Earnings Confirm This Analyst’s Bullish Outlook On The Stock
There are many sources of analysis and some investors will overlook analyst reports that aren’t from major Wall Street firms. We recently saw an analysis on a stock from a lesser known source and found the argument to be interesting. When we considered it in detail, we identified a trading opportunity.
Let’s start with the analysis and then turn to the trade.
The MoneyShow reported, “Luxury home goods retailer Williams-Sonoma (NYSE: WSM) earned $1.02 per share in fiscal Q3 2020 (vs. $1.01 est.). The firm had revenue of $1.44 billion, versus the $1.42 billion estimate.
The shares recently tumbled, even as the company raised the low end of its full-year guidance, which now stands at $4.65 to $4.80 of EPS (vs. $4.60 to $4.80 previously) and revenue between $5.77 billion and $5.90 billion (vs. $5.74 billion and $5.90 billion previously).
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CEO Laura Alber stated, “While we continue to innovate the experience in our stores, our revenue growth was led by e-commerce at 9%, reaching almost 57% of revenues. Highlights from the brands include West Elm, which led our performance with a 14.1% comp on top of an 8.3% comp last year.”
Ms. Alber concluded, “We are confident that we will deliver great service to our customers this holiday season and lead as an example of sustainability in our industry. We believe we are well equipped for an exceptional 2019 and we are ready for what’s to come in 2020.”
Williams-Somonma posted solid earnings and improved guidance, so it was a bit surprising to see shares hit hard for what view as no transgression at all. The stock has gained more than 35% this year, handsomely outpacing the S&P 500 Retail Industry Group’s 21% return.
Management said that the company’s mitigation strategies for the tariffs on Chinese goods have been paying off, and forward guidance includes no expectation that the tariffs will be repealed. Therefore, we think there would be additional upside if the tariffs were trimmed or eliminated.
We think that WSM remains a compelling value proposition (with metrics like a 14 times forward P/E ratio, a 2.9% yield and a 0.9 times P/S ratio) with strong growth prospects.
We continue to like WSM’s investments in technology, collaborations with other brands, in-store and in-home design consultations and sizable online presence. Our Target Price has been bumped up to $86.”
The stock is in a basing pattern for the past few weeks.
This base comes near the previous highs and a breakout could set up a significant move higher.
A Trade for Short Term Bulls
As with the ownership of any stock, buying WSM could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for WSM
Every day, we scan the markets looking for trades with 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.
For WSM, the January 17 options allow a trader to gain exposure to the stock.
A January 17 $70 call option can be bought for about $1.65 and the January 17 $72.50 call could be sold for about $0.62. This trade would cost $1.03 to open, or $103 since each contract covers 100 shares of stock.
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 $103.
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 WSM, the maximum gain is $1.47 ($72.50 – $70= $2.50; $2.50 – $1.03 = $1.47). This represents $147 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $103 to open this trade.
That is a potential gain of about 42% in WSM based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.