Bears Should Make Their Way Toward Red Hat

by Joseph Hargett | March 27, 2013 8:50 am

Business software firm and Linux OS specialist Red Hat (NYSE:RHT[1]) is slated to release its fiscal fourth-quarter earnings report after the close of trading today. Wall Street analysts are expecting earnings to rise about 3.4% year-over-year to 30 cents per share. Revenue, meanwhile, is seen rising 18% to $349.6 million.

Overall, analysts widely expect Red Hat to match the consensus estimate, and maybe even come in a bit higher. However, many on the Street are concerned about the company’s earnings guidance. In fact, Raymond James downgraded its rating on RHT earlier this week, citing growth prospects for fiscal 2013.

Unfortunately for Red Hat, there is plenty of room for more analysts to follow Raymond James’ lead. According to data from Thomson/First Call, 21 of the 33 brokerage firms following RHT rate the stock a “buy” or better, compared to 11 “holds,” one “underperform” and no “sell” ratings. There is also room for potential price-target cuts, as the current consensus 12-month target of $63.50 rests 28% above RHT’s close at $49.25 on Tuesday.

Elsewhere, while short sellers could hardly be called optimistic, they have been buying back their positions at a rapid pace during the past several months. Following a 12% decline during the most recent reporting period, only about 2.5% of RHT’s float, or shares available for public trading, remains sold short.

032713RHT 300x247 Bears Should Make Their Way Toward Red Hat
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The problem with this decline is that it has corresponded with an RHT decline, with the stock dropping more than 13% since the beginning of February. In other words, the overall selling pressure facing RHT has been more than enough to offset the buying power from short sellers covering their positions. In fact, selling pressure has been so strong that RHT breached former long-term support at the 50 level earlier this week — a move that was accompanied by strong volume.

Turing to the options pits, we find a veritable wealth of bullish bets heading into Red Hat’s quarterly earnings report. Specifically, there are more than 38,000 calls open in the April and May series of options, compared to put open interest of about 13,000 contracts. The resulting April/May put/call open interest ratio of 0.35 reveals that calls nearly triple puts in the front two months of options. Since calls typically represent bets that that the underlying shares will rise, speculative options traders appear to be quite bullish on RHT.

Taking a closer look at April options reveals that implieds are pricing in a post-earnings move of about 9.4% for RHT. While some investors might feel safer following the crowd on RHT and buying calls ahead of tonight’s report, the sheer volume of bullish sentiment, the stock’s weak price action and concerns about earnings guidance have me leaning toward a bearish put spread.

Specifically, the May 47/50 put spread looks particularly attractive. And, it lies well within the expected post-earnings move being priced in by implieds. At the close of trading on Tuesday, this spread was offered at $1.55, or $155 per pair of contracts. Breakeven lies at $48.45, while a maximum profit of $1.45, or $145 per pair of contracts, is possible if RHT closes at or below $47 when May options expire.

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

Endnotes:
  1. RHT: http://studio-5.financialcontent.com/investplace/quote?Symbol=RHT

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