A String of Earnings Surprises Doesn’t Always Boost Stock Prices
As companies report earnings, it’s not uncommon to see unexpected market reactions. One of the most common examples of this is the company that beats earnings and the stock falls. That’s what happened to The Kroger Co. (NYSE: KR).
The Report Looks Good, At First
According to ZACKS, “After reporting a positive earnings surprise of 15.9% in the first quarter of fiscal 2018, The Kroger Co. KR again delivered better-than-expected second-quarter bottom-line results. The top line also came ahead of the Zacks Consensus Estimate for eighth straight quarter.”
But, there were some concerns. Same store sales, without fuel, fell short of analysts’ expectations. Also, gross margins, an important measure of profitability, contracted. And, management disappointed.
As to the quarter, “the company delivered adjusted earnings of 41 cents a share that beat the Zacks Consensus Estimate of 38 cents and increased 5.1% from the prior-year quarter. [The] company continues to envision adjusted earnings in the range of $2.00-$2.15 per share. The current Zacks Consensus Estimate for fiscal 2018 stands at $2.12.”
However, the company revised its GAAP net earnings view to $3.88-$4.03 per share from its previous range of $3.64-$3.79 owing to the unrealized gain in Ocado shares, recorded in the quarter under review.
Total sales grew 1% to $27,869 million from the prior-year quarter and came marginally ahead of the Zacks Consensus Estimate of $27,823 million.
Excluding fuel, the convenience store business unit divestiture and the merger with Home Chef total sales jumped 1.8%. Digital sales surged more than 50% during the quarter under review.
The company’s identical sales, excluding fuel center sales, grew 1.6%. Kroger projects fiscal 2018 identical sales growth, excluding fuel, to be in the range of 2-2.5%.
Zack’s noted that gross margin contracted 40 basis points to 21.3%, after shrinking 30 basis points in the preceding quarter. Meanwhile, excluding fuel and the LIFO charge, gross margin fell 36 basis points during the quarter under review, after declining 13 basis points in the first quarter.
Management hinted that gross margin rate reflected price investments, higher transportation costs and growth of the specialty pharmacy business.
Analysts believe that Kroger’s dominant position enables it to expand store base and boost market share because the company’s customer-centric business model provides a strong value proposition to consumers.
But, an intensifying price war among grocery stores to lure budget-constrained consumers poses concern. That could weigh on the stock which has been in a down trend.
A Trading Strategy to Benefit from Potential Weakness
The prospects of further short-term gains in KR seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for KR
The bearish outlook for KR, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the October 19 $33 put can be bought for about $4.22 and the October 19 $28 put can be sold for about $0.50. This trade will cost about $3.72 to enter, or $372 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $372. This loss would be experienced if KR is above $33 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in KR, the maximum gain is $1.28 ($33 – $28 = $5; $5 – $3.72 = $1.28). This represents $128 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $372 to open this trade.
That is a potential gain of about 34% of the amount risked in the trade. This trade delivers the maximum gain if KR closes below $28 on October 19 when the options expire.
Put 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 $170 for this trade in KR.