$QCOM Before the Storm

by Dan March 8, 2016 2:15 pm • Commentary• Trade Ideas

Shares of Qualcomm (QCOM) had a miserable 2015, down 33%, vs the Philadelphia Semiconductor Index (SOX) down only 3.3%, and the Nasdaq Composite up 5.5%. The company had no shortage of issues last year, including threats from both Chinese and European regulators regarding their selling practices in those regions, while they have had some difficulty collecting licensing fees in countries like China for their mobile chips and a little more than a year ago settled anti-trust claims with the Chinese to the tune of $975 million.

Today there are media reports that U.S. regulators are going to restrict sales of Chinese handset and telecom equipment manufacturer ZTE’s products, per the WSJ:

Authorities allege ZTE broke export rules by supplying Iran with U.S.-made high-tech goods and said they uncovered plans by ZTE to use a series of shell companies “to illicitly reexport controlled items to Iran in violation of U.S. export control laws.”

The company is a major global supplier of telecom-networking equipment such as cellphone base stations and antennas, and is also the only Chinese smartphone brand with substantial handset sales in the U.S. Its global sales last year were about $15.5 billion.

And its not just that ZTE is a customer of U.S. chip-makers, but also fear of similar reprisal by the Chinese placing similar restrictions on our companies:

China’s foreign ministry has criticized the U.S. move, warning that it potentially harms relations. “We hope that the U.S. side can stop such erroneous practices so as to avoid further damage to China-U.S. economic cooperation and bilateral relations,” foreign ministry spokesman Hong Lei said at a daily media briefing on Monday.

This is of particular interest of QCOM when you consider 52% of their sales came from China in 2015 and 13% came from Taiwan.

Despite the stock’s rock solid balance sheet (~$20 billion in net cash vs $80 billion market cap), and commitment to capital return at the behest of activist investors (bought back more than $10 billion worth of shares in the last year and pays a dividend that yields 4%), the stock may be a tad expensive given the headwinds to growth like weak Chinese demand, strength of the U.S. dollar and always possible retaliation by the Chinese.  Why should QCOM trade at 13x expected 2016 earnings that are expected to be flat on a 5% yoy sales decrease vs Intel (INTC) at 12.,6x with expected eps growth of 4% and sales growth of 7%?

As for the chart, the downtrend over the last year has been fairly methodical, with a series of lower highs and lower lows, and once again testing the downtrend after the stock’s 25% rally in the last month:

from Bloomberg
from Bloomberg

Options prices in QCOM have come in dramatically from it he stock January lows, with 30 day implied volatility down about 20 points from 45% to 25%. Options prices seem fair to possibly cheap:

From Bloomberg
From Bloomberg

The next identifiable catalyst for QCOM will be their Q1 earnings on April 20th, but I would add that with the pace of the devaluation of the Chinese Yuan in 2016, there is a possibility the company could pre-announce negatively in March.

So what’s the trade? 

If you agree the stock could re-trace most of the recent move on a weak Q1 and guide down, then vertical put spreads targeting the earnings event make sense, I want to use April 22nd WEEKLY options that catch earnings:

*QCOM ($53) Bought April 22nd Weekly 53/43 Put Spread for ~$2
  • Bought 1 April 22nd weekly 53 put for 2.30
  • Sold 1 April 22nd weekly 43 put at .30

Break-Even on April 22nd weekly Expiration:

Profits: up to 8 between 51 and 43 with max gain of 8 below 43

Losses: up to between 51 and 53, with max loss of 2 above 53

Rationale:  This spread gives fairly near the money participation to the downside, with a little less than 4% of the underlying stock price at risk and the potential of 4 to 1 profits.