A protected covered call or collar search performed using PowerOptions tools, seeking to find the highest returning position for value companies with a maximum potential loss of 8% and a stock price in an uptrend, produced department store J.C. Penney (JCP), as shown below:
Click to enlarge.
Four of the top five spots belong to J.C. Penney with air transportation company US Airways (LCC) coming in at fourth place. The other four J.C. Penney positions have less maximum risk, but also have less potential return.
A protected covered call can be entered by selling a call option against a purchased or existing stock and using some of the proceeds from selling the call option to purchase a put option for protection. The protected covered call enables an investor to be in position to generate a potential return, yet remain protected in case the company's stock price takes a hit. The J.C. Penney protected covered call has a potential return of 3.5% (a whopping 106% annualized) and a maximum potential loss of 7.5%, so even if the price of J.C. Penney goes to zero, the maximum loss is 7.5% (at expiration).
The highest returning positions as shown above were found via sorting by the highest returning positions. Value companies were found by selecting to search for companies with a Price-to-Sales ratio (P/S) less than 1. Stock prices for companies in an up trend were found by selecting to include companies with a 100-day moving average greater than the 200-day moving average. The 8% maximum loss parameter was selected, as a loss of 8% or less can often be recovered fairly quickly using option income generating investment methods.
J.C. Penney's stock price appears to have gotten ahead of itself earlier in the year and has retreated back to its 200 day moving average as shown below:
A large part of the reason for J.C. Penney showing up as the highest returning covered call is its upcoming earnings call scheduled for Tuesday, May 15, 2012, as the implied volatility for the options of a company often increase near an earnings call. For the highest returning protected covered call shown above, the call option to sell is the 2012 May 34 at $1.63 and the put option to purchase is the 2012 May 30 at $0.49. A profit/loss graph for one contract of the protected covered position is shown below:
As a bonus, if the price of the stock is greater than the $34 strike price of the call option at expiration, the position will return 4.8% (146% annualized). For a stock price less than the $30 put option strike price, the value of the protected covered call remains unchanged (at expiration). And, if the price of the stock increases to around $37 the position can most likely be rolled in order to realize additional potential return.
It seems J.C. Penney has realized the average department store shopper is smarter than anyone thought, and this unexpected discovery could be about to save the company a whole lot of cash. Since a new 'Fair and Square' pricing plan was introduced in February 2012, discarding artificially-engineered discounts and not-quite-the-whole-dollar ticketing in favor of permanently lower prices and round dollar price tags, phone calls from customers have dropped by 30%. So J.C. Penney's Pittsburgh call center can close, shedding 300 employees to join a further 600 trimmed from its Plano, Texas, headquarters.
New CEO Ron Johnson, who honed his executive skills at Apple (AAPL) and Target (TGT), clearly intends to streamline the business. A targeted expense reduction of $900 million by 2013 includes $200 million in savings at corporate headquarters, $400 million in stores and $200 million in advertising expense.
Reinventing itself should come as second nature to the department store chain, following a number of transformations in its 110-year history. Beginning in the mining towns of the West, it expanded rapidly to reach its peak of over 2,000 stores plus a booming catalog operation in the 1970s, while the 1980s saw it undergo a makeover from mass merchandiser to fashion-oriented department store.
Now J.C. Penney has shed its print catalog in favor of a flourishing Internet business and incorporated beauty salons and optical, photography and decorating services into its apparel, jewelry and home furnishings-focused stores, while presenting a leaner profile of around 1,100 locations in 49 states and Puerto Rico. Home furnishings have declined slightly as a percentage of total sales in recent years while apparel has grown, producing a 2011 mix of 69% apparel and accessories, 15% home, 7% footwear, 4% jewelry and 5% services.
J.C. Penney's current strategy of transformation is based on what it calls 'the 6 Ps of retail': price, promotion, personality, product, presentation and place. The first three are already well under way with the new pricing model, themed promotional events each month and a new logo. A planned addition of more global brands will take care of the product aspect, while promotion and place will be the highlights of new-look stores centered on services areas in 'The Square', leading along 'The Street' to the store-within-a-store areas of 'The Shops'. J.C. Penney is trying to bring back the essential elements of the shopping experience its customers lost half a century ago, with an up-to-the-minute edge.
In common with all retailers, including competitors Nordstrom (JWN), Bloomingdale's and Macy's (M), Kohl's (KSS) and Sears (SHLD), J.C. Penney's business is highly seasonal. Its profitability largely depends on its promotional efforts to woo the consumer dollar in the final quarter of the calendar year. Recent times have seen ever greater competition for the dwindling amount of discretionary spending available, and the company must endeavor to meet and even anticipate the fickle tastes of consumers in order to avoid excess inventories and profit-lowering markdowns. Even adverse or unseasonable weather can have a significant impact on a retailer so dependent on apparel sales. Current economic conditions have caused the company to make a deliberate decision to delay the opening of some new stores, with an obvious effect on growth potential.
Merchandise is sourced both in the US and elsewhere, with buying and quality assurance inspection offices maintained in 15 foreign countries. There are 27 supply chain distribution centers, four of them dedicated to fulfilling online orders. During 2011 J.C. Penney completed its purchase of the global rights to the trademarks of the struggling fashion house Liz Claiborne (LIZ), making it the exclusive retailer for the brands involved. In addition, the company purchased a large parcel of stock in Martha Stewart Living Omnimedia (MSO) to back up the announced strategic alliance between the two organizations, which will result in Martha Stewart mini stores within J.C. Penney outlets in the near future.
Sales for FY 2011 were $17.3 billion and comparable store sales were flat. Revenue has been gradually decreasing for the past four years, except for a marginal recovery in 2010, and is now 13% lower than in 2007 although the number of stores operating is 7% higher. Gross margin fell to 36%, down from 39.2% in 2010. This considerable deterioration was caused, management says, by a soft selling environment, increased promotional expenses and the cost of the new pricing strategy.
Significant restructuring and management transition charges were incurred in 2011, so the company adjusts its GAAP operating loss of $2 million to a non-GAAP income from continuing operations of $207 million. A dividend of $0.80 per share has been declared for each of the last five years, but free cash flow dwindled to $23 million in 2011, down from $158 million in 2010 and $677 million in 2009. In February 2012 the company secured an increase of its revolving credit facility to $1.5 billion.
Michael Dastugue, the now-departed CFO, sought to emphasize the reduction in inventory and in S,G & A expenses during the Q4 2011 earnings call, taking the spotlight off the gross profit margin decline. Guidance for 2012 projects full year earnings of $0.59 per share, including $15 million of ongoing restructuring charges and $197 million of non-cash pension plan expense.
Since October 2011 J.C. Penney has gained a new CEO, president, COO, Chief Talent Officer, and, most recently, a new CFO, to add to its new logo and its aspiration for a new image. Q1 2012 results, due May 15, should give some early indications of all-important customer reactions to the new changes. A savvy investor can seek to take advantage of the increased implied volatility for J.C. Penney and enter the protected covered call mentioned above which provides positioning for potential return, yet provides protection in case bad news is released.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.