Yesterday we previewed CSCO’s fiscal Q2 report (below) that will take place tonight after the close. Our conclusion is a fairly simple one, given the prior two guide downs, estimates and expectations are fairly low heading into the print. For instance analysts expect earnings to decline at a pace of 10% sequentially, the steepest decline since 2011, while analyst also expect earnings and sales to decline year over year for the first time since 2009. What does this all mean? Well if the outlook is not as bad as some fear, the stock probably has some room to the upside as it tests key technical resistance at $23 which would easily result in a gap fill to at least $24.
On the flip side, if the company comes inline with their prior lowered guidance and once again downgrades the future outlook on poor visibility in emerging markets, then the stock is very likely to see its 3rd consecutive quarterly gap, with the first line of support at the 50 day moving average of about $21.85, but then no real meaningful support to just above $20.
Given the results from some other large enterprise technology vendors I am hard pressed to see an outlook that meaningfully beats expectations, despite the fact that the quarter is probably not too much worse than expectations. In that scenario the stock probably hangs in as investors view the potential for a turn around, the companies strong commitment to cash return (3% div yield and multi-billion share repurchase) and their strong balance sheet as a decent place to hide out.
We want to offer some options strategies for those who agree with one of those views:
BULL:
Buy the Feb/April 24 call calendar for 0.17
– Sell to open 1 Feb 24 call at .27
– Buy to open 1 April 24 call for .44
BEAR:
Buy the Feb/ April 21 put calendar for 0.23
– Sell to open 1 Feb 21 put at .16
– Buy to open 1 April 21 put for .39
NEUTRAL: (looked at this but don’t love it)
Buy March 20/23/26 call fly for 1.50
– Buy to open 1 March 20 call for 2.94
– Sell to open 2 March 23 calls at .75 (1.50 total)
– Buy to open 1 March 26 call for .06
We like the calendars as a way to play for the difference in implied vol between Feb and April and get directional bets on for not a lot of premium. If the move is under the expected move, these trades will do well. The real risk to these positions it the stock blasting through the strikes in either direction as more than a dollar though the strike will likely mean a loser.
We don’t love the risk/reward of the call fly only being about 1 to 1. But this is the best structure to have a defined risk bet against a big move.
Our View: We do think if you are playing directionally, calendars are an attractive way to increase your odds due to the nearly 2 to 1 difference in implied volatilities between Feb and April.
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Previous Post Feb. 11th, 2014: $CSCO Fiscal Q2 Earnings Preview
Event: CSCO reports its fiscal Q2 earnings tomorrow after the close. The options market is implying about a 6% move, vs. the 4 quarter average of about 7.75%, and the 8 quarter average of about 7.25%.
Sentiment: Wall Street analysts are somewhat positive on the stock, with 25 buys, 16 holds, and 5 sells, though the average 12 month price target is only $23.71. Short interest is negligible, at just 1% of the float. CSCO has been underperforming the broader market for many years now, as the stock is in the exact same spot that it was 15 years ago, 10 years ago, and 3 years ago.
Options Open Interest: Calls outnumber puts by a ratio of about 1.25 to 1. The one month average options volume has also favored calls over puts, by a ratio of 1.45 to 1. Despite numerous gaps on earnings over the past 5 years, CSCO has been rangebound the entire time, so options sellers have generally been on the right side of the trade in the long run.
The followings strikes have over 50k of open interest:
-Feb22nd 22 calls
-Feb22nd 23 calls
-Mar22nd 21 puts
-Jan15 20 puts
-Jan15 25 calls
Price Action/Technicals: CSCO has been rangebound for more than a decade now. In fact, the stock has traded between $14 and $35 for all of the past 10 years, and is near the middle of its 10 year range today.
On a daily chart, the stock held $20 support in late 2013 after a bad earnings miss in November, and has rallied up to its declining 150 day moving average around $23.25:
CSCO has had two straight gaps lower on earnings, neither of which have been filled yet. The first gap from November is $23.99, while the second gap from back in August is $26.38.
Those are the levels to watch on the upside. On the downside, $20 remains the most important support level, with minor support around $22.
Fundamentals/Valuation: Cisco has declined sharply after each of the past 2 earnings reports. Management has blamed a weak international macro environment (CSCO gets about 40% of its revenues from abroad) and a production transition for the weakness. As a result of the consecutive misses, the bar for this week’s report is quite low.
However, the macro environment in emerging markets in particular is likely worse today than it was last year. While many large-cap tech companies have reported improved demand in enterprise spending over the last couple months (ORCL, RHT, JNPR, etc.), CSCO might have benefitted less from that pop because its ongoing product transitions.
Guidance will be crucial since analysts are modeling a better second half of the year. CSCO trades at 12x earnings, with earnings growth of about 5% expected over the next couple years. Its strong balance sheet and 3% dividend attract the conservative investor base. More tepid earnings growth over the next 12 months, though, would likely mean more rangebound price action for CSCO going forward.
Volatility: Implied volatility in CSCO has been very consistent over the past 2 years, rising into the earnings event into the 30’s, and then selling off to into the high teens after the event:
We anticipate similar behavior this time around as well. CSCO stock usually calms down after the earnings move, though the actual earnings gap can be quite large.
Estimates from Bloomberg:
- 2Q adj. EPS est. 46c (range 45c-47c), 45c-47c forecast reaffirmed Dec. 12
- 2Q rev. est. $11.03b (-9% y/y), forecast -8% to -10% y/y
- 2Q gross margin est. 61.9% (range 61.4%-62.5%), forecast Nov. 14 61%-62%
- 3Q adj. EPS est. 48c (range 45c-50c)
- 3Q rev. est. $11.34b (range $10.95b-$11.84b)
- 3Q gross margin est. 62% (range 61.2%-62.5%