Traders Who Heed Chart's Warning Could Score 100% Profits : HSNI

Investors often think of stocks in terms of growth and value. Growth stocks tend to enjoy rapid growth in earnings and trade at high price-to-earnings (P/E) ratios. Value stocks usually have lower P/E ratios but offer investors relatively stable earnings growth and often pay a small dividend. Many companies begin trading as growth stocks and then become value stocks when earnings slow. One sign that this transition is under way could be the initiation of dividend payments.

Dividends are one of the ways that companies use the cash flow generated by their business.
Companies will also use cash flow to meet current operating expenses and to reinvest in the business so that they can generate more growth. As companies grow, they may find it challenging to find investment options that deliver the rate of return they like to see. When this happens, some companies initiate dividend payments and, in effect, signal shareholders that they cannot find a way to use all of their cash to maintain the previous growth rates in the current environment.

Last year, HSN Inc. (NASDAQ: HSNI) initiated a dividend. The company is a well-known retailer that was first known as Home Shopping Network. Home shopping channels are still an important part of the company's strategy, although catalogs, websites and retail outlets now supplement that strategy. In the past 12 months, the company has generated more than $3.3 billion in revenue from these diversified sales channels. Revenue growth is now in the low single digits and is expected to grow about 5% in the next year.

Earnings growth also seems to be slowing for the company. After averaging earnings per share (EPS) growth of more than 58% a year in the past five years, growth is expected to come in at 27% this year and 22% next year. Over the next five years, EPS growth is expected to average 16% a year, making the recent P/E ratio of nearly 19 look a little expensive. Traders often think that the P/E ratio should be equal to the EPS growth rate at fair value, and by this measure HSNI is overvalued.

The monthly chart also shows that HSNI could be due for a sell-off. The stock has been one of the biggest winners in the past four years, gaining more than 3,800%. The stock has now closed above its upper Bollinger Band four months in a row, indicating that it is overbought, and the stochastics indicator has just offered a sell signal.

The weekly chart is similar, although the stochastics sell signal is clearer. A short-term price target of $47.08, the 20-week moving average, can be found with the weekly chart. Eventually, a move back to the lower Bollinger Band would be expected.

HSNI could be sold short to profit from the expected decline. The dividend has been paid at an annual rate of $0.50 and short sellers would be liable for quarterly dividend payments as long as they are short. This seems like a small price to pay given the potential downside in the stock.

Put options can also be used for those who are uncomfortable shorting stocks. March $50 put options are trading at about $2.33 and would be profitable if HSNI falls below $47.67.

The company is scheduled to report earnings in early February, and the March expiration date allows traders to benefit if HSNI drops on that report. At least one analyst did lower their estimate for this quarter in the past few weeks, although several others have raised estimates. Analysts have fairly diverse opinions about the stock and there is a 25% range between the lowest and highest EPS estimates. This variability seems to be consistent with the reality that the company is in a transition from fast growth to slow growth and analysts are uncertain how the company will manage the transition.

HSNI is a short trade for aggressive traders. There seems to be little upside potential in the stock and the current price leaves little room for operational errors. Retailers often stumble, and after four years of exceptional growth, HSNI could be due for a rough patch.

Recommended Trade Setups:
-- Short HSNI at the market price
-- Set stop-loss at $53.50.
-- Set initial price target at $47 for a potential 10% gain in three months; a longer-term target of $40 is reasonable for a potential 23% gain
-- Buy HSNI March 50 Puts at $3 or less
-- Set stop-loss at $1.
-- Set price target at $6 for a potential 100% gain in four months