By John Critchley & Christopher Yip
Even before the real summer months hit, specialty retailers are left sweating after a heated wave of dismal earnings crushed their stock value and left many investors with sunburns. Apparel retailers were spared no mercy as traders abandoned shares of Gap (GPS), Aeropostale (ARO), and American Eagle (AEO) after earnings were reported and guidance were lowered across the board. Staples (SPLS) shares jumped off a cliff last Wednesday, gapping down 15% after earnings were reported in the premarket. This is very telling of the direction the market is taking on retailers. As people forecast for internet bubble 2.0, and point fingers at the LinkedIN IPO as proof of a pending disaster, the facts remain true. The internet is still a dominant force. And as such, businesses, especially retailers, should react appropriately to such a dominant force. After all, business models are not meant to be stiff and inelastic, they are supposed to be alive, malleable, and flexible. So why is Best Buy (BBY) doing what it’s doing?
BBY shares are still hobbling along after the stock took a hit in December, falling 17% after earnings missed and guidance for FY2011 was lowered. Shares are now trading at $31.09, with a short-term trend channeling up. BBY has since come out with the proposal of cutting down its supersized warehouse stores and coming out with smaller stores focused on mobile phone sales. But a quick walk down Broadway in lower Manhattan and you will quickly notice an array of cellular shops, ranging from the big guys at AT&T (T), Verizon (VZ), and Sprint (S) to the little guys in MetroPCS (PCS) and Leap Wireless (LEAP). This begs me to question what BBY mobile is able to offer shoppers that all these other shops have not already. I will give credit to BBY for quickly responding to its declining revenue and shrinking margin, but in this world, no grade is awarded for effort. Real results are needed and the bottom line is, this strategy does not seem like it will generate substantial revenue and at best is only aiming for cost savings in operating costs.
Internet shopping is one of the top culprits of BBY’s income statement, yet it is also one of the routes BBY has not yet explored. Often times customers who are shopping on BBY’s website discover that prices online are cheaper than that of the local BBY store. Instinctively, they go to the store to examine the product and upon checking out, expect the price to be matched to the online price. But they are turned down and are told that if they want to receive the online price, an online order must be placed. This is certainly a policy that BBY management will want to examine. As customers are flocking to sites that offer lower prices such as Newegg.com and Amazon.com (AMZN), the last thing BBY wants to do is alienate its remaining customer base. By matching the store price to its online price, BBY might lose money on shipping, handling, and inventory costs but for retaining a customer by providing convenience and service, those are costs that can be reevaluated and adjusted.
It is quite clear BBY has some more work to do. As their earnings report is expected to be out on June 14th, they certainly face a difficult but feasible task of navigating through this rough patch. Nonetheless, BBY has been an extremely reputable company in the past backed by the strategic move to buy Geek Squad and expand them into a fully technological servicing agency. Can they surprise on the next earnings report and leave Wall Street scratching its head? Bull or bear, we have you covered.
Here are two trade ideas that may catch your interest…
A Bearish Options Play
Do you believe that the traditional big box electronic retailing model is rapidly going into extinction? And that Best Buy, the last of the traditional electronic retailers will be the next domino to fall. If yes, let’s look at a bearish options play:
The 45-day implied volatility (July options) appears to be quite reasonable at the 31% level considering the upcoming earnings event on June 14th. These options are trading significantly lower than 52 week 30 day IV highs of 51% reached Jan of this past year and present some compelling medium term option value.
The play: To take advantage of normal downside implied volatility put skew and to benefit from any continuing downward pressure in Best Buy over the next few months.
a) Buy July 32-29 put spread for $1.21. Receiving about 2.9% in Implied Volatility skew (buying 30.4 IV vs. selling 33.3 IV)
To finance this spread:
Let’s sell the July 33 calls @ .74. This is approximately a 30.3% Implied Volatility.
Net debit: $.47
Risk: You will be Short the stock over $33, a 5.6 % upward move in Best Buy over the next couple of months.
A Bullish Options Play
Are you a ‘Best of Breed’ believer in Best Buy? Or thinking that Best Buy is the sole survivor in the ‘internet retailing age?’ If yes, let’s look at a long-term bullish options play:
The Jan ’12 options present an enticing long-term value.
The play: To take advantage of both normal upside implied volatility skew and the normal downside implied volatility skew.
Let’s do a risk reversal for a small debit to synthetically get Long BBY underlying:
a) Buy the Jan ‘12 33 calls for $2.33, buying approximately a 31.1% Implied Volatility.
b) Sell the Jan ’12 29 puts for $2.25, selling about a 32.5% Implied Volatility.
Net debit: $.08
Risk: You will be Long the stock under $29. Only a 7.6 % downward move in Best Buy over the next 6 months.
We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .
Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.
Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.