Name That Trade – $RHT: Tip of the Hat, or Wag of the Finger?

by Dan June 18, 2015 1:14 pm • Commentary

Event: Open source infrastructure software provider Redhat (RHT) reports fiscal Q1 results after the close. The options market is implying about an 8.5% one day move, which is rich to the 4 qtr avg of about 6.25%.

Price Action / Techncials:  The stock is up 13.5% in 2015, dramatically outperforming the Nasdaq, and many large cap software peers.  As for post earnings moves, it is important to note that following the last 2 quarterly reports the stock has gained 10% the next day (gaps circled), closing at new 14 year highs:

RHT 1yr chart from Bloomberg
RHT 1yr chart from Bloomberg

The stock has obviously held a very steady uptrend from the lows in October, and has been consolidating at highs not seen since 2000. 

On a longer term a basis the stock has consolidated and then gapped on earnings, rinse and repeat:

[caption id="attachment_54603" align="aligncenter" width="600"]RHT 3yr chart from Bloomberg RHT 3yr chart from Bloomberg[/caption]

Sentiment:  Wall Street analysts are fairly bullish with 23 Buy rating, 9 Holds and only 1 Sell with an avg 12 month price target of just $79.60. Short interest sits at just 3% of the float.

Valuation: Consensus is expecting 13% earnings and 12% sales growth in fiscal 2016. Not bad, but I am not sure it warrants trading at 43x expected earnings and 7x expected sales. Seems a tad rich for my blood.

Estimates and Forecasts from Bloomberg:
-1Q adj. EPS est. 41c (range 40c-41c)
-1Q rev. est. $472.7m (range $470m-$475m) vs forecast $469m-$474m (March 25)
-1Q billings growth est. 13.4% y/y (avg. of 3 ests.)

-2Q adj. EPS est. 45c
-2Q rev. est. $493.3m

-FY16 adj. EPS est. $1.81 (range $1.80-$1.83) vs forecast $1.79-$1.82 (March 25)
-FY16 rev. est. $2.01b (range $1.97b-$2.05b) vs forecast $1.99b-$2.02b (March 25)

My View into the Print: with the stock butting up against 15 year highs I suspect it would take a material beat and raise for the stock to breakout in line with the implied move, while the disappointments this week from ADBE, which was also right below 52 week highs, and ORCL last night suggest that investors might have been a tad to optimistic about enterprise demand for software of late. I would also add that the key culprit for ORCL’s disappointment was adverse currency affects, which RHT will not be immune to as 35% of their sales come from overseas.

As I felt with ADBE earlier in the week, expected growth does not justify the valuation in RHT, and I am hard-pressed to come up with a short list of potential acquirers who could or would buy RHT for a 30% premium to current price at about 10x sales, close to $20 billion.

If I had to choose, my sense would be to fade the move to the upside, targeting a pullback to the low $70s.  Option prices are obviously elevated into the print, making short dated long premium trades tough. One trade that looks interesting, if I were inclined to play for down move tomorrow is possibly the June 77.50/72.50/67.50 put butterfly for about 1.20 (stock ref $78.50).  This trade breaks-even at 76.30 on the downside, with a max gain of 3.80 at 72.50 and profits of up to 3.80 down to 68.70 while 1.20 is the max risk above 77.50 or below 67.50.

At this point I lack conviction on the move, and the odds on a long premium directional bet are obviously far worse than a coin flip. So gonna sit this one out.