Sometimes, the best trades come from neither super high growth nor crushing investor rejection of a stock. Sometimes, the best trades can come from plays that are stable, consistent and just in the right place at the right time.
When you think about trading on big tech names, you might naturally think Facebook, Microsoft or Google. But because of a disappointing earnings forecast and the current state of global economics, we have a trade in a very different side of the tech industry.
Cisco Systems (CSCO) is about as old and boring as you can get in the tech world. The company builds and manages networks for millions of companies and organizations around the world.
From its enormous data center infrastructure to its presence in networking hardware, you might suspect it is a relic of a bygone era of technology… like IBM or even Intel. But the company hasn’t just let the likes of Google and Amazon pass it by.
Today, Cisco has gotten into many fast-growing subsectors of the tech world. Its artificial intelligence-based networking solutions business, for instance, has been part of a revolution in modernizing many industries – from how oil producers automate the control systems of their oilfields to how large customer service companies connect callers with representatives.
Another area where Cisco is excelling beyond its reputation as a hardware and old-guard tech company is in the multi-cloud field. Its long history as a leading networking specialist has grown into a data systems expert as millions of business switch over to cloud-based networks.
In fact, it is on the forefront of connecting multiple clouds, combining, integrating and allowing users to analyze data from Amazon’s AWS to Microsoft’s Azure and everything in between.
As cloud computing continues to grow at a triple-digit pace each year, connecting all of these large clouds will become an essential piece of the puzzle.
All of this essentially means that Cisco, despite popular opinion, remains very much a growth story… long term. But that’s been part of the problem. It hasn’t been growing all that much.
While the company did top analyst estimates in its most recent earnings report last month, management’s forecast for its fiscal year 2020 was less than enthusiastic. It sees the ongoing trade conflict with China keeping sales and earnings flat for the foreseeable future. In the tech industry, that’s a hammer blow.
Shares are off more than 16% from their pre-earnings highs. They are still up for the year, but clearly lost investors’ interest.
However, the company has given three reasons to take the opposite view… and actually go long this tech behemoth:
It has implemented a shareholder value policy of distributing 50% of its cash flow to shareholders in dividends and stock buybacks.
From its first dividend in 2011, it has consistently increased those payments from 24 cents annually to $1.40 today. At today’s rate – and after the recent price correction – it now pays a substantial 2.8% yield.
That’s large for its industry, and something more investors will come to appreciate as the search for yield continues to sweep the financial community.
Cisco is the king of acquisitions to help it reposition or grow into faster-growing businesses. It has completed dozens of acquisitions over the past handful of years and continues to do so.
Most recently, it attempted to buy Datadog, a cloud-integration company that just went public earlier this month. The $7 billion offer was rejected as the newly public company got a better deal from its IPO. But it shows where Cisco is headed.
It is diving headfirst into cloud-based subscription applications – an incredibly profitable and lucrative field worth acquiring.
Others have suggested Cisco could either wait for Datadog’s post IPO price tag to come down or find an alternative with the likes of Splunk or Service Now… both, for the right price, could be a coup for Cisco.
Finally, Cisco just has an incredibly undervalued price tag of its own. Despite consistent earnings – if not fast-growing yet – investors are valuing it like the company is somehow losing money. And that’s far from the truth.
It’s price to earnings ratio stands at just 9.5. That includes the pressures felt from the Chinese tariffs. Meanwhile, others in the networking industry are trading much higher. It’s largest competitor, Juniper Networks, trades at 17.5 times its earnings. There’s plenty of room for shares of CSCO to move higher from here.
All of this points to a short-term contrarian trade. While others are still avoiding this massive tech play, we can take advantage of this significant price mismatch. Like we said, sometimes the best trades come from stable, consistent plays in the right place at the right time.
But instead of buying shares or placing a hard bet on this recovery, we have a better strategy for this particular situation.
A Strategy For Short Term Bulls
A bull call spread is a type of options trade that involves buying one call option on a stock set to bounce higher and selling a second one. The income from the latter call helps offset the cost of the former.
This ends up reducing both the total cost of the trade and the amount at risk, which are one in the same. The profit potential however, comes from share prices rising between the two strikes.
You can see how this works here:
Source: The Options Industry Council
The trader profits as shares go up, until they hit that second strike price. That’s the profit ceiling on this type of trade. However, if used on a stock like Cisco that isn’t likely to see an enormous bounce, a bull call spread offers the perfect blend of risk and reward.
Today, just such a trade is lining up for CSCO.
A Specific Trade on CSCO
Right now, a trader can buy a November 15 $47.50 call for $2.60 per share and sell a November 15 $52.50 call for $0.56 per share. This results in a cost – and therefore total amount at risk – of $2.04 per share. Since each is worth 100 shares of CSCO, that’s a net debit of $204.
The trader cannot lose any more than that $204. And the only way for that to happen would be if shares fell from their perch of $48.80 below $47.50. Like we noted, a bounce over the next several months is far likelier.
Those wanting to exit Cisco after its earnings last month have already done so. Those looking to get in on its cheap valuation, large dividend and forward-looking businesses have an opportunity right now.
So, a rally higher is definitely more likely. And if that happens, this trade could make serious money. To find the maximum profit potential of this bull call spread, take the difference in strike prices ($52.50 – $47.50 = $5), and subtract the cost ($5 – $2.04 = $2.96). On 100 shares, that’s a potential return of $296.
In other words, this trader is looking at a potential return of 145% on the amount at risk. With so much going right for the company Cisco… and so much of it overlooked in the stock CSCO… this is a rare opportunity to bank a potential double on this so-called old-guard of the tech industry.