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Power One (PWER) presents an opportunity for a version of the bullish reversal options strategy. Buying a vertical call spread out of the money, and funding it by the sale of out of the money puts, it's possible to gain upside exposure at minimal out of pocket cost, while committing to buy shares only if this value situation trades substantially lower.

Beta at 2.2 and implied volatility at 68.2% both indicate the possibility of rapid price movement, perhaps a gap in one direction or the other. Short interest at 40.28% adds potential fuel to the fire.

Overview

PWER was capably written up in an Investment View posted by Logical Thought here on Seeking Alpha. The stock has been coming up repeatedly in various value screens, and has been mentioned as a buyout prospect. Rather than do a full analysis, this article presents an options strategy that makes sense to me.

Briefly, Power One makes power inverters for the renewable energy market. After a reorganization, the company burst out with a large increase in revenue and profitability. Shares plunged following conservative guidance with 4th quarter 2010 EPS. The company acknowledged an inventory overhang as well as oversupply in the channel. Short interest is huge, at 40.28%.

P/E is extremely low, either TTM or forward: 8.7 and 6.7, respectively. Clearly the market thinks current revenue growth and margins are unsustainable.

Supply and Demand

Due to rapidly increasing demand during 2010, shortages developed, with resultant buyer panic and double ordering. Capacity and production are now ahead of demand, as is discussed in a report from IMS.

The industry is fragmented, and has attracted additional players due to the profitability and growth potential.

PWER gained share during the turmoil from increased demand, and is well positioned in terms of R&D expertise, with design centers positioned in proximity to the relevant markets. The industry requires design to customer specifications as well as regulatory requirements, which vary by country and region. New entrants may find it difficult to replicate the R&D positioning. PWER holds 116 active US patents, to include 32 on digital power management. It has licensed its technology to a number of well-known players, demonstrating the value of its intellectual properties.

In addition to its own manufacturing resources, PWER uses contract manufacturers and may be able to adjust capacity as the industry goes through the expected cycles. It has facilities in China giving it the ability to manufacture at a low cost in proximity to the Asian markets.

The company has a strong balance sheet, with relatively low debt and a strong cash position. Restructuring in 2009 reduced costs, while a reorganization in 2010 was intended to conserve NOLs (Net Operating Loss carry forwards). Profits will flow direct to the bottom line.

Supply and demand can be expected to go through periods of temporary misalignment in this growth area. PWER is a sturdy competitor and can be expected to surmount these difficulties. These headwinds are already baked into the price, which arguably doesn't reflect PWER's strength and positioning.

Shooting from the Hip on Valuation

In a situation of this type, I frequently fall back on Price/Sales, thinking along the lines suggested by Ken Fisher in "Super Stocks." For smokestack industrials, he suggested buying at P/S ratios of less than .4, and selling at .8.

For industrials where there is a larger R&D component, those ratios can be feathered upward. Looking at R&D as a percentage of revenue, it has declined steadily from 11.5% in 2006 to 3.4% in 2010. The decrease was driven primarily by increased revenues. These facts suggest that the R&D function has been generating value.

Midpoint guidance for 2011 revenues works out to 1.2 billion, or 11.53 per share. At recent share prices in the 8.50 area, that works out to a P/S ratio of .73. The P/S for Electronic Instruments and Controls is 1.41. Shifting Fisher's .4 to .8 rule of thumb range upward to .60 to 1.0, I would be a buyer at .60 X 11.53 = 7 and a seller at 11.53 X 1.0 = 11.

Options Strategy

It's possible to express the above opinions by means of options, as follows:

Buy to open 10 PWER Oct 22 2011 9.0 calls @ 1.25
Sell to open 10 PWER Oct 22 2011 11.0 calls @ .65
Sell to open 10 PWER Oct 22 2011 7.0 puts @ .80

The prices are mid bid/ask as of Friday's close, a net credit of .20 for the entire position. If the shares close between 7.00 and 9.00 at the October expiration, all options will expire worthless, leaving the investor with the net credit as a very small profit. If assigned on the puts, the investor has a cost per share of 6.80. If shares are above 11.00 at expiration, the profit is 2,200, for 10 contracts.

If prior to expiration the shares make a meaningful upward move, the position will become profitable and can be closed on a judgment basis.

Potential Catalysts

The nuclear incident in Japan has re-opened the topic of renewable energy, with a bias away from nuclear in favor of wind and solar. The developing discontent in the Mideast and North Africa renews concern for dependence on oil as an energy source, and likewise points toward solar and wind, as well as coal.

The short interest seems out of proportion to the situation here. PWER, has long term debt to equity of 10.6% as of the end of 2010, and posted a profit of .96 per share for the year. Although the company did not provide earnings guidance, analyst consensus for 2011 is 1.16. By the end of the 2nd quarter it will be clear whether the excess inventory has been worked off and whether government subsidies will be renewed or possibly increased as energy policies and stimulus plans are reconsidered.

There are a lot of very well-financed industrial companies that have been talking about their acquisition plans, opening the possibility of a takeover, or at the least rumors from time to time.

Source: Power One: Here's an Options Strategy for This Value Candidate