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A Sell Off Ahead of an Earnings Report Adds to the Bearish Outlook

A Sell Off Ahead of an Earnings Report Adds to the Bearish Outlook

DaVita HealthCare Partners Inc. (NYSE: DVA) appeared on the most active list early Monday. The company is a leading provider of dialysis services in the United States to patients suffering from chronic kidney failure, which is also known as end stage renal disease (ESRD).

The stock was selling off after JPMorgan downgraded DaVita from Neutral to Underweight with a price target of $51.00 (from $66.00). The stock was trading at about $60 before the downgrade but fell on the news.

JPMorgan’s analyst noted that investors lacked visibility into the company’s business operations and cited that as the leading reason for the downgrade.

In the research report, the analyst noted, “DVA has refused to publicly disclose its total number of AKF-subsidized commercial patients. Until we can receive greater clarity to the contrary, we advise investors to Underweight DVA shares.”

Earnings estimates for the next few years were also reduced. For the current year, the analyst’s earning per share (EPS) estimate is holding steady at $3.61. But, for next year, the EPS estimate falls from $3.77 to $3.52. For 2019. The EPS estimate falls from $4.24 to $3.74.

DaVita’s Strategy Raises Concerns

In recent years, DaVita has been increasing revenue by acquiring dialysis centers and businesses that own and operate similar centers and other ancillary services. This strategy has boosted the company’s top line from $6.2 billion in 2010 to more than $15 billion in the past twelve months.

Steady expansion in the overseas markets through strategic alliances and acquisition of dialysis centers has played a key role in boosting growth for DaVita.

In the past few years, the company has strengthened its position in the emerging and developing markets of Columbia, Portugal, Malaysia, Taiwan, Saudi Arabia, China, India and Germany. These moves are expected to help DaVita deliver more efficient patient care while increasing revenue.

However, according to management comments, the company expects to see an increase in its dialysis and related lab services and administrative expenses in the upcoming quarters. Additionally, plans to improve the company’s information technology infrastructure is likely to add to costs.

Other factors weighing on profits include required investments to support regulatory compliance and legal matters. On top of all this, efforts to take advantage of new business opportunities will also reduce the company’s bottom line.

These pressures are all seen in the company’s operating performance. The chart below shows the company’s EBITDA Margin, a measure of a company’s operating profitability as a percentage of its total revenue.

Source: S&P CapitalIQ

This ratio is equal to earnings before interest, tax, depreciation and amortization (EBITDA) divided by total revenue. Because EBITDA excludes interest, depreciation, amortization and taxes, EBITDA margin can provide an investor, business owner or financial professional with a clear view of a company’s operating profitability and cash flow.

In the case of DaVita, the margin shows a clear trend in the company’s performance. The trend for the past five years has been down. This is a bearish indicator for the stock, and that is confirmed by the price action of DVA which is shown in the next chart.

The stock price has been moving steadily lower. The largest down moves shown in the chart have generally been associated with earnings report. With the company expected to report earnings within weeks, traders should be preparing for another potential down move in the stock.

A Trading Strategy to Benefit From Potential Weakness

DaVita has a tendency to sell off in the week after reporting earnings. On average, the stock falls 2% in the week after the report. The next report is expected around November 1. This report could lead to additional selling pressure in the stock.

However, even if the stock doesn’t decline much, in the short term, DaVita seems unlikely to rally sharply. Traders will most likely want to see proof the company can overcome this news and they will most likely be watching for signs of progress in that next earnings report.

This means traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

The Trade Specifics for DVA

The bearish outlook for DVA, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.

A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the October 20 $60 put can be bought for about $5.00 and the October 20 $57.50 put can be sold for about $3.30. This trade will cost about $1.70 to enter, or $170 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spend to open the trade, or $170. This loss would be experienced if DVA is above $60 when the options expire. In that case, both options would expire worthless.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in DVA, the maximum gain is $0.80 ($60 – $57.50 = $2.50; $2.50 – $1.70 = $0.80). This represents $80 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $170 to open this trade.

That is a potential gain of more than 45% on the amount risked in the trade. This trade delivers the maximum gain if DVA closes below $57.50 on October 20 when the options expire. There is a relatively low probability of that according to the options pricing models.

Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $170 for this trade in DVA.

You can find more trades like this in the TradingTips.com service, Options Cash Cow. To learn more, click here.