During current market conditions, with many macro-economic problems and equity markets up significantly over the last two years, many investors are looking for a more careful and conservative approach to making equity investments.
We would like to highlight an interesting investment opportunity using equity options which provides investors an attractive rate of return as well as a significant margin of safety.
Aéropostale, Inc. is a mall-based, specialty retailer of casual apparel and accessories, principally targeting 14 to 17 year-old young women and men through its Aéropostale® stores and 7 to 12 year-old kids through its P.S. from Aéropostale™ stores. The company provides customers with a focused selection of high-quality, active-oriented, fashion and fashion basic merchandise at compelling values. The company operated more than 900 stores across the United States and Canada.
Net sales for 2010 were $2,400 mil USD, net income was $231 mil USD, and FCF was $163 mil USD. Over the last four years, the company has generated about $650 mil USD in FCF or $163 mil USD per year on average, and repurchased $257 mil USD worth of common stock during 2010, which is comparable to a 14.7% yield.
The teen retailer has cut its profit outlook for the first quarter of $0.20 per share versus its previously issued guidance of $0.35-$0.38 per share, with company’s CEO mentioning that "…core customers continue to be pressured by challenging macroeconomic conditions, teen sector remaining intensely promotional, and Aéropostale being more promotional than anticipated in the current quarter..".
As a result the stock plunged 16.5% on May 5th to $21.3 per share from $25.49.
On a trailing basis the company now has a P/E ratio of 7.5, P/S ratio of 0.72, FCF ratio of 10.7 (4 year avg) and EV/EBITDA ratio of only 3.7 (one of the lowest in the industry). Based on a conservative assumption that profit and EBITDA for the year will be lower by the same percentage as Q1 profit (compared to previously announced outlook), or 42% lower, the company currently trades at a P/E ratio of 15 and EV/EBITDA ratio of 6.46.
If the investor wants to take advantage of this investment opportunity but leave himself a meaningful margin of safety, he might find the strategy of selling out-of-the-money put options attractive. For example, Jan 2012 $17.5 Put option can be sold for $1.10 providing a 6.3% return (or 8.86% on an annualized basis).
By selling a cash-secured (covered) put option investor essentially sells an insurance policy on a stock and agrees to buy Aeropostale at $17.5. In return for agreeing to do so, investor receives a profit in the form of the option's premium. In case ARO declines further, the effective purchase price will be $16.4, - thus providing investor with a margin of safety of about 23% (which is significant given that S&P 500 declined 40% during stock market crash of 2008).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.