$CSCO Fiscal Q4 Earnings Preview

by Dan August 14, 2013 10:36 am • Commentary

Event: CSCO reports their fiscal Q3 earnings tonight after the close.  The options market is implying a one-day move of  ~6.5% vs the 4 quarter average move of ~7% and the 8 quarter average move of ~7.8%.

Sentiment:  Wall Street analysts are very positive on the stock with 35 Buys, 9 Holds and 4 Sells, but with an average 12-month price target of ~$26.60, just above where the stock is currently trading.  Short interest sits at only 1% of the float.  

Options Volumes / Open Interest:  Open interest is heavily skewed towards calls, with total call open interest of about 1.2 million contracts and total put open interest at about 758k contracts.   Below is a table of the 10 largest lines of open interest:

Expiraton Strike Option Quantity
aug 27 call 107,000
aug 28 call 89,000
jan 22 call 86,000
jan 25 call 83,000
aug 26 call 76,000
jan 20 put 61,000
jan 22 put 60,000
aug 25 call 53,000
aug 30 call 47,000
sept 30 call 45,000

data from Bloomberg

The fact that the August 27’s have the largest open interest could be important with the stock reporting earnings so close to August expiration (Friday.) That open interest could act as a magnet on a move higher in the stock on earnings. A move higher would need to be robust enough to get away from the pull of that line’s open interest. “Pinning” on expiration week tends to happen near lines with lots of option open interest because traders have stock to sell above that line and stock to buy below that line in order to manage deltas. That effect can “pin” a stock to 27 on a move higher until the options expire on Friday.

Unusual Activity:   There have been 2 large, interesting trades in the stock the last 2 weeks, First, was a buyer on Aug 8th of the January 2014 26/22 1×2 Put Spread for .84, 23,000 times by 46,000 times.  This structure could be an outright bearish bet that pays off on Jan expiration between $25.16 and $18.84 with the max profit of $3.16 at $22.  Above $26 on Jan expiration the trader losses all .84 or $1.9 million dollars, at $22 the trader makes ~$7.26 million and below $18.84 the trader starts to lose money. This trade could also be protection against a long stock position of approximately 2,300,000 shares until $18.84 at which point the trader gets longer the stock.  Second, someone bought 2,500,000 million shares, sold 42k Jan 29 Calls at . 73 and bought 42k Jan 24 Puts for .99,so the package costs .26, If this is an earnings play the break-even to the upside is the price they bought the stock (26.26) plus the premium paid .26, so 26.52 with profits capped at 29.00, so 2.48 of potential upside on Jan expiration, with losses covered below 24.00 plus the . 26 premium, so downside of 2.52 so a very even bet, risk 2.50 to maybe make 2.50 with gains and losses of the stock in btwn that $5 range.

Vol Snapshot:  Implied Volatility has come in a tad into Wednesday’s print, but only off of levels that are historically quite high. This has happened as Realized Volatility has hit very low historical levels on the stock’s rally over the last few months.

[caption id="attachment_29195" align="alignnone" width="674"]2 year chart of 30 day realized vol (blue) vs. 30 day implied vol (red), Courtesy of LiveVolPro 2 year chart of 30 day realized vol (blue) vs. 30 day implied vol (red), Courtesy of LiveVolPro[/caption]

Implied volatility in September is in the low 30’s but will fall to the low 20’s following the event. That means that option premium will come in 25-30% so any structures you would want for protection have to take that into account. In other words, buying a put for protection does one little good if a move lower in the stock is not dramatic. A slight move lower could mean losses in the stock and losses in your hedge. Therefore, hedging structures should try to either take advantage of, or at least attempt to mitigate, the impending options premium crush.

Price Action / Technicals:    CSCO is up ~33% on the year, massively outperforming the Nasdaq up 21% ytd and many of its large cap tech peers (EMC +6%, INTC +9.5%, IBM -1%, & MSFT +22%) with most of its out-performance coming in the last quarter.   The 4-year chart shows the $26-$28 (the low end of where it is trading now), with the top half signifying significant long term technical resistance, while the $24 level should serve as strong near term technical support.

Screen Shot 2013-08-13 at 11.09.21 AM

Fundamentals/Expectations:  Analysts have been active in front of tonight’s print, last week JPM upgraded the stock from a Sell to a Hold.  The analyst has not had a Buy on the stock since September of 2012 when CSCO was ~$19.  Needless to say he has been off sides on the story, but still remains a tad reluctant with the stock approaching 3 1/2 year highs.  On Monday, Goldman Sachs, who rates the stock a Buy, raised their 12 month price target from $28 to $30 on the heels of what that expect to beat and raise quarter.  Specifically:

We expect Cisco to report a solid F4Q quarter on improving enterprise networking demand, higher carrier capex, and strong execution, with EPS upside aided by better gross margins. Expect upside to guidance, with our yoy revenue growth estimate of 6.9% above consensus at 4.8% on accelerating cyclical and product cycle-driven growth in Ethernet switching, secular strength in WiFi, and continued share gains in servers.

Our view is driven by the broad-based improvement in enterprise networking demand during the quarter, as evidenced by the better-than expected results and/or guidance from a host of Cisco suppliers (e.g. Broadcom, Finisar, Jabil, Xilinx) and competitors (e.g. Juniper, Adtran, F5). Service provider (SP) capex in 2Q improved as well, as evidenced by qoq capex growth at AT&T, Verizon, and Sprint

ESTIMATES/GUIDANCE from Bloomberg:

  • 4Q adj. EPS est. 51c; May 15, CSCO forecast adj. EPS 50c-52c
  • 4Q rev. est. $12.41b, up 6% Y/y (range $12.27b-$12.62b); CSCO forecast Y/y rev. growth 4%-7%
  • 4Q gross margin est. 62.1% (range 61.5%-62.7%); CSCO forecast non-GAAP gross margin 61%-62%
  • 1Q adj. EPS est. 51c (range 48c-53c)
  • 1Q rev. est. $12.46b (range $12.19b-$12.70b)
  • 1Q gross margin est. 62% (range 61.4%-62.8%)

My View:   CSCO was a bit of a show me story for the better part of 2012 and 2013.  It wasn’t until the company’s beat and raise back in May where CSCO checks multiple boxes as it relates to current investment thesis.  Despite earnings and sales that are expected to grow slightly above mid single digits for the next couple years, the stock is cheap on a historical basis at ~12.2x next years expected earnings and to many of its peers.  The company has 35% of its market cap in cash (~$50 billion) and about 22% net of cash, they pay a dividend that yields 2.6%, and as of Jan. 26th the company has purchased and retired 3.8 billion shares at an avg of $20.34, with about $5 billion left on their current authorization.

If you believe that the world is about to see global growth reflate, if Europe has in fact come out of recession, and emerging markets are about to turn then CSCO is a must own for the next leg of the rally.  The company has spent the last few years shedding non-core businesses and cutting costs and moving away from legacy low margin comiditized products (routing) and make progress in storage networking and services.

We almost pulled the trigger on the long side back in May if we got a pull back from the earnings gap to $24, it obviously never came, but with expectations running very high, if we were to see weakness following the results, we would likely look to initiate a long biased position on any weakness.

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