Shares of Tiffany & Co. (NYSE:TIF) opened sharply higher Tuesday after the company released third quarter earnings.
The New York luxury jeweler reported earnings of $0.76 per share, up more than 8% from last year's figures. Revenue also grew, coming in at $949.3 million versus $923.8 million last year. Both revenue and earnings were above Wall Street analysts' projections, which helps to explain why the stock jumped sharply on Tuesday morning.
Sales were particularly strong in Japan, rising 13% thanks in part to a strong Japanese yen. Since its trough in June of 2015, the value of the yen has steadily appreciated compared to the U.S. dollar. A stronger yen makes it more affordable for Japanese consumers to purchase Tiffany jewelry. Plus, when Japanese tourists visit U.S. Tiffany stores, their yen converts more favorably into U.S. dollars, giving them more purchasing power.
Unfortunately, this "strong yen" tailwind is the primary reason why shares of TIF now look vulnerable to a decline.
The Dollar Rally Will Curb Tiffany's Strength
During Tiffany's fiscal third quarter (which ended October 31), the yen was trading near a 52-week high versus the dollar. Put another way, the U.S. dollar was weak compared to the yen. But all of that changed in November.
Take a look at the chart below which shows the U.S. dollar versus the yen. Note that when the line slopes lower, the dollar is weak (and the yen is strong). Conversely, if the chart trends higher, the dollar is strong compared to the yen.
Notice that in November, the U.S. dollar moved sharply higher (primarily as a response to the presidential election). A stronger dollar reverses the currency tailwind that has greatly benefited Tiffany's profits. In fact, if the strong yen was largely responsible for TIF's earnings beat, a strong dollar could very easily create a TIF earnings miss next quarter.
Despite the earnings beat, CEO Frederic Cumenal sounded ominously cautious when quoted in the company's press release:
"We are encouraged by some early signs of improvement in sales trends, but we clearly need more positive data over time before this can be considered an inflection point."
A strengthening dollar is likely to provide an inflection point, but not the kind that Cumenal is speaking of. Following the stock's gap higher on Tuesday morning, shares of TIF traded steadily lower throughout the day. It seemed that investors were slowly realizing that Tiffany's yen-powered profits were not likely to enjoy the same level of growth in the fourth quarter.
A Limited Risk Income Play for TIF
Income investors can profit from stocks trading lower by using a bear call spread. This strategy allows us to collect an instant cash payment upfront, while strictly limiting the amount of risk taken on the trade. When I saw shares of TIF giving up early gains on Tuesday, and began to put the pieces together as to why the stock was heading lower, I decided to use this strategy. You can see the actual trade I executed in the table below.
By selling the TIF $81.50 call contract, I am agreeing to sell shares of TIF at $81.50. But only if the shares are trading above this level when the market closes on December 16.
On the other hand, by purchasing the TIF $83 call contract, I am purchasing the right to buy shares of TIF at $83. This way, if shares of TIF trade sharply higher, my risk is limited. I can simply buy shares at $83 and sell them at $81.50. So my risk is limited to $1.50 per share.
I received cash for selling the $81.50 call contracts. And I paid cash to buy the $83 call contracts. But I paid less cash for the contracts I bought than the cash I received from selling. Altogether, I received 50 cents per share for entering this trade.
(Remember, each contract represents 100 shares. So each unit gave me income of $50. And since I entered three units, I received $150 for the trade.)
I expect shares of TIF to trade lower. A strengthening dollar should crimp profit growth and lead to a disappointing third quarter. And as long as TIF remains below $81.50, I'll be able to close out this trade profitably.
As the U.S. dollar appreciates, your money may go farther when shopping at Tiffany & Co. But at this point, you're probably better off investing in the jewelry than buying the stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have set up a bear call spread for TIF using the metrics discussed in the article.