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Good Earnings Sets Up a Good Trade

Good Earnings Sets Up a Good Trade

Barron’s recently reported “Splunk (Nasdaq: SPLK) stock rallied [recently] after the data-analytics-software company posted better-than-expected results for the fiscal third quarter ended Oct. 31.

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  • SPLK daily chart

    The surge marks a reversal of fortune from one quarter earlier, when the stock suffered a sharp decline on disappointing results and worries about shrinking cash flow.

    As reported yesterday afternoon, Splunk (SPLK) reported third-quarter revenue of $626 million, up 30% year over year, and ahead of the company’s own projection for $600 million. Adjusted earnings of 58 cents a share were ahead of the Wall Street analyst consensus at 54 cents.

    For the fourth quarter, the company is projecting revenue of $780 million, ahead of the previous Street consensus at $768.42 million.

    One quarter earlier, Splunk stock tanked after the company issued a disappointing cash-flow forecast, a reflection of the company’s ongoing business model shift to subscriptions and away from perpetual software licenses.

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  • Many companies have made that move, which always involves a certain amount of pain in the course of the adoption of the new model.

    The strong results this time around spurred a slew of upbeat analyst comments and price target upgrades from a half-dozen analysts or more.

    Splunk bulls pointed to strong bookings, a new focus on disclosure around annual run-rate revenue, or ARR—metrics are all the rage in the enterprise-software sector—and a $1 billion operating-cash-flow target for fiscal 2023.

    Brian White, an analyst at Monness Crespi Hardt, this morning repeated his Buy rating on Splunk stock and $200 price target.

    “Given our expectation for continued positive fundamental trends with the benefit of strong secular tailwinds, combined with a modest valuation for a next-gen software company, we believe Splunk remains attractive and worthy of further catch-up in its stock price before year-end,” White writes.

    He notes that the company beat revenue expectations for both license, and maintenance and services, and that deferred revenue of $855.6 million “put to shame” his own estimate of $725.6 million.

    White added that Splunk highlighted new product innovation, discussed several 8-figure U.S. government contracts and laid out the rationale for recent acquisitions.

    He adds that Splunk even “dared to revisit the operating-cash-flow discussion that poisoned the last earnings call,” but that this time the company “offered up some light at the end of this dark tunnel” by forecasting $1 billion in positive operating cash flow in fiscal 2023.

    Oppenheimer’s Shaun Eyal was similarly impressed and repeated his Outperform rating on Splunk stock this morning, keeping his $154 price target.

    “We expect SPLK to maintain a strong revenue-growth pace for some time to come, and over the medium-term we believe the company should be able to expand margins through operating leverage and efficiency gains,”

    Eyal writes in a research note. “Rising demand for data-driven insights continues to drive SPLK’s performance, and the company’s platform has positioned it to leverage data proliferation into revenue growth.”

    William Blair analyst David Griffin, who maintains an Outperform rating on the shares, thinks the stock looks cheap relative to other cloud-based software players.

    “On a 2020 basis, shares trade at an enterprise value of 7.6 times our revenue estimate, which we compare to the 11.6 times median of our fast-growth infrastructure and analytics peer group,:” he writes. “In our view, Splunk’s relative growth rate, margin profile, and attractive longer-term positioning warrant a lesser discount.”

    The weekly chart shows the stock is now near the top of a multi-month long trading range and a break could signal additional gains.

    SPLK weekly chart

    A Trade for Short Term Bulls

    As with the ownership of any stock, buying SPLK could require a significant amount of capital and exposes the investor to standard risks of owning a stock.

    To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

    Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

    To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

    This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

    bull call spread

    Source: The Options Industry Council

    Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

    This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

    A Specific Trade for SPLK

    Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

    When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

    For SPLK, the December 20 options allow a trader to gain exposure to the stock.

    A December 20 $140 call option can be bought for about $5.10 and the December 20 $145 call could be sold for about $2.85. This trade would cost $2.25 to open, or $225 since each contract covers 100 shares of stock.

    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 $225.

    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 SPLK the maximum gain is $2.75 ($145 – $140= $5; $5 – $2.25 = $2.75). This represents $275 per contract since each contract covers 100 shares.

    Most brokers will require minimum trading capital equal to the risk on the trade, or $225 to open this trade.

    That is a potential gain of about 22% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.

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