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A Downgrade Adds to the Woes of This Company

A Downgrade Adds to the Woes of This Company

In 2018, Alliance Data Systems Corp (NYSE: ADS) reported almost $8 billion in revenue. That could drop to less than $7 billion.

ADS provides data driven marketing and loyalty solutions serving consumer-based businesses in a range of industries.

The company offers a portfolio of integrated outsourced marketing solutions, including customer loyalty programs, database marketing services, end-to-end marketing services, analytics and creative services, direct marketing services, and private label and co-brand retail credit card programs.

One segment, LoyaltyOne, provides coalition and short-term loyalty programs through the company’s Canadian AIR MILES Reward Program. BrandLoyalty Group and Card Services provides risk management solutions, account origination, funding, transaction processing, customer care, collections and marketing services for the company’s private label and co-brand retail credit card programs.

While the decline in revenue is one problem, the stock’s troubles seem to be growing. As The Street noted,

“The numbers weren’t looking great [recently]for Alliance Data Systems (NYSE: ADS) with the stock price of the loyalty rewards marketer and credit card company taking a big hit after an analyst downgrade.

… Deutsche Bank downgraded the stock to hold from buy.

ADS daily chart

Analysts at the bank cited “multiple headwinds,” including the wind down of a portfolio slated for sale, reserve build, and the anticipation of further interest rate cuts, which could put a crimp on its earnings growth in 2020, according to published reports.

Deutsche Bank analyst Ashish Sabadra slashed the price target on Alliance Data Systems stock to $158, down from $162.

However, a spokeswoman for ADS ascribed the decline in the company’s stock price to the results of its “modified Dutch auction” rather than the analyst downgrade.

ADS [had] announced … it expects to spend $750 million acquire more than 5 million shares at $148 per share.

“Such a modest adjustment to the price target would be unlikely to result in the type of price movements we’ve experienced today, hence the impact of the tender offer closing,” noted Shelley Whiddon, vice president of public affairs, in an email.

ADS last month reported a 3% drop in second-quarter revenue to $1.35 billion, while earnings per share plunged 33% to $2.71.

The company said a key factor in the drop in EPS was its acquisition of $900 million worth of credit card portfolios in June, deals it had previously expected would close later in the year.

On July 1, ADS completed the sale of its Epsilon unit, with plans to use the proceeds to shed $2.4 billion in debt and repurchase $1.1 billion in company stock.

“Our second quarter results were mostly in line with expectations, although core EPS was negatively impacted by the timing of credit card portfolio acquisitions,” said Melisa Miller, ADS president and CEO, in a press release detailing the company’s second quarter results.

The news does come with the stock locked in a down trend.

ADS weekly chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

A Bear Call Spread in ADS

For ADS, we could sell a September 20 $135 call for about $6.80 and buy a September 20 $140 call for about $5. This trade generates a credit of $1.80, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $180. The credit received when the trade is opened, $180 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $320. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($180).

This trade offers a potential return of about 56% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if ADS is below $135 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $320 for this trade in ADS.