#$brcm

5 Trade ideas excerpted from the detailed analysis and plan for premium subscribers

Broadcom, Ticker: $BRCM

Broadcom, $BRCM, had been moving higher off of an October 2014 low until spiked in May. That spike sold off making a low with the market in August. Now it has hit resistance and backed off to a higher low and is rising again toward resistance. The RSI is rising and in the bullish zone along with the MACD. Watch for a push through resistance.

CF Industries, Ticker: $CF

CF Industries, $CF, started lower in July in a falling wedge. These are often thought of as bullish, but it broke the wedge to the downside. It made a low at the end of September and consolidated a few days before a strong thrust higher. Now it is at resistance and making a series of higher lows. The RSI is rising and on the edge of a move into the bullish zone with the MACD rising.

DexCom, Ticker: $DXCM

DexCom, $DXCM, was a pharma favorite all of 2015 until the August meltdown. The stock quickly recovered making a new high before the pharma/biotech sell off of September brought it down 30%. It has bounced off of that and built a small bull flag. Friday saw it push through the top of that flag. The RSI is at the mid line after a bounce off of oversold levels as the MACD is crossed up and rising.

FirstMerit, Ticker: $FMER

FirstMerit, $FMER, ran higher to a peak in June. The pullback from there found a bottom with the market in August and has been consolidating since. Friday saw a push through the important 18.30 level and to the 200 day SMA. The RSI is moving into the bullish zone and the MACD is rising, both supporting continued upside.

JB Hunt Transport Services, Ticker: $JBHT

JB Hunt Transport Services, $JBHT, traveled lower in a falling channel until it pulled off that road to the downside when the market sank in August. Since making a low it has bounced in a wide range against resistance. It is back against resistance again and has support for a push through to the upside from the rising and bullish RSI and MACD.

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After reviewing over 1,000 charts, I have found some good setups for the week. These were selected and should be viewed in the context of the broad Market Macro picture reviewed Friday which, heading into the last week of October, sees the equity markets looking strong.

Elsewhere looks for Gold to continue lower in its longer term downtrend while Crude Oil heads lower in the short term. The US Dollar Index is breaking to the upside while US Treasuries are marking time sideways. The Shanghai Composite and Emerging Markets are biased to the upside with Emerging Markets at a major resistance level.

Volatility looks to remain subdued keeping the bias higher for the equity index ETF's SPY, IWM and QQQ. The SPY and QQQ had major moves and look set up to continue higher into next week with the IWM lagging and at resistance. Use this information as you prepare for the coming week and trad'em well.

Based on its earnings history and its track record of crushing analyst estimates, Broadcom (NASDAQ:BRCM) will beat the $0.75 Wall St. consensus EPS estimate on Thursday afternoon.

We’ll start by providing our projections, proceed to an explanation of the rationale behind the projections, and finish with some additional analysis and supplementary charts. Our track record of past quarterly earnings predictions made by the model can be found here.

EPS PROJECTIONS

On average, sell-side analysts on Wall Street expect Broadcom to report $0.75 in EPS for this quarter. Our model projects a 65-75% probability that BRCM will beat these projections. It expects a large beat on estimates, ranging from 5-10% higher than consensus (EPS between $0.79 to $0.83).

REVENUE PROJECTIONS

On average, sell-side analysts on Wall Street expect Broadcom to report revenues of $2.11 billion for this quarter. Our model projects a 65-75% probability that BRCM will beat these projections. It expects a small beat on estimates, ranging from 0-5% higher than consensus (revenue between $2.12B to $2.21B).

RATIONALE

Analyst estimates are consistently too conservative as companies beat earnings estimates over 60% of the time. Analysts may do this to stimulate trading (e.g., Hayes 1998), to obtain access to management (e.g., Lim 2001) or to confirm a prior sentiment on a stock (e.g. Hwang 1996). In any case, analysts are incentivized to “play nice” with the companies that they cover, and this manifests itself in earnings estimates that are consistently lower than they should be.

This pattern of earnings estimate manipulation can be taken to the extreme in certain companies. Thus, an important factor to analyze when predicting whether a company will beat earnings estimates ahead of time is to look at its past track record of estimate beats. Broadcom appears to be an extreme example of earnings estimate manipulation as it almost never misses earnings estimates. Logically, you’d assume that analysts would simply revise their estimates higher (since they’re always too low) but for one reason or another, they don’t. Below is BRCM’s earnings history:

BRCM has only missed one EPS estimate in the last 10 quarters: FQ2 2013 when it missed by 2¢ on the Wall St. Consensus of $0.49 (4% miss). Since then, it hasn’t missed EPS and has beaten by an average of 15%. The trend in EPS beat size is clearly negative, as each of the last 3 beats have been smaller than the one prior. It should also be noted that over the last 24 quarters (6 years), BRCM has only missed on EPS twice, a remarkable consistency. A company’s recent EPS and revenue growth rates can also shine a light on growth trends in the company to see how analysts estimates compare to history. Below is BRCM’s EPS and revenue growth rates from the past 3 years.

The analyst consensus of $0.75 represents 63% Year-over-year (YoY) EPS growth from the $0.46 reported the same quarter a year ago. YoY EPS growth rose to 93.94% last quarter, and has been trending upwards ever since it was last negative FQ2 2012. Analysts are clearly expecting this EPS growth to slow down considerably to 63%, which seems overly pessimistic given the companies growth rate the past two quarters. Our estimate of $0.81 is more inline with BRCM’s current growth rates at 76%. Analysts appear to be continuing their trend of setting low expectations for BRCM.

From a revenue standpoint, analysts have been more inline with reported results, making revenue predictions based on past results less certain. Below is BRCM’s revenue history:  

The strongest pattern from the past 12 quarters of revenue estimates is that analysts consistently set expectations too high for FQ2 and too low throughout the rest of the year. This pattern counters the basis for an upcoming revenue beat. The $2.11B that analysts are expecting this quarter would represent 3.38% YoY revenue growth from the $2.04B reported in FQ2 2014. This 3.38% would be inline with the recent slowing of BRCM’s revenue growth rate and is in line with our predicted revenue beats of 0-5%.

Another factor that plays a big role in our predictive model is the recent performance of BRCM’s stock price. We’ve found through extensive historical back testing that the market tends to anticipate strong earnings ahead of time, and thus stocks are bid up in price ahead of earnings. Below is a look at some of the inputs to our technical analysis model, that shows how BRCM’s current price compares to its recent moving averages:

BRCM is underperforming its short-term moving averages of 20 and 50 days, but outperforming the longer moving average of 200 days. These numbers are highly influenced by the 21% price surge that BRCM experienced on May 27th when it announced that it would be acquired by Avago for $37 billion (the largest ever merger between chip makers). The stock is slowly correcting from the high of $57.70 from that day, but remains 12.5% higher than it closed on May 26th. These earnings may be of reduced importance given that the buyout price has been agreed upon (shareholders can elect Avago stock (0.4378 shares) or $54.50 in cash), but nonetheless, given the adverse effects of unexpected EPS misses on BRCM’s share price (and the smaller, positive effects of EPS beats) traders can use this opportunity to take a short-term position on the stock.

CONCLUSIONS

Broadcom shares have a 1-day average price change on earnings of 5.78%. Options are pricing in an implied move of 5.34% off earnings. While an EPS beat is more likely, the downside from a miss will have a greater effect on the stock’s price. The average gain following an EPS beat over the last 12 quarters has been 3.3%, while the average drop from a miss is 15%. Over those same 12 quarters, BRCM’s stock price has dropped 4 times following an EPS and revenue beat. Both revenue misses over those 12 quarters resulted in a price drop.

While we expect the recent buyout announcement to reduce the importance of this quarter’s earnings announcement, there is still an opportunity for traders to profit given the historical volatility of this stock’s share price on earnings day. We anticipate a large EPS beat with confidence, but feel less certain about a revenue beat given the downward trend in the company’s revenue growth. If history is any indication, expect a downward revision should BRCM fail to beat the $2.11 billion revenue estimate, and an even bigger revision should the company miss the $0.75 EPS estimate.

From a more structural perspective Semiconductors have been a space we’ve wanted to stay away from for most of the year. Every time the sector index made new highs, it quickly failed. This along with consistent bearish momentum divergences on multiple time frames over the past year have kept us in the cautious camp and we’ve preferred to look elsewhere for long positions.

Looking at the PHLX Semiconductor Index, prices today are exactly where they were a year ago. This is essentially a basket of chip makers including the likes of Qualcomm, Texas Instruments, Intel, Broadcom, etc. The first chart shows the weekly candlesticks coming down to former resistance from last year (shaded in gray) that also served as support earlier this year. Notice how we are also right at this uptrend line from where this rally first got going in the second half of 2012.

With momentum putting in lower highs over the past year while prices rallied and then failed after each new high, we’ve been gun-shy on the long side. Looking at it today, RSI has held near the 40 level without getting oversold. That’s a good thing. If prices can hold onto this support and can prove it can stay above this uptrend line, I think that structurally this would be very positive.

Here is a closer look at the Semiconductor Index. Notice the bullish momentum divergence as RSI put in a higher low while prices made new lows over the past week:

The way I see it, there is a ton of potential here if prices can hang on to these levels. We only want to be long semi’s if prices are above this uptrend line. If prices cannot get/stay above it, then I do not see any reason to be involved on the long side. The levels are very well defined, which is what we want.

We can have potentially 75 points to the upside in this Index, but again, we would only want to be long if we can get above and stay above this uptrend line. If that doesn’t occur, then this is a moot point. Either way, the level is clear and I believe it’s well worth watching.***

It’s late in the second quarter with U.S. equity markets marginally ahead on the year. The next leg of the bull market was supposed to come from Capex but it appears CEO’s have found a quicker way to drive returns. With organic growth slowing and an economy struggling near the flat line management is turning to M&A as the Holy Grail. It’s no secret the pace of deals is picking up with barely a day going by without some announcement on your favorite financial news channel. Just tweet about the potential of a deal and it’s enough to send shorts scrambling for cover as investors stampede into the target.

According to Forbes there have been 15 + deals in 2015 north of $10 Billion and the list seems to grow with each passing week. Europe’s BG tops the list at $70 Billion with Charter’s (CHTR) take out of Time Warner Cable (TWC) following at $55 Billion. Comcast (CMCSA) failed in their Time Warner bid as regulators made it clear they weren’t going to give this one a pass. Just last week one of our recent additions Broadcom (BRCM) shot up on the heels of a $37 Billion buyout offer from Avago (AVGO) in cash and stock.  

Investors Bidding up Buyers and Sellers

Some companies aren’t even waiting for the deals to develop and are hiring bankers seeking "strategic alternatives.” On Friday Humana (HUM) announced they had hired Goldman Sachs to advise them on potential offers making it clear they are for sale.  

GDP Last 5 Years

One look at current stats and it’s easy to see why CEO’s are looking to ride the M&A wave. On Friday we got news the economy contracted for the third time since the recovery started. We seem to stumble from one quarter to the next taking hits from weather, dock strikes, a slowdown in China and the never ending story of a potential Grexit. The truth is when you have an economy this slow, negative GDP quarterly growth is going to be part of the mix more often then we’d like.

While Fed action likely saved us from the Abyss and has been a bonanza for asset prices it hasn’t really trickled down to the Main Street economy. Mr. Bernanke and Ms. Yellen took monetary policy to the limit in an effort to keep the patient alive long enough to get back on their feet and to a large degree that was a success. Regardless of whether you believe these actions were the right move it is clear this era has passed and the Fed is slowly but inevitably heading toward the exit.

In the last five years fiscal policy failed to keep up with the Fed and I believe history will view it as largely a failure. I’ll leave it to the political talking heads to point fingers but for now it’s difficult to ignore the obvious.

The SPX above 2100 is a testament to just how resilient the market has been in the face of weak data. Pullbacks have been shallow with buyers lurking at every level of support.

Green Shoots

Most of the economic data hasn’t been promising but in a recent Barron’s interview heavyweight Byron Wien pointed out the ECRI (Economic Cycle Research Institute) Index had recently turned up indicating that future quarters could show improvement. In the chart above I plotted the ECRI data during the last five years alongside the S&P 500. As Byron points out it has turned up. While the two charts do seem to move together I’m not sure a case can be made for the ECRI having real predictive power.

Why Now for M&A

We shouldn’t be surprised to see this level of M&A activity given the economic backdrop. With so many companies struggling with revenue growth management is becoming increasingly inventive with efforts to grow the bottom line. Buybacks and other sources of financial engineering have been a big driver of price momentum but nothing works better than a good old fashioned merger.

Think of it management’s point of view. You eliminate a competitor and come up with a treasure chest of synergies to drive margins and earnings for the next several years. Unfortunately, one of the first casualties when two companies combine is jobs.

You don’t need two sales departments and even in the C suite there will be some job losses however, I suspect the severance packages will be a little more generous.

As the pace of deals picks up announced transactions are getting bigger. The chart above from Business Insider shows the trend and size of deals. With global growth in the doldrums this may be just the tip of the ice berg. Get ready for some shocking numbers and merger announcements from companies you never would have thought would put themselves up for sale.

If you can’t grow organically then M&A may be the next best thing. The premiums will move higher as more deals get announced and the best prospects are taken out of play. Those who move first should end up with the best deals for shareholders with late comers picking up the scraps.

The increased pace of announcements smells of panic as companies scramble to find partners. As the best of breed get gobbled up pretty soon even the wall flower starts to look good. It’s too soon to say if the buyers are overpaying but that’s how it always ends.