An Earnings Beat, and a Selloff
Sometimes a company delivers what appears to be a good earnings report. They beat expectations and they deliver a positive outlook for the current quarter. Yet, sometimes, all that good news isn’t good enough and the stock sells off after the report is released.
That appears to be the case with Tractor Supply Co. (Nasdaq: TSCO) which recently reported its earnings for the fourth quarter.
Earnings per share (EPS) of $0.91, adjusted for pretax expenses, beat the average estimate of 12 analysts surveyed by Zacks Investment Research who expected EPS of $0.87.
The retailer for farmers and ranchers posted revenue of $1.95 billion in the period, which matched the forecasts of analysts according to Zacks.
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Executives were happy with the overall results. “Tractor Supply had a strong fourth quarter,” CEO Greg Sandfort said in a press release, “which included increases in both comparable store transaction count and average ticket.”
He added that, “I am very pleased with the foundation we have established to build customer loyalty and to significantly enhance our digital capabilities.”
Plans for expansion remain on track. “In 2018, we anticipate balancing investments between new store growth and our [multichannel] strategic initiative, while also investing in the day-to-day business to provide our customers with a seamless shopping experience anytime, anywhere and in any way they choose,” Sandfort explained.
These moves should translate into increased market share, according to management, even if their costs partially offset financial gains provided by recent changes to U.S. tax law.
Looking ahead, the company expects its effective tax rate to fall to about 23% in 2018, a significant drop from the 36.7% rate the company reported for 2017.
Those savings should allow the company to increase its investments in the business as capital expenditures are expected to increase to between $260 million and $300 million, from $250 million last year.
Even after the big jump in capital spending, management expects net income to increase for the current year.
The company’s initial 2018 growth outlook predicts steady comparable store sales gains that should be between 2% and 3%. Management noted that in line with their standard practice, the target will be subject to a potentially large revision in about six months, following fiscal second-quarter results.
At that time, they noted, management will have a much better reading on how demand trends are shaping up for its peak spring selling period.
Tractor Supply expects full-year earnings to be $3.95 to $4.15 per share, with revenue in the range of $7.69 billion to $7.77 billion.
The Report Highlights Valuation
Before the report, TSCO was trading at a relatively high price to earnings (P/E) ratio.
Source: Standard & Poor’s
The P/E ratio of 24 is high for a company that is delivering earnings growth that is in line with the market averaged.
Analysts had been expecting the company to grow into its lofty valuation. Before management issued its guidance for 2018, analysts had been expecting EPS of about $4.52. The rapid selloff in the stock seems to reflect the change in the earnings outlook.
Using the midpoint of management’s guidance, the stock is now trading for about 17 times this year’s expected earnings. This is possibly the fair value for the stock. That means, although there could be a bounce in the price, the stock is unlikely to rally much in the coming weeks.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative best option strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A credit spread option strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in TSCO
For TSCO, we have a number of options available. Short term investment options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a February 16 $70 call for about $1.75 and buy a February 16 $75 call for about $0.40. This trade generates a credit of $1.35, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $135. The credit received when the trade is opened, $135 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $365. The risk is found by subtracting the difference in the strike prices ($500 or $5 times 100 since each contract covers 100 shares) and then subtracting the premium received ($135).
This trade offers a potential return of about 37% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if TSCO is below $70 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 $365 for this trade in TSCO.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.