This Earnings Report Shows Retail Troubles Will Hurt Some Companies
Source: Gap Inc.
Moody’s, the investment ratings agency, recently updated its outlook on the retail sector. The report noted,
“The last few years have seen a bevy of high-profile retailers either go bankrupt or close stores across the country, raising concern that brick-and-mortar retailers are doomed. It’s undoubtedly true that consumers are buying more and more goods online, and that’s putting pressure on some retailers.
However, it’s important to put this in context: So far, the overall decline of brick-and-mortar retail is a relatively minor change in the economy, and not a major structural disruption.
It’s not hard to see why the “death of retail” story has gotten so much traction in the anecdote-driven news world. It’s easy to find examples across the country of empty malls, vacant big boxes, and abandoned retail strips that create the impression that the demand for brick-and-mortar shopping has cratered. However, the data tell a different story.”
The analysts concluded,
“This analysis suggests that when there is an empty mall or abandoned big box store, there is a good chance that it can be explained by lack of population growth or a weak economy.
While e-commerce is undoubtedly growing and has been a factor in the closing of some retailers, the brick-and-mortar retail sector overall is not undergoing the kind of structural job loss seen, for example, in manufacturing. Instead, retail is undergoing a process of gradual change that is necessary in a dynamic economy, but it is not yet a major disruption or cause for concern.”
While the changes are not catastrophic, they are evident in the employment trend.
The impact will continue to be seen in some large national brands, as a recent earnings report demonstrated.
The Gap Disappoints
Shares of The Gap Inc. (NYSE: GPS) fell after the company disappointed investors when it released its earnings. There was some good news in the report as the company reported its sixth consecutive quarterly revenue beat.
But, earnings failed to meet expectations, after four straight quarters of better than expected numbers. The Gap reported earnings per share of $0.42, three cents below the $0.45 expected according to the Zacks Consensus Estimate.
Net sales grew 10% to $3,783 million, coming in above the Zacks Consensus Estimate of $3,608 million. Comparable store sales, an important indicator for retailers that measures sales at stress open at least one year, were up 1%.
Same store sales growth was driven by 3% increases at Old Navy and Banana Republic. These gains offset a decline of 4% at the company’s Gap brand stores.
Finally, management reaffirmed its guidance for the full year. Analysts were told to expect flat to slightly up same store sales and earnings between $2.55 and $2.70 a share. According to Zacks, the Consensus Estimate for the fiscal year is near the lower end of the range at $2.61.
Traders sold on the news.
Looking Ahead, There Could Be More Pain
In the conference call with analysts after the announcement, Gap’s Chief Financial Officer Teri List-Stoll described the issues at Gap as the brand being “heavy on inventory,” which impacted margins, and the “timing of inventory flow.”
The missteps led to promotions during the quarter and a $28 million inventory charge. “As back-to-school aligns with the beginning of the back half, that is when we feel like we’re largely out of the operational issues,” said Art Peck, chief executive of Gap Inc.
That’s also when changes to areas like inventory and assortment “should start to impact.”
SunTrust Robinson Humphrey analysts are not convinced.
“While management seems confident in their ability to turn the Gap brand around in the second half, we have little to hang our hat on as of yet as the challenges at the division weighed on both comps and gross margin in the first quarter and inventory has not been fully right-sized,” analysts led by Pamela Quintiliano wrote.
“Old Navy has been firing on all cylinders but the performance in the first quarter was not enough to drive margin improvement at the company level despite representing just under half the business.”
SunTrust rates Gap Inc. shares hold and lowered its price target to $29 from $35.
With inventory problems weighing on the company, it could take time for the stock to recover.
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 GPS
For GPS, we have a number of options available. Short term options allow us to trade frequently and potentially increase 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 June 15 $29 call for about $0.45 and buy a June 15 $30 call for about $0.20. This trade generates a credit of $0.25, 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 $25. The credit received when the trade is opened, $25 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $75. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($25).
This trade offers a potential return of about 33% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if GPS is below $29 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 $75 for this trade in GPS.
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.