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Bullish on Coinstar

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The following is a sample alert sent to subscribers of Steve Smith's Optionsmith yesterday.

My overall market take on is undefined. As usual, the intellectual argument seems to fall squarely on the bear side. Looking at a slow-growth top line, an eventual reversion to the mean for profit margins leading to shrinking EPS, coupled with dysfunctional fiscal policy of unsustainable debt -- alongside a manipulative monetary policy that currently distorts prices, and will at some point things will unhinge as an exit strategy is attempted. It’s easy to conjure doom scenarios. Layer on top an increasing bullish sentiment, whether it’s measured from bull/bear polls, record inflows (retail buying at the top) or VIX and put/call ratios it would seem we are heading for a fall. But many of these reasons and indicators have flashed similarly over the past 3 years only to see the bull march higher. Valuation remains relatively low, corporate balance sheets are strong and interest rates are zero. I’m going to leave the bantering alone for now and just search out trade opportunities and ways to limit risk.

I’m adding a bullish position in Coinstar (NASDAQ:CSTR), which is better known for its Redbox DVD rental than its eponymous coin counting and cashing machines. I’ve traded in this name various times from the short side, so this will be a new experience. Let’s see if I can build a bull case for an intermediate term trade.

The chart is not glorious but it does have some support just below current levels around $46.80 a share. Longer-term support comes in at $45 a share.

There is an extreme level of short interest; it currently stands at 40% of the float which translates into 15 days to cover based on average trading volume over the past 30 days. Remember, shorts are embedded buyers so the squeeze potential high.

The stock is inexpensive at just 9x forward earnings compared to 15% average earnings growth over the past 2 years. The company has beaten earnings the last two quarters and with Q4 estimates having been marked down of late, from $1.03 per share two months ago to $0.75 a share currently, CSTR should be poised to beat the lowers hurdle. Profit margins are a healthy 8.1%. By comparison Netflix (NASDAQ:NFLX) trades at 110x earnings and has a slim 2.1% profit margin.

The kiosk vending machines may seem mundane, but they provide stable returns. The Redbox vending machines serve an under addressed market in the U.S and is seeing nice growth in emerging markets where streaming or subscription models are not yet available or affordable. A recent alliance with Verizon to start providing streaming also provides potential growth acceleration. The namesake coin cashing machines are just gravy; they take a 7%-9% fee just for counting coins. Other self serve vending machines, such as coffee, are also starting to rollout across the 20,000 locations it currently populates.

The Trade

I think things line up for the stock to move back above the $60 level in the next few months. The company reports earnings February 7 . This has created a forward skew in which the February options have a higher implied volatility, around 48%, than April, around 37%. I’m going to try to use this to our advantage by establishing a calendar/back spread. That is, selling some near-term closer to the money calls and buying a greater amount of longer term and slightly further out of the money calls.

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POSITION:  Position in CSTR options.