Event: Cisco Sytems (CSCO) reports fiscal Q1 results tonight after the close. The options market is implying about a 5.5% one day move tomorrow, which is rich to the 4 qtr average of about 4%, but shy of the 10 year average of about 5.8%.
On October 23rd, following Microsoft’s (MSFT) 10% post earnings explosion that brought the stock to new 15 year highs, we took a look at CSCO, and the potential for it to have a similar catch up move after tonight’s results (here). We concluded:
I have been cautiously optimistic on CSCO for a while now, which may mean it is right to finally pull the trigger. Here is the thing, the stock is very cheap relative to most if not all mega-cap tech peers. Like MSFT they have a new CEO who is looking to right his own script for the company they inherited, have a killer balance sheet, committed to massive levels of cash return. CSCO’s exposure to emerging markets could be a problem if we don’t get an uptick in global growth anytime soon, and the recent bounce of the dollar is likely to pose no shortage of headwinds to forward guidance, but it seems for now investors are looking past know headwinds.
I’m not pulling the trigger on today’s euphoria but this simple trade makes sense on a slight pullback for those that want to play for a breakout. Options prices are not exactly cheap, but these fairly near the money calls capture two earnings events, and if I were to get a move through the long call strike it would give me the opportunity to spread the call by selling a higher strike call in the same expiration, reducing my premium at risk.
At the time, when the stock was $29.20, or about 4.3% higher than current levels, the idea was to buy calls at the long term breakout level, $30:
On a much shorter term basis CSCO recently got rejected just above $29 at technical resistance. It is now hovering around its 200 day moving average (purple below) at $28.10, with near term support at $27 and massive one year support at $25:
Implied Vol SnapShot: Short dated options prices have ticked up to levels of the prior three earnings reports, with the big difference that 30 day realized vol (how much the stock has been moving) is well above levels of the last three reports. So in relative terms, (implied vs actual) options prices are not as expensive as they have been in the prior quarterly reports:
Estimates and Forecasts from Bloomberg:
- 1Q adj. EPS est. 56c; Aug. 12, CSCO forecast 55c-57c
- 1Q rev. est. $12.65b, up 3% y/y; CSCO forecast 2%-4% growth
- 1Q gross margin est. 61.9%; CSCO forecast 61%-62%
- 2Q adj. EPS est. 56c (range 53c-59c)
- 2Q rev. est. $12.54b, up 5% y/y (range $12.01b-$12.88b)
- 2Q gross margin est. 61.9% (range 60.5%-62.5%)
My Take: the main headwinds for CSCO are not as former CEO John Chambers used to say “the things that they can control”. Since the company reported Q4 results and gave Q1 guidance on August 12th, there have been some seismic shifts for U.S. multi-nationals. First, the day before the report the PBOC devalued the yuan, and the repercussions for global risk assets were massive, if you have not forgotten. Despite most equity markets having come back to mid August levels, the U.S. dollar (DXY) is a couple percent higher, and with the backdrop of continued easing from most every other major central bank on the planet, I am hard-pressed to see US dollar too much lower anytime soon. CSCO gets about 40% of their sales from outside the Americas, and the real question is how investors will react to what was likely a challenged quarter in emerging markets, with guidance that factors in dollar headwinds.
To be frank, since we outlined the bullish trade last month, its my sense that investor sentiment has changed a bit, a tad less sanguine on global growth, and the ability for US multinationals to offset currency headwinds in what could be a rising US rate and dollar environment. I find the trade set-up much less compelling now for a breakout and I am more inclined to see the stock’s reaction to guidance, and then trade.
Trade Ideas: A few weeks back, after MSFT’s breakout, the idea for those inclined to play for a massive long term breakout was to merely buy calls at the breakout. Since we detailed the trade idea on Oct 23rd (we did not pull the trigger), the stock is down 4.2%, and the Feb 30 calls have lost 45% of their value. This is a perfect example of how difficult it can be to express directional views with straight up long premium trades.
With the stock a little lower, implied volatility across the term structure lines up for an interesting two legged trade for those who are inclined to play directionally. Vertical call calendars where we can finance January by selling a Nov13th weeklies at a slightly outside strikes.
For those looking to finance a bullish view into the new year:
Bullish: CSCO ($28) Buy Nov13th 29.5/ Jan 29 Vertical Call Calendar for 50 cents
- Sell 1 Nov13th 29.50 call at 13 cents
- Buy 1 January 29 call for 63 cents
Rationale – This is a defined risk breakout play that only risks .50 but has unlimited upside if the stock expires on Friday below 29.50. The risk here is being wrong on the magnitude of the move. If the stock gaps above $30 on earnings the profits quickly trail off as the Nov13th weekly calls sold short are essentially short stock vs The Jan calls (which would be less than 100 deltas). But you won’t lose on this trade if that happens. You will merely break even. If the stock were to go down on earnings you may find yourself with a small loser but you are unlikely to lose the entire .50 (unless the stock was down massively and the Jan 29s were worthless (unlikely).
For those that think the stock trends back towards the recent lows:
Bearish: CSCO ($28) Buy the Nov13th 26/ Jan 27 vertical put calendar for .65
- Sell 1 Nov13 26 put at .10
- Buy 1 Jan 27 put for .75
Rationale – Similar to the call vertical calendar this targets support around 26 which is just outside the implied event move. If it were to move substantially lower this trade would be a winner but profits would be locked in below 26. A move higher and this trade will lose money as your essentially just long the Jan 27 put for .65.
In Sum: On both of these trades if the move is inside the implied the Jan portions can then be spread further either by rolling the front month of the calendar into Dec or simply creating a straight vertical within January.