Pairs trades, going long one company while shorting another, provide outstanding returns for those that can identify trends in an industry or in the broader economy.
To say a pairs trade is risky, is an understatement. Using the equity from a short sale to cover a long position on another can decimate accounts in a very short time. Being wrong on either end of the trade can be costly. Wrong on both, disastrous.
Just take a look at the charts for these two companies since 2006.
Since May 2006, Best Buy has fallen from $52.20 to $19.17 (-63.2%), while Amazon has risen from $35.19 to $212.89 (+505%)
A $5k pairs trade of short BBY / long AMZN put on six years ago would be worth over $32k. To say that this pairs trade has paid off, is quite the understatement.
The question is, has the time finally come to reverse the trade?
The Best of Times, The Worst of Times
In 2006, Best Buy was riding high. The dominant electronics retailer at the time, it was consistently expanding, gaining market share and making inroads against Circuit City, while expanding its offerings through Geek Squad on site services. Amazon was mainly considered a competitor for Barnes & Noble (BKS) and Borders, while continuing to shake off doubters from the dotcom bubble.
How times have changed. Circuit City and Borders are now defunct and many are now doomsaying the futures of Best Buy and other brick-and-mortar retailers. E-Commerce will conquer all in this brand new world and Best Buy will suffer the same fate as Circuit City in the coming years. That is certainly what the recent price action of the stocks would have us believe.
Time for a quick rundown on some basic metrics and compare the two companies to see whether the market is overreacting.
- May 25 Closing Price: $212.89
- TTM EPS: $1.22
- TTM PE: 175
- FY 2013 Estimated EPS: $2.50
- FY 2013 PE: 85
- 5 Year PEG Ratio: 5.99
- Cash per Share: $12.69
- Debt per Share: $0.00
- Revenue Growth: 33.80%
- Earnings Growth: -35.30%
- Price / Sales: 1.89
- Price / Book: 13.32
- Profit Margin: 1.09%
- Operating Margin: 1.42%
- May 25 Closing Price: $19.17
- TTM EPS: -$3.08
- TTM PE: N/A
- FY 2013 Estimated EPS: $3.76
- FY 2013 PE: 5.10
- 5 Year PEG Ratio: 0.94
- Cash per Share: $3.50
- Debt per Share: $6.46
- Revenue Growth: 3.40%
- Earnings Growth: -401.85%
- Price / Sales: 0.13
- Price / Book: 1.72
- Profit Margin: -2.43%
- Operating Margin: 4.64%
Okay, done with the number spam. Let's dive in. The first thing that pops out to me when looking at these numbers is the extreme premium that the market is placing on Amazon's earnings growth. For Amazon to have a 5 year PEG ratio over 5, the market is predicting an explosion in earnings in the near to medium term.
Ignore the fact that the AMZN EPS numbers we are seeing now are lower than the EPS we saw in 2004. Ignore the fact that AMZN EPS forecasts are being taken down 50-90% quarter after quarter to allow for minimal beats when earnings are actually announced. Ignore the fact that AMZN margins are declining quarter after quarter across the board.
To see earnings decline year after year, but the stock continue marching up - well, it's an amazing sight to behold.
The majority of the BBY earnings miss is due to a goodwill impairment that, while damaging in the short term, allows for potential future gains if the ship can be righted and the brand restored. On an earnings and margins basis, the market is placing an extreme premium on AMZN's results, while ignoring the still solid numbers coming out of BBY.
The Ole Switcheroo
Like all trades, the timing has to be right to initiate. For this pairs trade, the time is fast approaching for a quick reversal to Long BBY / Short AMZN. Why, you might ask? It's all about the taxes.
Currently, Best Buy is a showroom for Amazon. Purchases, especially large ticket purchases, are being made with the customer inspecting the item in a brick-and-mortar store like Best Buy and then making the final purchase on Amazon or other internet retailer to avoid state sales taxes.
With the average state sales tax around 5%, the savings on a $1,000 purchase is nothing to scoff at. Each year on Black Friday, we are treated to examples of the lengths customers will go to secure a savings.
Sadly for Amazon, two of its major markets, Texas and California, are going to be collecting state sales tax starting this year (TX in July, CA in September). In California, this means an automatic 7.25% price increase across the board for all residents. Texans get off easy at only 6.25%.
While many bulls shrug this off as a non-event, the impact to revenue growth should be significant once the customer's habits adjust to these effective price increases. Just to give you an idea of what percent of the US market this will impact, let's look at AMZN's current state sales tax situation:
- States AMZN currently pays Sales Tax in - KS, KY, ND, NY, WA - 11.0% of the US Market
- States with no Sales Tax - AL, DE, MT, NH, OR - 2.5% of the US Market
- States AMZN will start paying taxes in 2012 - CA, TX - 20.4% of the US Market
If current Amazon customers continue to go to the brick-and-mortar showroom to inspect their purchases, there will no longer be a price advantage for bringing their business to Amazon, which should benefit Best Buy and friends.
Also, without the huge price advantage, Best Buy, Wal-Mart (WMT) and the like will now have the opportunity to leverage their superior operating and profit margins to finally compete and undercut Amazon on sticker price.
At 1.42%, Amazon's operating margins are razor thin. There is simply no meat left on that bone. By comparison, Best Buy has a comparably healthy margin of 4.64%. Even if it went crazy and cut its margins to match, it would be able to maintain a 3% pricing advantage to Amazon. Alternatively, it could reduce margins by eliminating the other advantage Amazon has, and offer free shipping on all or total amount limited purchases. Its margins allow for flexibility, while Amazon's are stretched to their limit.
The removal of the pricing advantage that sales taxes provide Amazon should cause a slowdown in growth, while potentially boosting brick-and-mortar retailers. Since Amazon's stock performance is directly linked with top line growth, any slowdown could see an absolute collapse of the stock.
Timing the Trade
As with the short BBY / long AMZN trade, this should be a long-term winner. While timing the bubble bursting in AMZN has been a losing venture for a while, we now have a rough guess of when the winds may change.
If CA and TX start charging taxes in 2H2012, the top line impact will not start until 4Q2012 or 1Q2013. While I would lean towards 1Q2013 results, the change is early enough that AMZN might not be able to meet the high expectations that will be placed on it for the 2012 Holiday Season. Establishing a short AMZN / long BBY position prior to 4Q earnings could pay off nicely as BBY benefits from AMZN's weakness. Size it properly and you can try again with 1Q2013 results.
If you believe AMZN is a bubble and the reports of BBY's death are off base, when you enter the trade should be less important than your conviction. An additional bonus to this positioning is the dividend that BBY pays. At 3.34%, this should easily cover whatever interest charges you might incur on the borrowed AMZN shares.
While AMZN can always run higher and BBY lower, we may start seeing cracks form in the conventional wisdom of Best Buy to the morgue and Amazon to the moon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.