This Bargain Might Not Really Offer Value
Source: Sally Beauty Holdings.com
A stock trading with a low price to earnings (P/E) ratio is usually considered a bargain. But, sometimes the stock is trading with a low P/E ratio because the company is in trouble. That seems to be case with Sally Beauty Holdings, Inc. (NYSE: SBH).
The stock is trading with a P/E ratio of 8.9. Anything below 10 is usually considered cheap and potentially attractive. Analysts expect SBH to report strong earnings and to average growth in earnings per share of more than 8% a year.
Yet, the company announced “that its Board of Directors has approved a cost reduction plan designed to help fund important long-term growth initiatives. This program includes cost savings initiatives focused on organizational efficiencies, sourcing of product and brands for resale, indirect procurement, store operating expenses, and inventory management.”
Sally Beauty Holdings is an international specialty retailer and distributor of professional beauty supplies with revenues of approximately $3.9 billion annually.
The company sells and distributes through 5,177 stores, including approximately 184 franchised units, and has operations throughout the United States, Puerto Rico, Canada, Mexico, Peru, Chile, the United Kingdom, Ireland, Belgium, France, the Netherlands, Spain and Germany.
Sally Beauty Supply stores offer up to 8,000 products for hair, skin, and nails through professional lines. Its outside sales consultants sell up to 10,500 professionally branded products including Paul Mitchell®, Wella®, Matrix®, Schwarzkopf®, Kenra®, Goldwell®, Joico® and Aquage®, intended for use in salons and for resale by salons to retail consumers.
Restructuring Is Needed
In November, the company announced plans to restructure its operations. Now, the company is telling investors that, “as a first step, the Company is implementing headcount reductions, primarily at its corporate headquarters.”
Layoffs are expected to generate annualized benefits in the range of $14 million to $15 million, with benefits in fiscal year 2018 in the range of $6 million to $7 million. The charges to be incurred in connection with this plan are expected to be in the range of $15 million to $16 million.
Other restructuring actions are expected to generate annualized benefits in the range of $12 million to $14 million, with approximately $8 million realized in fiscal year 2018. Total restructuring charges are now expected in the range of $28 million to $30 million.
Traders reacted to the news by selling the stock.
Momentum, shown as MACD at the bottom of the chart, is bearish. Often, when bad news is delivered while momentum indicators indicate the chart is bearish, a stock suffers a significant decline. That would be consistent with the long term pattern in SBH shown in the next chart.
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 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 SBH
For SBH, we have a number of options available. Short term 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 May 18 $17.50 call for about $0.60 and buy a May 18 $20 call for about $0.10 This trade generates a credit of $0.50, 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 $0.50. The credit received when the trade is opened, $50 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $200. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($50).
This trade offers a potential return of about 25% of the amount risked for a holding period that is less than two months. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if SBH is below $17.50 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 $200 for this trade in SBH.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.