$CSCO Fiscal Q4 Earnings Preview

by Enis August 12, 2014 12:01 pm • Commentary

Event:  CSCO reports its fiscal Q4 earnings tomorrow after the close.  The options market is implying about a 5% move, which is below both the 4 quarter and 8 quarter average move of about 6.75%.

Sentiment:  Wall Street analysts are mixed on the stock, with 29 buys, 17 holds, and 5 sells, and the average 12 month price target is only around $26.50.  Short interest is negligible, at just 1.5% of the float, though that is near a 2 year high.  CSCO has outperformed the broader market and the Nasdaq index in 2014, rallying 12.5% year-to-date.

Options Open Interest:  Calls outnumber puts by a ratio of about 1.2 to 1 in total open interest, much of that difference due to much more calls trading in the past month.  The options volumes over the past month have favored calls over puts by a ratio of 2.1 to 1.

The Aug16th 25 and 26 calls have been particularly active, and both have over 40k of total open interest.  The Sept 27 calls have over 140k of open interest, the most of any single strike.  The Oct 26 calls and the Jan15 25 calls also both have over 60k of open interest.  The 25 to 27 area is of obvious importance for options market makers.

On the put side, the Jan15 20 put has over 75k of open interest, and the Jan16 15 put has over 100k of open interest.  

Price Action/Technicals:  CSCO is one of the few defensive, mega cap tech stocks that has not made a new 52 week high in the past few months.  While the stock has shown some strength, it remains below its summer 2013 high around $26.50:

[caption id="attachment_44093" align="aligncenter" width="600"]CSCO daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg CSCO daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]

However, the stock has remained within striking distance of a new high, and this week’s earnings report could be the catalyst.  On the downside, $24 is the obvious support level to watch as the May earnings gap remains unfilled.

On the longer-term 10 year weekly chart, CSCO is not on the verge of a major long-term breakout a la MSFT or INTC:

[caption id="attachment_44094" align="aligncenter" width="600"]CSCO weekly chart, Courtesy of Bloomberg CSCO weekly chart, Courtesy of Bloomberg[/caption]

A break above the 2013 high near $26.50 would leave the $27.74 high from April 2010 as the only major obstacle before targeting the price spike between $30 and $34.24 from 2007.

Fundamentals/Valuation:  Dan laid out the bull case for CSCO in a new trade post in late June:

Back in late March, when CSCO was just below $22, I made similar argument (read here) that I am going to make now, that despite what amounts to anemic expected sales and earnings growth, the stock is attractive because it has a massive cash balance, a commitment to cash return (stated policy for capital allocation “return a minimum of 50% of our free cash flow annually through dividends and share repurchases” currently 3% dividend yield and $4 billion worth of stock bought back in fiscal Q2 and $2 billion in fiscal Q3), geographic reach and rock bottom valuation (trades 11.5x next years expected earnings, VS INTC and MSFT  at 14.5x.)  Since I first made the argument, CSCO has rallied about 10%, which represents much of its year to date gains. But the stock still lags many of its old tech peers like INTC and MSFT which have both made new 14 year highs, while CSCO is till 27% below its 2007 high.

My largest concern with CSCO is the lack of expected growth, analyst expect earnings and sales to only grow about 5% in the current fiscal year, which is essentially in line with that of most mega cap tech peers, but for some reason CSCO trades at a healthy discount.

GS Research is also bullish on the stock, though they expect more improvement in the next 2 quarters:

We expect Cisco’s results and guidance to be in line to modestly above consensus, with book to bill above one, as the company begins to see the benefits of its switching and routing product cycles. We expect further acceleration into 2H, aided by easy comps and improving end demand in the enterprise and public sector verticals.

It’s an important point about easy comparisons – sales are expected to actually decline year-over-year, and EPS is expected to be flat year-over-year for the August and November quarters combined.  That’s a low bar for CSCO until the end of the year.

Volatility:  CSCO is pricing in a slightly lower than normal implied move (5% vs. the 6.75% average of the past couple of years), and overall implied volatility is also slightly lower than the norm of the past 2 years:

[caption id="attachment_44095" align="aligncenter" width="600"]30 day implied volatility in CSCO, Courtesy of Bloomberg 30 day implied volatility in CSCO, Courtesy of Bloomberg[/caption]

CSCO has had very low realized volatility since the May earnings gap higher, so options traders are not expecting much volatility after the earnings move this month as well.  Expect 30 day implied volatility to fall back into the mid-teens after the event.

Our View:  Despite CSCO’s 12% ytd gains, it has failed to keep pace with other large cap tech peers, with many like MSFT and INTC matching levels not seen since the internet bubble burst.  CSCO’s relative under-performance suggests a continued underweight positioning by large capital pools, which coupled with low expectations could create a scenario where the stock plays catch up on the slightest bit of good news.  We made our play last  month with a Sept 25/27 call spread, but exited for unchanged as the inability for the stock to meaningfully break above $26 which suggests considerable technical resistance. For now we are on the sidelines as we see the risk/reward fairly balanced with three likely outcomes.

First: Q4 inline and full year guidance just enough and the stock settles between $24 and $26

Second: Q4 miss and guide down and stock goes back to technical support at $23 which is also the 200 day moving average.

Third: Q4 beat and raise of full year fiscal 2015 guidance and stock rallies 10% to the five year high made in 2010, just below $28.

I suspect the base case is the inline qtr and guidance and the stock is between $24 and $26 which would mean that structures both bullish and bearish may want to focus on selling the move. But for us the premiums aren’t enough to be worth the risk reward.