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An Options Play in the Face of Earnings Decay for Patterson

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As the cost of health care rises -- and dental insurance is usually an add-on people are ready to forego -- the company's revenues and earnings are in decay.

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MINYANVILLE ORIGINAL While I'm sure there will always be more businesses to be bearish on, Patterson (NASDAQ:PDCO) is the third of my three little bears. It joins Tiffany (NYSE:TIF) (see Use January Options to Play Lackluster Tiffany Ahead of Earnings) and Accenture (NYSE:ACN) (see Accentuate the Negative) as part of a group of stocks that should be sleeping on the short side of your portfolio.

Patterson is in the dental business; it supplies very basic items, from toothbrushes to chairs to the cotton balls that get shoved in your mouth during a visit to the dentist. The company has been trying to move up the product chain (into products with higher margins) through some billing and data software, but that's still a negligible part of the business.

The challenges facing this company became apparent when it reported very disappointing earnings on November 20 and the stock gapped down some 15% to the $31 level. That was the third quarter in a row that the stock responded to less-than-expected earnings with a big gap down. In the previous quarter it had recovered nicely and went on to new 52-week highs within the following two months. I don't think this third time will be the charm, unless you are bearish, as I am.

No Smiles in Dentistry

Patterson's business is in a declining sales mode and faces further headwinds due to shifts in insurance coverage. Simply put, as the cost of health care rises -- and dental insurance is usually an add-on people are ready to forego -- both revenues and earnings are in decay. The slowdown ranges from the recommended preventive six-month check-up, to nonessential cosmetic treatments that might come out of pocket. Exhibit A would be Align Technology (NASDAQ:ALGN), which, all mumbo jumbo aside, is basically an orthopedic braces maker. When it reported disappointing earnings in mid October, the stock got crushed with a 30% decline. It has since stabilized in the mid $25 range, but is listless. Likewise, I think Patterson, which is actually breaking back down to $34 per share as I type, will be challenged in the coming months.

Ignoring all the research that suggests that teeth can be the canary in the coal mine for predicting and preventing the spread of major organ disease, it is still treated (or not) as a secondary, non-required health issue by both insurance companies and individuals. A slowdown for dental visits (essential or otherwise) puts real pressure on practices, which tend to be small, independent operations of five to 15 people. There is little reason to purchase new chairs, lights, or even cotton balls if the cash isn't flowing.

Even after the recent sell-off the stock trades at 19x forward earnings while analyst estimates call for just 7% earnings growth into 2013. Despite the efforts to move to higher technology services, this stock is in secular decay.

The Options Play

To get bearish on this stock I'm looking at a fairly aggressive strategy, which is referred to as a risk/reversal. In this case it is established through the sale of an out of-the-money call to help finance the purchase of an out-of-the-money put.

Specifically, I would sell the January $34 call for $0.60 and buy the January $33 put for $0.80. This is a $0.20 net debit. There is the danger that if the stock zooms higher losses could be significant due the naked call so I would use a stop loss of $34.50 for exiting the position. My downside target would be $29 per share.

Sink your teeth into this bear and we'll see how we fare.

Twitter: @steve13smith

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No positions in stocks mentioned.

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