Name That Trade – $QCOM: Activist Bait?

by Enis November 5, 2014 1:45 pm • Commentary

QCOM reports earnings today after the close.  I detailed the earnings setup in yesterday’s preview, with the following conclusion:

Our View:  QCOM has consistently been viewed by investors as a Growth at a Reasonable Price stock over the past 5 years.  However, the “Growth” part of that equation is starting to get strained.

QCOM is a 15x P/E stock, so the valuation remains quite reasonable.  But EPS growth over the next 2 years is only expected to average around 5-6%, on sales growth of about the same.  That’s a far cry from the 10-30% EPS growth over much of the past 5 years.  More worrying perhaps is the possibility that the smartphone market has become saturated in the near term, which could hurt QCOM and possibly cause flat EPS growth over the next year.

With the stock pushing against technical resistance, and the fundamental backdrop far from stellar, the risk/reward in QCOM shares seems skewed to the downside for the first time in many years.

That’s the overall view.  We wanted an options trade that took those factors into account without risking too much on just the earnings event.  With that in mind, here was the idea:  

We did not execute this trade because of the reasoning explained in the rationale, though this was our preferred structure.

Hypothetical Trade:  Buy the QCOM ($77.10) Dec20th 77.5/70/62.5 put butterfly for $1.75

-Buy 1 Dec20th 77.5 Put for 2.50

-Sell 2 Dec20th 70 Puts at 0.45 each or 0.90 total

-Buy 1 Dec20th 62.5 Put for 0.15

Break-Even on Dec20th Expiration:

Profits: btwn 64.25 and 75.75 make up to 5.75 with max gain of 5.75 at 70

Losses: btwn 62.50 and 64.25 lose up to 1.75, btwn 75.75 and 77.50 lose up to 1.75, below 62.5 and above 77.5 lose full 1.75

Rationale:  QCOM faces significant resistance between $78 and $82.  Add to that the high bar the stock has for both this quarter and next quarter, and I would be quite surprised to see a beat on both the current expectations as well as guidance for next quarter.  That’s the risk that could cause a breakout to new highs, but I see it as low probability considering the stock’s backdrop.  Finally, the chip sector as a whole has generally gotten hit on earnings reports in the past month.

BUT, the reason why I did not pull the trigger on this trade is that QCOM is one of the very few remaining large cap tech stocks that has a totally unlevered balance sheet.  The company has $33 billion in cash and no outstanding debt.  As a result, the upside risk is that QCOM announces a significant levering of its balance sheet, which could be the one major positive catalyst for the stock outside of earnings.

As for the structure, the Dec put fly targets the October low around $70.  The risk/reward is attractive since the break-even of the trade is $75.75, which is only 1.5% lower than the current level.  This structure also holds its value ok if QCOM is flat to slightly higher tomorrow after the report.