

My View:  ADBE is in the process of transitioning from a pure licensing model for some of their core products to a subscription model that they call Creative Cloud.  As customers have begun to adopt this new model over the last couple quarters, the company has been able to demonstrate better than expected results for subscriptions, but some bears in the name remain cautious on the impact of their Digital Media segment that accounts for almost 75% of their overall revenue.

My sense would be that the macro headwinds in the quarter, and the generally weak trends in their media and advertising end markets that a beat and raise is probably unlikely, but if so, and just modest, the news is probably in the stock at 2 yr highs .

We are looking at a few different trades, will most likely settle on a Dec/Jan Put Calendar.  Stay Tuned. We will post after we decide on the trade.