Event: Adobe Systems (ADBE) reports fiscal Q4 results tomorrow after the close. The options market is implying about a 6% one day move, which is rich to the 4 qtr average of about 4% and the 10 year average of about 5.5%.
Price Action / Technicals: ADBE is up 25% year to date, gaining almost 2.5x in market cap their expected 2015 sales of $4.8 billion.
On October 6th, ADBE management guided down for the next fiscal year, from Bloomberg:
Revenue for the year that ends in November 2016 will be about $5.7 billion and profit excluding certain costs will be about $2.70 a share, the San Jose…..Analysts on average projected annual sales of $5.94 billion and per-share profit of $3.20.
Since gapping down about 7% Oct 7th, below $80 (circled in yellow), the stock has done little else than rally, now up about 15% from the lows:[caption id="attachment_59101" align="aligncenter" width="600"] ADBE 1yr chart from Bloomberg[/caption]
Near term the prior break-out level of $87 should serve as support, with little support down to about $80, another 10% lower from those levels.
Longer term, I think it makes sense to look at the uptrend that has been in place since late 2012, placing a re-test back towards the $80 support identified above:[caption id="attachment_59102" align="aligncenter" width="600"] ADBE 7r chart from Bloomberg[/caption]
Sentiment: Wall Street analysts are fairly bullish on the stock with 17 Buy ratings, 8 Holds and No sells with an average 12 month target of about $93, about 2% higher than current levels. Short interest at less than 2% of the float.
Options Open Interest: With the stock just 3% from its recent all time highs, options open interest and volumes are very near a 6 month lows. Despite the stock’s strong performance ytd there seems to be little build up in options positioning into earnings:[caption id="attachment_59103" align="aligncenter" width="559"] ADBE 1yr chart of options open interest and volumes from Bloomberg[/caption]
Implied Volatility Snapshot: short dated options prices are above 3 of the last 4 quarter’s earnings reports, excluding its Q3 report in September when the broad market was sill in the throes of a volatility bout:[caption id="attachment_59104" align="aligncenter" width="600"] ADBE 1yr chart of 30 day at the money implied vol from Bloomberg[/caption]
Valuation: This one is far less egregious than other high growth, high valuation software “cloud” plays like SalesForce.com (CRM). ADBE is trading 32x fiscal 2016 expected earnings which consensus has growing 36%, on 20% sales growth. I would add that while CRM has a $53 billion market cap, the company is only expected to grow sales next year at about 20%, and earnings by about 30% (albeit off of a low base).
My View: ADBE has benefited in 2015 from investors desire to pay for growth at any price. Despite recently tempered guidance for next year, the stock remains bid with positive sentiment. I suspect that a tweak lower in guidance, or any signs that cloud signings are decelerating greater than expected then the stock could see the sort of reversal from highs we are getting today in Costco (COST) and yesterday in Southwest Airlines (LUV). While these stocks have nothing to do with eachother, they have a lot to do with recent investor psychology where investors have been crowding into what has been working, regardless of valuation (save LUV).
So What’s the Trade?
For those that are long or thinking if getting long for a breakout, we really think getting defensive is in order. Here is a hedge against long stock followed by a stock alternative in lieu of long stock:
Hedge vs 100 shares of long stock:
Buy the ADBE (90) Dec 87.5/80 vs Dec 97.5 put spread collar for .90
- buy 1 Dec 87.5 put for 1.75
- sell 1 Dec 80 put at .35
- sell 1 Dec 97.5 call at .50
Rationale – This stock overlay risks 1% of the underlying price and will expire worthless between 87.5 and 97.5. It provides 1 to 1 protection on the downside between 86.60 and 80 but no protection below. Profits above where the stock is trading from the long stock but capped at 96.60 where you are effectively flat with the short call vs stock.
This is the trade for those willing to risk 1% of the underlying to stay in the stock with greatly reduced risk. The stock can be called away on a massive gap higher but that is unlikely and even so would be profitable with gains in the stock of 7% on the event.
Stock Alternative/ Replacement in lieu of 100 shares of stock:
Buy the ADBE (90) January 87.5/97.5/105 (unbalanced) call fly for 3.20
- buy 1 Jan 87.5 call for 4.90
- sell 2 Jan 97.5 calls at .95 (1.90 total)
- buy 1 Jan 105 call for .20
Rationale – This trade defines risk to 3.20 in ADBE and starts in the money so it minimizes risk of being long premium (it’s breakeven is just .70 higher at 90.70). Profits are like stock (on January expiration) above 90.70 and with a max gain of up to 6.80 at 97.50. Gains trail off above that.
This trade risks just 3.5% of the underlying with the chance to make up to 7.5% of the underlying on a move towards 97.50 in January. We like the idea of defining risk as we think just being long stock near highs is too risky given the potential downside vs upside moves. This trade reflects that opinion.