Name That Trade(s) – $CSCO Skid?

by Dan October 21, 2015 2:03 pm • Commentary

Last week it was Intel (INTC) and Seagate (STX), yesterday it was IBM, and today it’s VmWare (VMW), all reporting results and issuing guidance that speak to weak demand from businesses for hardware and services.  VMW’s 20% decline today is sort of eye-popping when you consider just last week their CEO referred to the company as the “crown jewel” of the convoluted $67 billion debt fueled acquisition of EMC (who owns 80% of VMW) by private DELL. Today’s price action in VMW, possibly exacerbated by the proposed structure of the deal, of which EMC’s VMW holding plays a key role in getting it done (the FT did a great job of breaking it down here).

But with all of these warnings, one would think that sentiment would be just a tad worse towards large cap tech stocks given the outlook for global growth and enterprise demand for tech products.  Which leads me to Cisco (CSCO). The telecom equipment provider who has large exposure to big businesses both here and abroad, with 40% of their sales coming from outside the U.S.  The stock has had a brilliant run in October, up almost 12%, putting the stock back in the black for the year, currently up about 2.5%.  I would add that since making am 8 year high in February, the stock has made a series of lower highs and lower lows, and today just failing at the downtrend:

CSCO 1yr chart from Bloomberg
CSCO 1yr chart from Bloomberg

In the near term the stock could be vulnerable to a pullback as investors digest a larger swath of tech earnings and consider the potential for the recent market bounce discounting any good news, while also creating the potential for sharp declines in the event of miscues like we have seen in IBM, STX & VMW.

Looking past CSCO expected fiscal Q1 report on November 12th, it’s hard to ignore the vigor of the new CEO, the company’s propensity for cash return which last year equaled almost $9 billion, or 70% of their free cash flow and the fact the stock trades 12x earnings, well below a market multiple.  Oh, and the 16 year chart below shows what has been a long dirt nap for the stock as it has spent the better part of the post area between the mid teens and the high $20s:

CSCO 16 year chart from Bloomberg
CSCO 16 year chart from Bloomberg

The stock is clearly threatening a breakout of epic proportion, and if the company were able to report inline and guide up, a 3 handle is coming to a theater near you. That said a $28.50 long entry after the stock’s recent run is not advisable.

Options prices remain elevated in CSCO, with 30 day at the money implied volatility just below 24%, very near the levels it usually gets to right before earnings:

CSCO 1 year chart of 30 day at the money implied volatility from Bloomberg
CSCO 1 year chart of 30 day at the money implied volatility from Bloomberg

If I were inclined to look past the upcoming quarter a set up for an early 2016 breakout I might consider the following trade:  

Potential Trade; CSCO ($28.50) Buy Feb 26/30 Risk Reversal for 5 cents

-Sell to open 1 Feb 26 put at 65 cents

-Buy to open 1 Feb 30 call for 70 cents

Break-Even on February Expiration:

Profits:  above 30.05, up about 5.5%

Losses: of 5 cents between 30 and 26, with losses of 1 to 1 as if long 100 shares of stock below 26, down 9%.

Rationale: the break-even to the upside is far closer than that of the downside representing heightened fear of a downside move by options market makers.  The company will also pay a 21 cent dividend in January.



CSCO ($28.50) Buy Nov 28.50/26 put spread for .62

-Buy to open 1 Nov 28.50 put at 79 cents

-Sell to open 1 Nov 26  put 17 cents

Break-Even on Nov Expiration:

Profits: between 27.88 and 26 make up to 1.88, or 3x premium at risk

Losses: up to 62 cents between 27.88 and 28.50, max loss of .62 above 28.50

Rationale:  The stock is overbought and the fundamental inputs from large tech companies speak to potential weakness in CSCO’s own end markets.