How To Play The Seagate Technology Earnings Announcement This Week

Jul.21.13 | About: Seagate Technology (STX)

The earnings season continues in a big way this week, and I would like to focus on one of the smaller players, Seagate Technology (NASDAQ:STX), a data storage company which announced on March 12, 2013 that they were the first disk manufacturer to ship 2 billion hard disk drives. The first billion took 29 years to achieve (in 2008), indicating that growth in this segment of the industry is accelerating.

STX has had a huge run-up of about 20% since its last earnings announcement on May 1st and hit a new high ($47.76) on Friday. This kind of price action suggests that expectations might be running a tad high going into the company's earnings announcement scheduled after the close of trading on Wednesday, July 24, 2013.

Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves. I call it the Expectation Model. Basically, I examine recent stock price activity, estimates vs. whisper numbers, past post-earnings price changes vs. results, current RSI levels, and come up with a measure of whether expectations are unusually high or low.

If expectations are unusually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met. (Unusually low expectations are generally less predictive of higher post-announcement prices, however - unusually high expectations more reliably predict lower prices after the announcement).

Last week I wrote a Seeking Alpha article entitled How To Play The Google Earnings Announcement This Week in which I showed how the model predicted that Google (NASDAQ:GOOG) would fall after the announcement. It proved to be right. People who waited until after the announcement could have bought GOOG for as much as $50 less than the pre-announcement close (in after-market trading) or $14 less at the close on Friday. Anyone who followed the options spread I suggested should have made well over 50% for the day (at Terry's Tips, we waited until late Thursday and bought 915 calls in several different future series and sold 910 calls that expired the next day, and made an average gain of 58% after commissions on those trades).

Going into earnings, STX seems to share many characteristics with GOOG a week ago. Here is the record of how STX has responded to earnings announcements over the last year (with the price change from just before the announcement until the Friday close after the announcement when the weekly options expired):

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The company doesn't have a great record of beating estimates. Half the time they have come up short, but in each case, the market didn't punish the company much. In fact, both times they failed to meet estimates, the shares managed to notch a small gain after the announcement.

In the January 2013 announcement, actual earnings exceeded estimates by 8.7% yet the shares were clobbered by 10%. The company's chart yields an explanation of why that happened (adding support to our Expectation Model):

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Check out the sharply higher stock prices going into the January announcement. Expectations were clearly sky-high. Even though the company exceeded estimates by a large margin (after falling short for the prior two quarters), the stock was clobbered. Our model would have predicted just that kind of price action.

In the month leading up to the May earnings report, the stock hardly budged. Expectations were presumably low. When actual earnings exceeded the estimates (by less than they had a quarter earlier), the stock got a big boost due to the reduced expectations.

Option prices are predicting a move of about $3, or 6.3%, well below the size of the change in the past two quarters.

This time around, expectations seem to be unusually high. Whisper numbers are higher than estimates, ($1.24 vs. $1.19), and the stock has enjoyed a dramatic run-up going into the announcement (and reaching a new high Friday).

RSI numbers add even more support to this notion - at 94 and in a "very overbought" condition. Even if actual earnings are much higher than estimates and whisper numbers, it is doubtful to me that the stock will trade significantly higher after the announcement, and there is a very good chance that it might trade much lower if any part of the announcement (earnings, revenues, margins, or guidance) disappoint in any way.

There is another bit of evidence suggesting that the stock may be headed lower. Institutional investors have sold 19% of their holdings over the past three months, going against the tide of steadily higher prices. The institutions are surely not always right, but with their superior resources, they are in a better position than any individual to be able to predict what is likely to happen next. And they are selling.

Bottom line, if you would like to own Seagate, I would wait until after the announcement to make your purchase. If you are an options nut like me, I would buy a diagonal call spread with the buy side at a strike higher than the at-the-money Jul4-13 calls you sell. I would wait until late Wednesday to place the trade (although I plan to buy some of these spreads early in case the stock falls before the announcement like GOOG did last week). If you were to place that trade now (with the stock price at $47.52), you might buy Aug-13 48 calls, and this would be the risk profile graph if you assumed that IV of the August calls falls from 34 to 26 after the announcement:

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I think it is unlikely that the stock will move up by $2 after the announcement so that a loss on the upside would come about. On the other hand, the stock could fall by as much as 5% before a loss would be encountered on the downside. The maximum loss if the stock falls would be the initial cost (about $8 per spread) plus commissions. Each spread would involve a $50 maintenance requirement so the above 10 spreads would involve an investment of less than $600. A more aggressive bet that the stock will fall would be to buy the Aug-13 49 calls instead of the 48 calls - that spread could be placed for a credit and would guarantee a gain no matter how far the stock might fall (but would offer very little upside protection if the stock moved higher).

STX has had a spectacular year so far, but it looks to me that it has gotten a little ahead of itself right now, especially since it has picked up over 20% since the last earnings announcement. The gain since the day before that announcement has been closer to 30%, a huge amount for a fairly mature company to chalk up in a single quarter.

It seems clear to me that the stock is due to take a breather, and possibly fall back a fair amount once the numbers are revealed next Wednesday, even if the company manages to beat the estimates.

Disclosure: I am long GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a short options position in STX in the next 72 hours.