Trade Idea – $NTAP On Tap

by Dan November 18, 2015 12:56 pm • Commentary

Event: NetApp Inc (NTAP) reports Q3 results after the close.  The options market is implying about a 8.5% one day move, which is rich to the 4 qtr avg one day move of about 6%, which is essentially the average quarterly one day move for the last 10 years.  

NTAP has been on my radar since the fairly convoluted merger proposition from private company DELL to acquire data storage company EMC (which owns 80% of virtualization software provider VMW) for cash and a huge slug of debt for a combined value north of $65 billion . This deal was blessed by influential activist investor Elliot Management who was a large EMC holder and been very active in technology over the last five years.

Which brings me back to NTAP, a former target of Elliot, from a post on Oct 15:

Elliott had once set their sites on another data storage company,  NetApp (NTAP), accumulating a 6% position in the stock in early 2013 with the intent to push for greater cash return.  Interestingly, Elliot got their way but exited their stake a year later as the stock was lower.

What’s interesting to me about NTAP is that while sales have been flat to even down low single digits since 2012, sales at EMC haven’t been much better, in the mid to low single digits for the last couple years.  And what does stick out with NTAP is the strength of their balance sheet. With a $10 billion market cap, the company has $5 billion in cash and only $1.5 billion in debt. The company has an existing $2.5 billion share repurchase program in place and pays a dividend that yields 2.15% (a tad better than the yield on the 10 year treasury.)

Not much has changed since I wrote that a month ago, despite the fact that the stock has declined almost 10%, and now has a $9.1 billion market cap.

Technicals: Taking a quick look at the five year chart, mid $20s on the downside seems entirely possible on a meaningful downgrade to forward guidance, which could be in the offing. And with that, I’d be hard pressed to think that any sort of deal could get done below $40:

[caption id="attachment_58670" align="aligncenter" width="600"]NTAP 5 year chart from Bloomberg NTAP 5 year chart from Bloomberg[/caption]

Implied Volatility Snapshot / Options Open Interest:  Short dated options prices are through the roof, approaching multi-year highs:

[caption id="attachment_58672" align="aligncenter" width="600"]NTAP 3 yr chart of 30 day at the money implied volatility from Bloomberg NTAP 3 yr chart of 30 day at the money implied volatility from Bloomberg[/caption]

Despite the fact that total options volume is nearing 52 week lows and open interest is well below the 52 week highs from the spring, showing general hedge fund disinterest:

[caption id="attachment_58673" align="aligncenter" width="600"]NTAP 1yr options volume and open interest from Bloomberg NTAP 1yr options volume and open interest from Bloomberg[/caption]

So what’s the trade? If you were of the mindset that the company’s rock solid, possibly under levered balance sheet could attract financial buyers, or that combined with cheap valuation, and the merger activity in the space could attract a strategic buyer, than it could make sense to sell short dated expensive out of the money calls to finance owning longer dated calls.  We are going to be patient and see how the stock reacts to what we suspect will be disappointing results, but this is how we would play for a bounce:

Trade – Buy the Nov/Jan 34 call calendar for .40
  • Sell 1 Nov 34 call at .30
  • Buy 1 Jan 34 call for .70

Rationale – This trade targets potential near term resistance to the upside. And finances upside calls by the sale of calls expiring this week. The Vol sold in November is about 100 points higher than that bought in January, albeit the Nov vol expires this week and is therefore pumped beyond recognition in order to not be too dollar cheap. But that does provide an opportunity. The risk of this trade is the stock tanks and the January calls become somewhat worthless lotto tickets. There’s also the small chance of the stock outperforming to the upside too much, where profits begin to trail off above $34.