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Dark Horse Hedge – October

Dark Horse Hedge – October (updated)

By Scott Brown at Sabrient, and Ilene, at Phil’s Stock World

October 
And the trees are stripped bare 
Of all they wear 
What do I care 
October 
And kingdoms rise and kingdoms fall 
But You go on 
And on

October, U2

Actions for Monday, October 4, 2010:

Buy American Eagle Outfitters (AEO).

Establish a Bear Put Spread and Sell Naked (out of the money) Calls for Interoil (IOC)

With the unusual September setting behind us, the best September for the S&P  since 1939, we enter October timidly following a mixed bag of economic figures and our technical market indicators on the brink of rolling over.

The Dark Horse Hedge strategy has served us well by tilting long and short while using options to earn "dividends" on stocks we want to own long term. XRTX had the dubious distinction of being punished to the tune of 14% in Thursday’s trading while beating estimates by 20%. Its revenues were 74% higher than a year ago. The drop doesn’t really effect the DHH virtual portfolio as we recommended owning the stock and selling December calls, so we are earning time premium while marking time. However, it is worth noting how irrational the market can be. XRTX made $37 million in profits for the quarter versus $7 million in the same quarter a year ago. The only concern I could glean from the earnings call transcript had to do with Q4 revenues being forwarded into Q3. The company still guided $.60-.86 for Q4, the consensus being $.86. Let’s say that XRTX comes in at $.66, at the low end, after making $1.19 in Q3. That is $1.85 for the second half of the year. Had the sales not moved forward from Q4 to Q3 the company would have announced $1.00 in Q3, in-line with guidance, and meeting the $.86 figure for Q4. So the second half of the year would be $1.86 or the same amount. The executives who have managed this amazing business led analysts to believe they are well positioned going into 2011 as well. So why would 4th quarter revenue pushed forward into Q3 trigger a 14% bludgeoning? (See also Xyratex Gored as Outlook Disappoints.)

Remember the flash crash day and how things such as " Waddell and Reed, and their destructive hedging trade of 75,000 e-minis (ZH)," along with simple headlines, without details, prompted "machines" to start making trades that ultimately created a panic? XRTX is trading at four times earnings which makes it seemingly undervalued, and Capstone just came out with a Buy rating on XRTX last week with a price target of $24. Enough said about XRTX, but it doesn’t make sense to me. The end result for us is that we will ride out the next 2 months of yield enhancement through our option contracts and reevaluate it later.

Despite the S&P 500 trading north of the 200 and 50 day moving averages for the last seven trading days, we have not jumped on the bullish band wagon. Historically, September rallies (especially a low volume one such as this) have often been met with bad Octobers and this latest rally leaves the markets looking very overbought. On the last day of September the 12-26-9 MACD was within a cats whisker of rolling over. Until we get more conviction that the September rally will carry through October, we will maintain our Long:Short virtual portfolio slightly long tilt with the addition of both a long and a bearish option trade on Monday.

Chart by freestockcharts.com.

Monday Additions to DHH’s virtual portfolio:

Bearish Interoil Corporation (IOC) Option Play

Our research on Interoil (IOC) leads us to believe there may be a lot of skeletons in its closet, making it a top choice for our next bearish position.

As background, Interoil Corporation’s principal activity is to develop an oil refinery in Papua New Guinea (PNG). The Group also explores and develops oil and gas in PNG. Sabrient has a hold rating on the stock, with a value score of only 22 out of 100. The timeliness score, 67, factors in its current uptrend in price. But all good trends come to an end, and we believe IOC isn’t far from a reversal for fundamental reasons.

Most notably, it appears the reserves claimed by the company (which have driven the market cap to $2.9 Billion) have not been proven to exist. But the company’s market capitalization is based on the assumption that these reserves exist and that Interoil can find the oil and gas and the capital to develop it commercially.

For example, in "InterOil (IOC) Is Running On Fumes, Says Whitney Tilson," Henry Blodget (Business Insider) writes:

We are confident without looking that Wall Street folks raved about IOC’s recent quarterly results and outlook. So we figure there might be interest in a more skeptical take.

Fortunately, fund manager Whitney Tilson of T2 Partners, who is short the stock, has provided one…

"The earnings and EBITDA (driven by the refinery operation) are irrelevant for a company that has a $2.9 BILLION (not a typo) market cap; what really matters is whether there is, in fact, the Sierra Madre of oil and gas in the areas being explored by InterOil and, if so, whether they have the cash to find it, develop it commercially, etc.

Re. the former, there continues to be no proven or even probable reserves – just more hype and gibberish like this from the earnings release:

The Antelope 2 horizontal well confirmed a higher condensate-to-natural gas ratio of 20.4 barrels per million cubic feet of natural gas, 27% higher than observed at the top of the reservoir. The horizontal well also demonstrated dolomitization and higher porosity deeper in the reservoir than previously modeled.

And regarding the cash, this company is going to hit the wall soon

[…]

To summarize, InterOil has only $31.7 million in unrestricted cash as of June 30th and they’re burning an average of $45.5 million of cash each quarter.   No wonder the company entered a short-term $25 million credit facility last week ( http://finance.yahoo.com/news/InterOil-Enters-Short-Term-25-prnews-1473636862.html?x=0&.v=1) on distressed terms: 10% interest (in this environment!), secured by a 2.5% stake in InterOil’s Elk and Antelope fields. Note that the provider of financing was a very dicey outfit, Clarion Finanz and known stock promoter Carlo Civelli – see http://whitecollarfraud.blogspot.com/2009/07/interoil-john-thomas-financial-and.html.

In InterOil, John Thomas Financial, and Clarion Finanz: Anatomy of a Stock Market Manipulation SchemeSam Antar writes:

In this blog post, I will provide evidence of what I believe is a stock market manipulation scheme involving InterOil (NYSE: IOC), John Thomas Financial, and Clarion Finanz AG. I believe that InterOil, with the assistance of Clarion Finanz concealed John Thomas Financial’s involvement in helping it raise $95 million through a private placement of convertible debt securities.

Clarion Finanz acted as a buffer between InterOil and John Thomas Financial to help InterOil hide John Thomas Financial’s role in raising funds. Afterwards, InterOil filed false and misleading reports with the Securities and Exchange Commission in an effort to conceal John Thomas Financial’s role in helping the company raise $95 million in convertible debt. Continue here.

Whitney Tilson, another Interoil non-believer (quoted earlier), explained in his resent letter to clients why he thinks Interoil is a good short. As Courtney Comstock at Business Insider reports in "Whitney Tilson: ‘ We’ve Never Had More Conviction, In A Short:" 

Tilson’s letter delivers an opus on why he thinks Interoil is a good short (it starts at the bottom of page 2). He seems to be responding to the speculation that Tilson might have changed his views on the stock following his reporting a long stake in Interoil in his most recent 13-F."

The best lines:

We’ve never had more conviction and Interoil is currently our largest bearish position.

After more than a decade of drilling, InterOil has no proven or even probable reserves – just a lot of hype and unfulfilled promises (and more than 200 press releases).

It’s red flags galore. IOC is an Australian based company and it gets its largest credit facility from BNP Parabas. BNP Parabas recently issued a gushing report about IOC and its "prospects" for business. Thus, the lender, BNP Parabas, is issuing positive reports on a client company it lends money to. Now follow Edward Speal with me for a moment. Speal had been a director of Interoil for the past seven years but had to leave in June for "personal reasons." He is now the head of BNP Parabus Global Equities and Commodity derivatives – Americas. On September 16, 2010, Speal, after leaving Interoil to go to BNP Parabus, the largest lender to Interoil, files a rule 144 form stating that Edward Speal is exercising 60K options on IOC stock for the net value of $3.6 million. This in and of itself is odd, but combined with a recent announcement that IOC is going to enter discussions with an unnamed party that they don’t have a deal with yet, seems like an attempt to hype the stock.

Considering these pieces of information, we think it’s only a matter of time before this overvalued company meets with reality. However, because IOC has a history of causing short sellers pain, rather than simply shorting the stock, we asked Phil Davis for a good options strategy that allows DHH followers to take advantage of the IOC situation while staying within our desired risk paramaters. The strategy he proposed is designed to manage risk and provide a nice return if IOC drops in price. It’s useful when you think there’s a good chance a stock will decline, but you don’t know when, and you want to limit your risk.

Together we are  recommending a combination between a bear put spread and selling a naked call. Here’s how this works:

BUY 5 March 2011 70 PUT IOC110319P00070000 for approx. $12.05
 
SELL 5 March 2011 65 PUT IOC110319P00065000 for approx. $9.40
 
SELL 5 January 2011 85 CALL IOC110122C00085000 for approx. $2.40

This puts you in the $5 March bear put spread at net .25 ($12.05 – $9.40 – $2.40 = 0.25), providing IOC stays below $85 through January’s options expiration (21st).  This trade has a $5 upside if IOC is below $65 at March expiration (18th). Note: We are buying or selling 5 puts/calls for each position because that represents about 7.5% of the virtual DHH virtual portfolio, considering the value of the long put position only.  Adjust your positions according to your risk tolerance and virtual portfolio size.) 

The January scenarios are:

#1)  If on January 21, 2011 IOC is below $85 per share (nearly 30% higher than the close on Friday) we will keep the $2.40 per contract premium and reevaluate.
#2)  If on January 21, 2011 IOC is above $85 per share we will be short 500 shares of IOC at $85.

The March scenarios are:

#1) If on March 18, 2011, IOC is below $65 per share the March $70 puts we bought will be worth $5 per contract more than the $65 puts we sold, giving us a $5 profit per contract.
#2) If on March 18, 2011, IOC is between $65 and $70 per share we can roll the options forward to a future expiration date, or depending on the price, take our profits.  For instance, if IOC is at $66 per share, the March $65 PUT we sold can be bought back for $1 per contract, and the March 70 PUT we bought can be sold for $4.  So we would have a $3 per contract profit. Thus, if on March 18th, 2011, IOC is between $65 and $70, our profit is the difference between the two less the net 0.25 paid for the entire position. 
#3) If on March 18, 2011 IOC is above $70 per share we would roll our option trade forward to a future expiration date.

Thus, we will earn the most profit if IOC stays below $65 per share, which we are betting it will.

Summary:  Bear Put Spread and Selling Naked (out of the money) Call for Interoil (IOC) on Monday, October 4, 2010

We also would like to add American Eagle Outfitters ( AEO) to maintain our current slightly long tilt.

From Sabrient’s Ratings Report

American Eagle Outfitters, Inc. offers on-trend clothing, accessories and personal care products. It operates under the American Eagle (AE), aerie by American Eagle, 77kids by american eagle and MARTIN+OSA (M+O) brands. As of January 30, 2010, it operated 938 American Eagle Outfitters stores in the United States and Canada, 137 aerie stand-alone stores and 28 MARTIN+OSA stores. 

Earnings and Revenue Update: For the quarter ended July 31, 2010, American Eagle reported earnings of $9.7 million or $0.05 per share compared with $10.8 million or $0.05 per share for the prior quarter and $28.6 million or $0.14 per share for the same quarter one year ago. Revenues were $651.5 million for the quarter ended July 31, 2010 compared with $659.5 million for the prior quarter and $646.8 million for the same quarter one year ago. Last twelve months’ earnings were $0.67 per share compared with $0.60 per share a year ago. Last twelve months’ revenues were $3.0 billion compared with $2.9 billion a year ago.

AEO has a good retail brand heading into holiday shopping season, and the insiders have been stepping up with many recent open market purchases. It trades at a P/E of 15, and so we are looking for growth to give us positive return. Sabrient has a hold rating on the stock. Twenty eight analysts following AEO expect an average of $.25 for the October quarter and $.41 for the December quarter. We are going to join in with the insiders buying and recommend buying AEO (7.5% of virtual portfolio) to help ring in our holiday cheer.

Buy American Eagle Outfitters (AEO) on Monday, October 4, 2010.

*****

Practical Options Strategies for Any Market: Free

Watch Schwab’s Director of Trading and Derivatives, Randy Frederick, as he reveals the potential benefits and risks of trading spreads in bullish, bearish and neutral markets. Sign up for this free webinar now.

[Note: there are several questions on the sign up page and they require a response of $250K or more investable assets, and at least 36 trades per year. I’m noting this because I know many people prefer to skip these questions.]

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