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Another Retail Disaster Provides a Setup for a Trade

Another Retail Disaster Provides a Setup for a Trade

Retailers generally need to shine at this time of year to make their investors happy. However, it has been a difficult year for the sector. And, as earnings come in from leading retailers this week it appears that the year may not improve in the final weeks.

Retailers have been under increasing pressure this year. Although online sales account for just a small part of the retail environment, online sales are growing. This has led to concerns about whether or not traditional retailers can compete.

A number of retailers have been pushed into bankruptcy. There are concerns about retailers, including one-time market leaders like Sears and J.C. Penney, could enter bankruptcy. Thousands of stores have already been closed. Additional bankruptcies would close more stores.

As stores close, retail centers became less attractive to consumers. Fewer consumers go to malls that are half empty and strip malls become less enticing as well. In this environment, traders are nervous and appear to be ready to sell stocks in the sector at the first hint of bad news.

On Tuesday, Dick’s Sporting Goods, Inc. (NYSE: DKS) delivered its quarterly earnings report. The numbers were strong. Earnings, adjusted for pretax gains, were $0.30 per share, which topped Wall Street expectations by $0.04, according to a survey by Zacks Investment Research.

For the current quarter ending in January, Dick’s expects to deliver earnings per share (EPS) within a range from $1.12 to $1.24. Analysts surveyed by Zacks had forecast adjusted EPS of $1.10. Revenue rose 7.4% to $1.94 billion, also beating Street forecasts.

Guidance for the full year reflected the increased expectations for the quarter. The company expects full-year earnings in the range of $2.92 to $3.04 per share. That’s a shift from a prior range of $2.85 to $3.05 per share.

However, looking ahead to next year, there is cause for concern. The company expects a sharp profit drop in 2018 as it boosts its online spending at a time of tightening margins and flat sales. “We expect earnings per diluted share to decline by as much as 20 percent in 2018,” said CEO Edward Stack.

Traders sold the stock on the news, pushing the stock even lower. The company’s stock price has already fallen more than 50% since the beginning of the year.

Value Investors Might See a Bargain

With the stock down so much, it could begin to capture the attention of value investors. Based on analysts’ estimates, the stock is trading at less than 10 times this year’s and next year’s expected earnings.

This year’s sell off has pushed the price to earnings (P/E) ratio down to the levels seen in the bear market that ended in 2009. At this price, the stock should be attractive to value investors.

Source: Standard & Poor’s

The stock could also be attractive as a potential acquisition candidate for a private equity firm or a competitor seeking to consolidate within the retail sector. Acquisitions are often priced on ratios such as the total enterprise value (TEV) to earnings before interest, taxes, depreciation and amortization (EBITDA).

TEV considers the entire cost of buying a company. This value considers any preferred stock that may have been issued along with debt that the company has issued and cash or other short term assets like account receivables that could be converted to cash to help fund the deal.

EBITDA is a measure of how much cash the company generates. Management makes decisions that affect the level of taxes that are paid, the amount of interest the company is committed to pay and how to invest in assets that will need to be depreciated.

In a buyout, the new owner would be responsible for all assets and liabilities. Therefore, the TEV to EBITDA ratio is a comprehensive way to evaluate the financial situation of the possible target. The next chart shows that the ratio is as low as it was in the bear market.

Source: Standard & Poor’s

These charts don’t mean that value investors or potential acquirers are definitely interested in the company. They do show that Dick’s Sporting Goods is trading at levels that would seem to be appealing to these potential investors.

However, these investors are unlikely to act until there are signs of a reversal in the company and that is months away. The ideal trading strategy in DKS could be one that benefits from the limited upside potential in the stock while limiting the risk of a potential buyout.

Trading the Trend

To benefit from weakness, an investor could buy put options. But, as the chart shows, DKS has been in a downtrend and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.

But, high prices on put options suggests an alternative trading 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 spread options 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 DKS

For DKS, we have a number of options available. Short term options allow us to trade frequently and potentially increase our account size quickly.

In this case, we could sell a December 15 $26 call for about $0.80 and buy a December 15 $27 call for about $0.50. This trade generates a credit of $0.30, 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 $30.

The credit received when the trade is opened, $30 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $70. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($30).

This trade offers a return of more than 42% for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if DKS is below $26 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 $70 for this trade in DKS.

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.