If History Repeats, This Growth Stock Is Money In The Bank
Growth investors are notoriously fickle when it comes to earnings reports. Unbridled enthusiasm leads them to bid up shares of rising stars, only to stampede for the exits when the company fails to meet ridiculously high expectations.
Sometimes it doesn't even take an earnings miss to send shares crashing, but merely a change in the company's financial outlook. Lowered guidance may send analysts and shareholders fleeing, even if the company is still on a strong growth trajectory.
In many cases, it's not long before investors calm down and once again look at the company rationally. They reassess the longer-term outlook -- the same story that probably got them excited about the stock in the first place -- and bid shares right back up.
So, when I see a best-of-breed company in one of my favorite long-term industries plummet after its earnings report, I get excited.
Herd Quick To Bail On This Growth Stock… And Then Buy Again
Few firms have been as innovative in information security as FireEye (Nasdaq: FEYE) with its advanced detection technology and threat intelligence feed.
Security advisory firm SSP Blue estimates global spending on information security could reach $170 billion by 2020, which represents nearly 18% compound annual growth from the $75 billion spent in 2015. Much of this growth is expected to be driven by the Internet of Things revolution and the shift to cloud-based storage, which present new challenges for companies in this space.
In its 2016 analyst day briefing, FireEye reported its Multi-Vector Virtual Execution (MVX) engine has a 99% accuracy at reporting "true positives," i.e., actual security threats, versus an accuracy rate of just 37% for competitor Cisco Systems (Nasdaq: CSCO) and 26% for Check Point Software (Nasdaq: CHKP). Meanwhile, FireEye said products from competitors reported up to 246 times more "false positives" -- warnings of nonexistent threats, which waste valuable time and resources -- than FireEye products.
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It's not surprising that this kind of industry would attract rabid growth investors. Unfortunately, FEYE shares seem to attract the worst in herd mentality.
The stock is notorious for its volatile performance around earnings, but upon closer inspection, a pattern has developed.
FireEye has beaten earnings expectations by an average of 11% over the past 12 quarters but has seen its shares tumble on the release in 10 of the past 12 quarters. It seems a combination of strong growth and investor exuberance drives expectations and shares skyward ahead of the quarterly reports, irrational selling follows, and it starts all over again.
Following the most recent earnings announcement, FEYE plummeted as much as 17.6% on Aug. 5. The company reported an adjusted Q2 loss of $0.33 per share, but this was better than the $0.39 loss analysts were expecting. While revenue came in below estimates, it jumped 19% year over year. FireEye also added 308 new customers during the quarter.
The disappointment came as management lowered its guidance for full-year revenue by about $70 million and forecast a 2016 loss of $1.30 per share. This caused a number of firms, including JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C), to downgrade shares to "hold" or "neutral."
Part of the company's problem over the most recent quarter was its position as a premium security consulting service. Management noted that fewer large-scale hacking events had been reported so far this year, which means customers may be more likely to gamble on cheaper products and services from FireEye's competitors.
FireEye has decided to target mid-market customers by separating its MVX Engine into a customer premise-based sensor and a cloud-based threat subscription service. This will enable it to offer its cloud-based service at a lower price and compete for price-conscious clients.
Management also announced a restructuring plan to cut $80 million from costs through 2017, including up to 400 layoffs.
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Even on the lowered guidance, the midpoint of $722 million for expected 2016 sales still represents growth of 16% over last year, while the expected full-year loss of $1.30 per share is an improvement over last year's loss of $1.61.
How to Profit From FEYE's Post-Earnings Pattern
Last week's sell-off is a familiar song -- and one that could mean handsome profits for investors and traders.
Long-term investors should come out ahead as double-digit sales growth eventually results in profits. Between headlines of hacking for political information and the constant reports of financial information breaches, digital security is sure to be one of the most promising industries of the next decade.
Short-term traders are also presented with an opportunity to position themselves in shares now for a near-term rebound. Looking at price performance following quarterly earnings since the end of 2013, FEYE has closed an average of 10.4% higher two months after the report
But since the stock is so volatile, I prefer to use a strategy that offers some downside protection. It's known as a covered call, and many of you may already be familiar with this simple and conservative strategy. If you're not, you can get a 90-second crash course here.
Basically, a covered call involves buying at least 100 shares of a stock and then immediately selling a call option against them to bring in additional income. By accepting this payment, you agree to sell your shares at a higher price (the option's strike price) if they are above this level when the option expires. The income from selling the call is yours to keep no matter what, so if the stock falls, the covered call trader is in a better position than the person who bought shares outright.
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With FEYE trading at $13.91 at the time of this writing, we can buy 100 shares and simultaneously sell one FEYE Sep 14 Call, which is trading around $0.87 ($87 per contract, which controls 100 shares). This gives us a net cost of $13.04 per share, which is a 6.3% discount to the current price and a huge 22.2% discount to where shares were trading before the post-earnings sell-off.
If the shares close above the $14 strike price at expiration on Sept. 16, our shares will be sold for that price. In this case, we will make $0.09 in capital gains, plus the $0.87 for selling the call. That gives us a total return of $0.96 for a 7.4% gain on our cost basis of $13.04. Because we'd earn that in 37 days, the annualized return works out to 73%.
If shares fail to reach the $14 strike price on expiration, I would gladly hold them and sell another call option against the position each month until shares rebound and get called away. My guess is it won't be long before long-term growth has investors bidding the shares up again, and I think FireEye can be profitable as soon as the second half of next year.
Growth in information security means this leader can endure these temporary growing pains to reward investors able to see beyond the knee-jerk reaction to earnings. Of course, while we're waiting for shares to rebound, we can continue to bring in income by selling calls. If you want to learn how you can use covered calls to earn an additional $3,000 per month, follow this link.
This article was originally published on ProfitableTrading.com: If History Repeats, This Growth Stock Is Money In The Bank
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