Double Digit Growth Isn’t Enough to Save This Stock
Traders often buy stocks of companies that are growing earnings quickly. They target rapid growth because that tends to fuel gains in the stock price of those companies. However, that means a slow down in earnings can lead to a sudden reversal in the stock price.
Traders in IPG Photonics Corporation (Nasdaq: IPGP) were reminded of that relationship after the company’s most recent earnings report.
IPG Photonics Corporation develops and manufactures a range of high-performance fiber lasers, fiber amplifiers, and diode lasers used in various applications primarily in materials processing worldwide.
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Some of its products are deployed in broadband networks, such as fiber to the home, fiber to the curb, passive optical networks, and dense wavelength division multiplexing (DWDM) networks; ytterbium and thulium specialty fiber amplifiers and broadband light sources; and single-frequency, linearly polarized, and polarization-maintaining versions of its amplifier products.
Its lasers and amplifiers are also used in materials processing, advanced communications, and medical applications.
A Slowdown Hits the Stock
The company has seen earnings at an average of 22% a year in the past five years. However, in the most recent quarter, earnings per share only increased by 16% and the reported EPS of $2.21 missed analysts’ expectations by $0.03 per share. Revenue of $413.6 million also missed expectations of $418.6 million.
Traders sold on the news.
Management told analysts to expect continued weakness. The company stated that revenue in the upcoming quarter will land between $360 million and $390 million. Analysts had been expecting revenue of $425 million.
Earnings in the third quarter are expected to be between $1.80 and $2.05. That is well below analysts’ expectations of $2.27.
Dr. Valentin Gapontsev, IPG Photonics’ CEO and founder, added to the bearish cash by noting, “While orders grew slightly on a year-over-year basis, order flow was below our target as demand softened in Europe and China at the end of the quarter.
This more-modest year-over-year growth in orders has persisted through July, and we believe is primarily driven by macroeconomic and geopolitical factors rather than competitive dynamics.”
Dr. Gapontsev also stated that currency movements are going to be a big headwind for the business in the near term. The long term chart shows that without a turnaround in earnings, the stock could fall more since there is no real support in this one time high flyer.
A Trading Strategy to Benefit From Potential Weakness
The prospect of a further short term gain in IPGP seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
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 IPGP
The bearish outlook for IPGP, 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 August 17 $165 put can be bought for about $5.30 and the August 17 $160 put can be sold for about $4.30. This trade will cost about $1.00 to enter, or $100 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 spent to open the trade, or $100. This loss would be experienced if IPGP is above $165 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 IPGP, the maximum gain is $4.00 ($165 – $160 = $5; $5 – $1.00 = $4.00). This represents $400 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 300% of the amount risked in the trade. This trade delivers the maximum gain if IPGP closes below $160 on August 17 when the options expire.
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 $100 for this trade in IPGP.