Event: Palo Alto (PANW) reports their fiscal Q2 results tonight after the close. The options market is implying about a 10% one day move, which is rich to the 4 quarter average of about 5%. Since the company went public in mid 2012, the average one day post earnings move over the last 13 quarters has been about 5%, with the last 10 moves being higher and only two in the whole data set being lower, both back in 2013.
Sentiment: Wall Street analysts are overwhelmingly bullish, with 36 Buy ratings, 4 Hold ratings and zero Sells, with an average 12 month price target of about $193, or about 48% higher than current levels, and not far from its all time high made in July at $200. Short interest at 6% is near a 12 month low.
Price Action / Technicals: PANW is down 26% on the year, and down 35% from its all time high made in late July, and at its 52 lows earlier in the month, the stock was down 45% from its all time highs.
The one year chart shows fairly obvious technical resistance at $140 which was the August 24th flash-crash low, and a recent break-down level in late January:[caption id="attachment_61699" align="aligncenter" width="600"] PANW 1yr chart from Bloomberg[/caption]
Let’s look at the long term chart since its ipo, the uptrend from its 2013 lows, in line with its 2012 ipo price, is well defined, but the break in trend is violent, and I’d be surprised if the stock were back above the uptrend anytime soon:[caption id="attachment_61700" align="aligncenter" width="600"] PANW since 2012 IPO from Bloomberg[/caption]
Implied Volatility SnaptShot: Short dated options prices have exploded in 2016 with the stock’s sharp decline. The one year chart below of 30 day at the money implied volatility (blue below) shows the move from 30% in early January to 84% earlier this month, while realized volatility (white below, how much the stock has been moving) has gone from near 52 week lows at just below 19% to current levels near 70%. Options prices seem fair relative to recent movement, the stock’s valuation (more on that below) and what appears to be a fairly dicey technical set up:[caption id="attachment_61702" align="aligncenter" width="600"] PANW 1yr chart of 30 day atm IV vs realized vol from Bloomberg[/caption]
My View: PANW is a best of breed security software provider, which has been a net taker of market share the last few years, and has grown sales 50% plus a year in each of the years since going public and with the last calendar year having topped $1 billion in sales. While EPS has been positive and growing on an adjusted basis, on a GAAP basis the company is still expected to lose close to $1.50 a share, down from its $2 loss in 2015. The stock trades at 74x expected 2016 earnings, and 8.2x EV/Sales, vs peers FEYE at 2.5x, FTNT at 3x and FFIV at 2.7x, WOW, that’s some premium. Valuation did not matter in this stock until this year, so the magnitude of the beat and raise, and the quality of results will be the determining factor of whether or not the stock can recover a bit.
I think it makes sense to consider SalesForce.com’s (CRM) performance today following its better than expected results last night. The stock is up 9% today, basically in line with the implied move in the options market. Heading into the print, CRM had a similar set up, from a sentiment, technical, valuation and price action perspective.
So What’s the Trade?:
If you think PANW has the ability to do what CRM did on a solid report and guide higher (like CRM’s 10% pop) tomorrow, you want to define your risk in a similar way in case it goes hard the other way:
In lieu of 100 shares of PANW ($128.50):
PANW ($128.50) Buy the March 125 / 150 / 175 Call butterfly for $7.50
- Buy to open 1 March 125 call for 10.90
- Sell to open 2 March 150 calls at 1.80 each (3.60 total)
- Buy to open 1 March 175 call for 0.20
Break-Even on March Expiration:
Profits: above 132.50 and below 167.50 with max gain of 17.50 at $150
Losses: of up to 7.50 below 132.50 and above 167.50 with max loss below 125 and above 175
Rationale: Similar to the CRM trade from yesterday this defines risk in case of a steep decline on the event while targeting a realistic upside in the stock over the next few weeks. The trade is no longer bullish at 167.50 but the odss of that kind of move are small, so 150 seems realistic. The fly starts in the money by 3.50 so only $4 of the trade is extrinsic premium (i.e. the trade’s breakeven is $4 higher than where stock is now).
The large skew to the downside in weekly puts makes put spreads for protection (or if you’re a playa, an outright bearish position) the way to position for downside:
Bearish/ Hedge for longs:
PANW ($128.50) Buy Feb26th weekly 125/ 110 put spread for 4.00
- Buy 1 Feb 26th weekly 125 put for 5.40
- Sell 1 Feb 26th 110 put at 1.40
Breakeven on tomorrows expiration:
Profits: of up to 11 below $121 with max gain of 11 at or below $110
Losses: of up to 4 above $121 with total loss of 4 above $125
Rationale – The skew (i.e. the amount higher in implied volatility of out of the money options vs at the money options) is pretty high in PANW into the event. Implying worries about tail risk and manifested by people buying dollar cheap but volatility expensive out of the money puts. A put spread takes advantage of this by buying near the money puts and selling out of the money puts for a decent risk reward into a volatile event. The downside to this trade vs a long is if the stock goes nowhere. The ideal situation is the stock going much higher than $4 and the 4$ spent to stay in the stock and define the risk to the downside being money well spent for the move higher.