Short Screen Turns Up this Tech Name Ready to Turn Down

The tone of the market has certainly changed over the past week. The broad market red flags we waved last month are now morphing into stock specific problems. Earnings season has started on a very sour note. We are losing industry after industry as companies post disappointing results and stocks are being taken out one by one and shot.

Retailers had a disappointing holiday with companies from Tiffany (TIF) to Best Buy (BBY) to Kors (KOR) all dropping by more than 8% following reports.

Homebuilders, which had been hitting 52-week highs, have issued profit warnings and the sector has been taken to the woodshed. My bullish thesis on the sector is in need of serious repair.

Recent reports JP Morgan (JPM) and Bank America (BAC) show banks are suffering from zero bound rates environment, which squeezes net interest margins. The SPDR Financials (XLF) find has tumbled 8% in the past three weeks and sits at a four month low.

I don’t think I need to remind you about what is happening in the energy patch; complete devastation with some names down 50%-70% in a matter of months.

The bottom line is things have changed. And when things change your investment and trading strategy needs to change along with it. I’ve already discussed how to place some broad market portfolio protection to help you sleep well at night. Now I’m starting to screen for short candidates to profit from continued decline in prices.

Great Expectations

With bottom line earnings back in focus I want to look for companies that are likely to miss expectations in upcoming earnings reports. I scanned for companies that have reported declining revenues over the past two quarters and missed their last earnings report. But, and here is the key, analysts have not yet reduced their estimates for the next quarter or 2015.

This sets up a situation in which expectations are likely not to be met. Companies that disappoint suffer greatly. Wall Street can deal with mediocre results but it does not like surprises.

The name standing out as a prime candidate to disappoint is MicroStrategy (MSTR), a provider of consulting services and software programs that help companies analyze and manage enterprise data.

The company is scheduled to report earnings on January 26th and consensus estimates call for earnings of $1.08 per share on $167 million in revenue. These numbers are flat from the year ago period but that comes after analysts recently raised estimates by $0.03 cents a share.

Wall Street must have been encouraged by MicroStrategy’s recent implementation of far-reaching cost-cutting plan. In July, management set a goal to reduce annual expenses by $40 million. By October, they boosted that savings target to around $75 million, which comes mostly from job cuts, some 20% of their 3,000-person workforce.

The plan was effective to the end that analysts doubled their 2015 earnings per share forecasts to around $5 from $2.50 and shares enjoyed a nice run towards a high of $173 in early December. The problem is that MicroStrategy has missed earnings estimates for three consecutive quarters and has posted an anemic 1% sales growth over the past two years. This begs the question of how management can simultaneously boost growth prospects while reducing investments in sales, product development and other key support areas.

Some investors might be getting wise as the stock has been in a well-defined downward channel for the past month, declining some 11% since its highs.

MSTR 011515

But analysts have not yet budged on this quarter or full year estimates. Even with the recent decline the stock sells at 31 x forward earnings. That’s not unusual for stocks in the “big data” or “cloud” space. But rivals such as Splunk (SPLK) and Tableau Software (DATA), which carry similar multiples, are expected to grow sales by 30% or 40% in 2015.

Not only isn’t MicroStratgey growing its cost cutting result in it losing existing customers not only to more nimble players but deep pocketed big boys like Oracle (ORCL) and IBM (IBM). Indeed in MicroStrategy’s customer support renewal rates have slid for five-straight quarters to a recent 88% and could get worse.

MicroStrategy’s decision to retrench may prove ill timed. At some point, perhaps sooner rather than later, investors will come to see the disconnect between this stock’s valuation and its poor competitive positioning. That reckoning could be this coming earnings report.

The Trade:

It’s always dangerous to short stock, especially into an earnings report, as losses can be swift and large. This is using options makes a lot of sense.   But it’s also important to understand how options’ price behaves around earnings reports.

The implied volatility or premiums get pumped up prior to the release in anticipation of potentially price moving news. The implied volatility then declined immediately after the report. It’s something I refer to as the Post Earnings Premium Crush or PEPC.

To mitigate the impact of PEPC I want to use a vertical put spread. This involves the simultaneous purchase and sale options with two different strike prices but the same expiration date.

I’m targeting for the stock to fall to below its 200 day moving average at the $142 level. To achieve the maximum profit I set my lower strike just below that level.

Buy February $150 puts and sell February $140 puts for $3.00 net debit for the spread.

The maximum profit of $7 will be achieved if shares are at or below $140 on the February 20th expiration. That would be not so micro 230% profit for a 6.5% decline in the stock.

— Steve Smith

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About the Author: Steve Smith