Name That Trade – $CSCO Skid

by Enis August 28, 2013 2:37 pm • Commentary

We haven’t traded CSCO much this year, but we’ve followed the story closely.  Here is what Dan had to say in the earnings preview from earlier this month:

CSCO was a bit of a show me story for the better part of 2012 and 2013.  It wasn’t until the company’s beat and raise back in May where CSCO checks multiple boxes as it relates to current investment thesis.  Despite earnings and sales that are expected to grow slightly above mid single digits for the next couple years, the stock is cheap on a historical basis at ~12.2x next years expected earnings and to many of its peers.  The company has 35% of its market cap in cash (~$50 billion) and about 22% net of cash, they pay a dividend that yields 2.6%, and as of Jan. 26th the company has purchased and retired 3.8 billion shares at an avg of $20.34, with about $5 billion left on their current authorization.

The company has spent the last few years shedding non-core businesses and cutting costs and moving away from legacy low margin comiditized products (routing) and make progress in storage networking and services.

The stock ended up getting hit after that earnings report, as the company’s outlook was less optimistic than in its May report, and it announced that it was cutting 4,000 jobs as it continued to use the cost lever to maintain earnings.  The real disappointment was in the Asia-Pacific region, where order growth was down 3%, the first year-over-year decline in almost 4 years.

Fortunately for CSCO, it still gets about 60% of its revenues from the U.S. and Canada, which have been the better regional performers in the past year.  The stock has been in a straight line lower ever since the earnings report (today is actually its 6th straight down day), but this has become a value stock where management has a keen focus on maintaining earnings power.  

The stock’s 3 year chart shows the long-term importance of the $22 level:

[caption id="attachment_29715" align="alignnone" width="600"]Daily chart of CSCO, 50 day ma in pink, 200 day ma in black, Courtesy of Bloomberg Daily chart of CSCO, 50 day ma in pink, 200 day ma in black, Courtesy of Bloomberg[/caption]

In the short-term, $22 is still 6% away, and the stock is already quite oversold, so the stock’s low in May at $23.06 is the level we’re watching.  Given the large gap lower, we think the 25-26 area is likely to be resistance, but the with 22/23 as strong support, we might look at initiating a long biased position anywhere near $23, with upside capped above $25.  Two potential trade structures if the stock got near $23:

Buy the Nov 23/25 Call Spread for $0.65

-This trade structure would capture CSCO’s next earnings event, and would be a decent risk/reward way to play for a retest of the 25-26 area.

Sell the Oct 25/22 Put Spread at $2.00

-This trade structure would be a different way of getting long CSCO stock, but only risking $1 of downside for $2 of upside.  Since we don’t expect a move above 25/26 in the near term, this structure gives us similar risk/reward to long stock with much less risk.

For now, we’re just keeping our eye on CSCO stock as it sells off, but we wanted to get our full thoughts out there in case it comes time to pull the trigger.