Shake the Shorts for More Seagate Profits

by Joseph Hargett | January 10, 2013 8:56 am

When you think of companies with strong growth potential in the current market environment, you generally don’t think about hard disk drive manufacturers. And that’s why many on Wall Street were caught off guard earlier this week when Seagate Technology (NASDAQ:STX[1]) boosted its fiscal second-quarter sales outlook[2] from $3.5 billion to $3.6 billion.

While the company is officially scheduled to release its full Q2 report on Jan. 28, Seagate just couldn’t wait to tell investors. Solid unit sales figures drove revenue, with Seagate shipping about 58 million drives in the quarter. Additionally, the company reported adjusted gross margin of 27% and said it paid $1.1 billion in share redemptions and dividends during the quarter.

STX shares jumped 6.6% on the news to close at their highest point in more than four months. For a broader perspective, Seagate added 85% in 2012, making it the second-hottest tech stock in the S&P 500. What’s more, investors already have gotten more than 8% gains out of STX in 2013.

STXchart 300x251 Shake the Shorts for More Seagate Profits
Click to Enlarge
Technically, the most recent leg of STX’s rally began after the shares rebounded from support near $25 in late-November, pushing the stock past former resistance at $33. Shares have since added more than 32% along support at their 10- and 20-day moving averages. What’s more, the stock’s 50- and 200-day trendlines are on the verge of a “golden cross” — a bullish technical formation that could bring a wealth of buyers to the table.

Despite STX’s strong price action and solid fundamentals, there is a wealth of negative sentiment levied against the shares. For instance, 19 of the 23 analysts following the shares still rate them a “hold” or worse. Additionally, the consensus 12-month price target for STX rests at $29.50 — a discount of 13.5% to the stock’s close at $33.46 on Wednesday.

Further negativity is evident among short sellers. Specifically, the number of STX shares sold short have more than doubled from 22.2 million shares in September to more than 48.5 million shares in the most recent report … though that report’s data was as of Dec. 14. That said, this sizable short position accounts for nearly 15% of STX’s total float, and it would take nearly five days to repurchase at the stock’s average daily trading volume.

In layman’s terms, STX could be ripe for a short squeeze if the shares see follow-through buying in the wake of this week’s earnings news.

Options traders aren’t prepared for a rally. In fact, the put/call ratio for the January and February series of options arrives at a beefy 2.64, meaning that put open interest more than doubles call open interest in the front two months. Drilling down, we find that the most active strikes are the January 22 put, with 5,639 contracts, and the February 31 strike, where 7,961 puts reside.

Given the wealth of pessimistic sentiment despite the stock’s strong technicals and fundamentals, STX appears to offer a golden opportunity for a contrarian option play. To allow time for bears to unwind their positions, traders might want to consider buying an STX February 33 call, which was asked at $2.10, or $210 per contract, at the close of trading on Wednesday.

Those looking to lower their risk should consider converting their call into a bullish call spread. With STX historically experiencing turbulence at $35, it makes sense to sell the February 35 call, which was bid at $1.15, or $115 per contract, at the close yesterday. Altogether, the February 33/35 bull call spread would set you back 53 cents, or $53 per pair of contracts. The maximum profit arrives at $1.47, or $147 per pair of contracts, and is possible if STX closes at or above $35 when February options expire.

As of this writing, Joseph Hargett did not hold a position in any of the aforementioned securities.

Endnotes:
  1. STX: http://studio-5.financialcontent.com/investplace/quote?Symbol=STX
  2. boosted its fiscal second-quarter sales outlook: http://www.bloomberg.com/news/2013-01-08/seagate-s-second-quarter-sales-of-3-6-billion-exceeded-forecast.html

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