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After a Big Deal, This Stock Could Fall

After a Big Deal, This Stock Could Fall

Deals make headlines and then some investors ignore the companies involved. They might believe it will take time for the deal to be completed and stock prices might not move much during that time. Investors might also believe it will take time to integrate the acquisition, allowing more time for the stock to trade in a relatively narrow range.

These beliefs make sense from a business perspective. The companies will need time to close a deal. This process is in some ways similar to closing on a house. It can take months from the time an offer on real estate is accepted before possession changes hands.

Integrating an acquisition can take years. It is also likely the integration will prove to be more difficult than expected. In the end, the hoped for cost savings may not be as large as projected and the acquisition might not add as much to the bottom line as expected.

The fact that so many acquisitions eventually prove to be disappointing provides the basis for a trading strategy. However, there should be confirming indicators in place since no signal in the markets will ever work 100% of the time.

News From Michael Kors

Michael Kors (NYSE: KORS) agreed to acquire Jimmy Choo for $1.2B. Kors noted that they expect to grow Jimmy Choo sales to $1B a year and create long-term operational synergies with the existing MK business.

Michael Kors has been searching for a way to deliver growth as its eponymous brand has struggled. The company has been a pioneer the “affordable luxury” sector. That means its products remain relatively expensive compared to mall-based chains, like J.Crew. It’s a niche that has not delivered as expected.

The chart below shows the recent trend in sales growth for Kors. The trend is clear. The down trend is a clear explanation for the acquisition for Choo.

Source: Finance Yahoo

Jimmy Choo’s revenue, on the other hand, has been growing.

Source: Financial Times

Michael Kors “thinks it can use its own global infrastructure to expand Jimmy Choo’s footprint. It says it plans to “support the growth of Jimmy Choo through retail store openings and further development of its online presence as well as through an expanded assortment of additional fashion product offerings.” It also said it intends to leave the brand’s existing management team in place.”

KORS Will Need Time to Prove the Concept

It is possible KORS could succeed with this strategy. The company has an extensive distribution system in place and a large manufacturing capacity. Choo has those same capabilities. The new company will be able to consolidate operations resulting in cost savings that should increase profits.

Before investors had a chance to understand the news, Kors’ CEO gave an interview to CNBC. “This will not be [Michael Kors’] last acquisition,” CEO John Idol told CNBC in a phone interview shortly after the deal was announced.

Idol reiterated that Michael Kors is focused on forming a “luxury group,” as the company laid out in its “2020 plan,” a strategic move with the goal of returning to growth by 2018.

This plan creates a degree of uncertainty which could explain the market’s reaction to the news. KORS opened lower on Tuesday, but rallied through the day. The stock remains locked into a downtrend and shows a loss of almost 20% since the beginning of the year.

The company is expected to announce earnings before the market opens on August 8. Traders have reacted by selling previous earnings announcement. On average, KORS shows a decline of 5% in the week after earnings are announced.

These two factors, the stock’s current trend and the fact that the stock typically sells off after earnings are announced, are bearish.

Even if the stock doesn’t decline much, in the short term, KORS seems unlikely to rally sharply given its history. This means traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.

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. This diagram is from The Options Industry Council web site.

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

The bearish outlook for KORS, at least for the purposes of this trade, is a short term opinion. In the long run, this stock could move significantly higher. The stock did trade at more than $100 a share in July 2014. However, it has declined for most of the past three years.

KORS is likely to consolidate or drift lower into its earnings report. Then, based on the historical pattern, a selloff could develop after the earnings report. To benefit from a potential selloff, 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.

For KORS, there are a number of options expiring in August. With earnings expected on August 8, the options expiring August 11 could be the least expensive options for this trade. Using options that expire the next week would require a larger outlay of capital.

Specifically, the August 11 $35 put can be bought for about $1.90 and the August 11 $32.50 put can be sold for about $0.90. This trade will cost about $1 to enter, ignoring the cost of commissions which should be small when using a deep discount broker.

The maximum loss is experienced if KORS rises above $35. In that case, both options would expire worthless.

The maximum gain on the trade is equal to the difference in exercise prices less the premium paid, or $1.50 in this trade ($35 – $32.50 = $2.50; $2.50 – $1 = $1.50). Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.

That is a potential gain of 150% on the amount risked in the trade. This trade delivers the maximum gain if KORS closes below $32.50 on August 11, when the options expire. If KORS closes between $32.50 and $35 that day, the gain will be less than $1.50.

With KORS currently trading near the exercise price of the put option that was bought, there is a high probability of success in this trade. Any decline in the stock should lead to a profit. This would not be true if a less expensive option was bought.

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 $100 for this trade in KORS.