Last month I wrote an article detailing the sale of cash-secured puts on cash-rich companies as a hedged way to gain returns. The thesis is simple: By selling out-of-the-money puts at strike prices close to the company's cash balance, we achieve one of the following outcomes:
- We retain the premium (or a portion thereof) on the sold put as a return on risk capital.
- We purchase the stock at a level nearer to its cash per share balance, at a substantial discount to current prices on an enterprise value basis.
To give an idea of the cushion provided by these hedged plays, only one of the seven stocks then profiled (VNDA) is now trading below the downside price (defined as the strike price minus the premium). This is despite the fact that the broad market has dropped 15% since the publication of that article. To be sure, the price of the puts sold has risen dramatically, and further market decline will likely trigger exercise of some, if not all, of those puts (this is why individual investors must secure these puts with cash equal to the risk capital; a trader who sold naked puts on those underlying stocks would right now be facing the near-term risk of punishing margin calls). But, even amidst a steep decline, the strategy has so far achieved one of its goals of capital preservation.
As such, with a further decline offering depressed stock prices, and the spike in volatility offering increased option premiums, I wanted to return to the strategy as a cautious way to trade amidst a dangerous market. Bear in mind that some of the companies have limited liquidity and/or large spreads, so commit to your trade and use limit orders to get improved pricing relative to the listed bid.
Four companies will be listed here, with four more coming in Part II later in the week:
Force Protection (FRPT)
Closing Price 8/10: $3.38
I had a good deal of success trading in and out of FRPT options for much of 2009 and 2010, as the combination of a range-bound stock and solid premiums provided good returns for short-term trades. The company finally broke through mid-term support around $4.50, and then long-term support at $4, to close Wednesday at $3.38, a level not seen since late 2008.
Force Protection supplies armored vehicles to the military; the recent debt ceiling drama and the announced cuts in military spending have hurt the stock (87% of 2010 revenue came from the U.S. government according to the company's 10-K). Second quarter earnings didn't help either, as they missed analysts' estimates badly on both revenues and earnings.
Still, the company offers $2.09/share in cash net of a small amount of liabilities, about 61% of the company's market cap. The company noted that the second half of 2011 should be much stronger, and still projects full-year revenue above that of 2010, when the company earned 22 cents per share (an enterprise value-to-earnings ratio below 6) and generated $21.5MM in free cash (23% of current enterprise value). Going forward, Force Protection is responding to projected US budget cuts by expanding sales to US allies (the first delivery to the UK will be made later this year) and bidding for maintenance contracts in addition to simply manufacturing vehicles.
FRPT bulls can sell the September 3 put, currently bid at 15 cents, with the last trade at 20 cents. At the bid, this trade offers a 5.3% return on risk capital on a 40-day trade, or 47.4% annualized. Downside is owning FRPT at $2.85, 15% off current levels, with an enterprise value 41% off of current levels. Bulls can also look at selling a covered call on the December 3 option, bid at 70 cents. There is currently no put bid at that strike, but a December 3 covered call offers a downside of $2.30, barely over the company's cash balance.
Sigma Designs (SIGM)
Closing Price 8/10: $8.37
The maker of chips for home entertainment networking devices has held up rather well during the downturn, dropping only about 5.5% since hitting recent highs on July 25. The company had a difficult first quarter, posting a net loss and negative operating cash flow, which lead to some unimpressive-looking fundamentals for the stock. Trailing twelve-month earnings are only 3 cents per share (though $1.03 on a non-GAAP basis, as reported by the company), and trailing twelve-month cash flow is only $7.2 million, about 6% of enterprise value. The balance sheet remains strong, as SIGM offers a net cash per share balance of $4.62, 55% of its share price.
Despite recent struggles, the company has historically been very profitable. Total free cash flow for fiscal years 2008 through 2011 (ending in April) was $130 million, compared to the company's current enterprise value of about $119 million. The company does expect a difficult second quarter, with revenues and earnings expected to rebound in the second half as the home connectivity market resumes. Investors interested in playing the rebound can sell puts in the near term, picking up either a decent return or ownership of SIGM at a discount, hoping to profit should earnings improve toward the end of the year.
Short-term traders can look at the October 7.5 put, bid at 35 cents, offering a 4.9% return on a 68-day trade, or 26.2% annualized. (Despite being a semiconductor stock, SIGM is less volatile than one might expect, with a beta of only 0.78.) Break-even is $7.15, a 15% drop in those 10 weeks, or 32% of enterprise value. Further out, the January 7.5 is bid at 60 cents, offering 8.7% on a 24-week trade, or 19.1% annualized. Break-even is $6.90, a 17.6% drop, or 39% on an enterprise value basis.
Entropic Communications (ENTR)
Closing Price 8/10: $3.57
Like Sigma Designs, Entropic sells components for home networking (the two companies have even partnered on designing set-top boxes). Unlike Sigma, Entropic has been absolutely hammered in the recent downturn, with the stock down over 60% over the last month. Disappointing second quarter earnings last week were the main driver.
But as I wrote on Monday, the long-term story still holds for Entropic. The multimedia home entertainment market will grow; it's just not growing right now. In the meantime, Entropic is still generating cash flow $8 million in that "awful" 2nd quarter, which is still 22% of enterprise value on an annualized basis. With $2.18 per share in cash, and solid share in a growing market, ENTR offers downside cushion with solid upside should the macro picture brighten.
We can increase that cushion with a variety of hedged plays on ENTR stock. Potential investors should recognize the volatility in this stock. In less than 2 years, the stock has gone from 3 to 13 to 4, with a beta of 2.59 along the way. There is clearly a reason that ENTR premiums are high.
The most aggressive short-term play is to sell the in-the-money September 4 put, bid at 70 cents. With a 12% rebound (or a dead cat bounce) in the next 40 days, we will receive our maximum return of 21.2%, or 193% annualized. That is, of course, a very aggressive move. Should the stock stay flat, we still receive 8.2%, or 74% on an annualized basis.
ENTR must drop to $3.30, a further 7.5% drop, in less than six weeks to reach our downside price. Given the technicals and the volatility in the stock, this is definitely possible. However, such an aggressive trade also limits the likelihood of losing upside should a bottom finally be reached in the stock.
More conservative investors can look further out; the February 3 is bid at 45 cents, ask is at $0.60; use a limit order for at least $0.50), offering a 17.6% return on about a 29-week trade (32.0% annualized). Our downside is owning ENTR at $2.55, requiring a drop in enterprise value of over 73 percent.
BSQUARE Corporation (BSQR)
Closing Price 8/10: $4.61
BSQUARE makes software for testing of so-called "smart devices", ranging from smartphones and tablets to industrial applications to in-dash systems in automobiles. BSQR missed analysts' estimates for second quarter earnings last week; the recent slide capped a 6-month drop of about 65% to current levels.
BSQR offers a cash per share balance of about $2.16, nearly half of the share price; revenues have grown 13% year-over-year in the first half and the company gave guidance for a more profitable third quarter. Trailing twelve-month cash flow is $5.29 million, 21% of enterprise value.
The steep drop and low volume for this microcap limits hedging options. However, we can write an in-the-money December 5 put (bid 90, last 1.00, ask 1.25). At the bid, our maximum gain is 22% (61% annualized). We need a 8.5% gain in the underlying stock to achieve this gain. If the stock stays flat through expiration, our expected gain is 9.5% (26% annualized), with our downside at $4.10, a 21% decrease in enterprise value and a 11% drop in the underlying stock. Using limit orders to the last can improve our returns as well.